- Fiscal stimulus looks to be boosting the economy and corporate profits, for now.
- Higher interest rates could restrain the economy later this year.
- Rising rates may have made Treasury securities more attractive.
Viewpoints last spoke with Lisa Emsbo-Mattingly, Fidelity's director of asset allocation research, as the market was in the midst of a correction in February. We checked in with her again in early May to review the changes in the market and the economy since that time, and to ask where she thinks it's headed. Her key takeaway: The tax cuts that appear to be stimulating the economy now could eventually lead to higher interest rates, and that could hold back growth.
Q. We last spoke in early February. At that time, you were anticipating higher volatility after a remarkably stable 2017. How would you describe the market since then?
Emsbo-Mattingly: We've seen the increase in volatility that we expected, although it has subsided somewhat since the February peak. Meanwhile, the market corrected in early February and remains below its late-January peak. Greater volatility tends to have a negative impact on market returns: It causes some investors to think harder about the risk-reward balance of their investments, and some have more difficulty justifying extreme valuations. Interest rates rose too, which led to a double-whammy of resistance for stock prices.
Q. Talk of a trade war between the United States and China also has worried investors. What's your take on the direction of trade and its impact on the market?
Emsbo-Mattingly: For 25 years, the US economy has benefited from the expansion of global supply chains and the globalization of labor and capital markets. Corporate entities have been able to use these tools to increase their efficiency. Those trends have had a powerful deflationary effect. They also have been very positive for corporate profit margins, which are an important consideration for investors.
All the data we have indicates that this globalization trend has peaked and is slowly waning. The Brexit vote and the election of Donald Trump were landmark moments in that shift. But while the Trump administration talked about trade at times during its first year, it made no substantive trade policy changes.
Over the last couple of months, we've started to see the administration adopt more provoking trade rhetoric, with a sharper tone and apparent willingness to move toward greater protectionism. If this leads to more restrictive and costly trade policies, it would have negative implications for corporate profit margins and for inflation, so it could weaken the outlook for stocks to some extent.
Q. The other big market development in the first quarter was the drop in the software and social media stocks that had been one of the market leaders for years. What is your take on that shift, and what can investors learn from it?
Emsbo-Mattingly: My impression is that this part of the tech sector had been like the Wild West, and now many people are becoming more concerned about how their personal data is used. This shift in attitudes could lead to a headwind for some of these companies’ profitability because data monetization has been part of their strategies. Their stock declines served as a reminder of what can happen when you invest in a highly valued company with extremely strong growth prospects. Those are fantastic stories when you can find them, but even a small change in the profit outlook can lead to losses. When valuations are elevated, it’s even more important to keep an eye on the pace of earnings growth.
Q. Where does the economy stand now?
Emsbo-Mattingly: I think we could have what I'm calling a "boomerang year." We started the year with a big positive force from tax cuts and fiscal stimulus. They boosted the bottom line for the corporate sector and certain parts of the household sector. However, the stimulus is also contributing to a rise in interest rates, and higher interest rates could hold back the economy later in the year. So, the very same factor that is positive for the economy and the markets early in the year might lead to outcomes that are negative for the economy and markets later.
For example, the economy has been benefiting from strength in autos and housing. Now, rising rates mean that it's getting more expensive for people to buy their next house or to become first-time homebuyers or to replace an old car. On the margin, these are headwinds to the economy.
Higher interest rates also have an impact on corporate profitability. The US non-financial corporate sector has taken on quite a bit of debt over the last decade. As rates rise, that part of the economy is going to have to spend more time, effort, and money financing or servicing those debt burdens.
Q. What do you think the boomerang effect means for the overall economic outlook?
Emsbo-Mattingly: I first want to note that we're in an unprecedented situation for the US economy. To my knowledge, we've never seen such a large amount of fiscal stimulus when the economy is doing relatively well. So, we're in uncharted waters.
I like to think in terms of the business cycle, and to identify to the best of our ability where we are in it. The corporate profit, credit, and inventory cycles all feed into the overall business cycle, so we consider the state of each one. The inventory cycle looks fine. The credit cycle has been fine, but I think rising interest rates will create challenges for it. As for the third leg of the stool—corporate profits—the tax cut should be positive, for now. But a year from now companies will face some extremely difficult comparisons to this year; at the same time they’re likely to be contending with increased costs from a strong labor market and higher interest rates.
Overall, I think the global and US economies are still in expansion mode—there’s no sign of recession—but I think you'll see more headwinds in the latter part of 2018. The market probably is pricing in some of that possibility already.
Q. You were previously concerned about signs that China's economy was weakening. What is the state of China's economy now, and what does that mean for the rest of the world?
Emsbo-Mattingly: China's industrial side looks weak to me. That's being offset for now by China's household sector, which looks euphoric: Consumer confidence is through the roof, household borrowing is skyrocketing, and there's a lot of spending tied to asset wealth. I think there are a lot of parallels to the US in 2006 and 2007. As we all learned then, that kind of euphoric, credit-fueled spending works for a while, and then it doesn't. Meanwhile, tightening by the Federal Reserve has negative implications for China's economy. At some point, the business cycle in China will turn, and it could be painful.
China is a huge source of demand in the global economy, so weakness there would affect the rest of the world. I'm continuing to watch the situation very carefully.
Q. What does all this mean for investors?
Emsbo-Mattingly: I have been saying for quite a while that people should keep their portfolio allocations close to their long-term targets. I'm still saying that. All asset classes look fully valued, and there are too many cross currents in the global economy to have any confidence in a big bet.
That said, I think higher interest rates have made Treasury securities more attractive than they have been in a long time. For most of the last 10 years, Treasuries have been appealing mainly for protection against a financial crisis or stock downturn. Now, it has become easier to consider them as an investment in their own right.
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