Waiting for the Economy to Catch up with Sentiment

The surge of optimism among households and businesses still isn’t reflected in the economy, other than stock prices and the labor market. To put it another way, consumer and business optimism increased since October, but behavior hasn’t changed.

The NFIB Small Business Optimism Index recently surged to its highest level since December 2004. Consumer Confidence, as measured by The Conference Board, soared and is at its highest level since the financial crisis. Consumer Sentiment, as measured by the University of Michigan, is just below its highest levels since the financial crisis and much higher than in late 2016. Surveys by the Federal Reserve regional banks and the Institute for Supply Management also reveal rising optimism and expectations.

Yet, retail sales growth hasn’t changed much, and capital investments by businesses have increased only a little. Most other economic measures show little or no change in recent months. Economic growth probably increased in the first quarter, but that’s not saying much since the fourth quarter of 2016 was disappointing.

There are a lot of conflicting pressures in the U.S. economy that explain the apparent paradox.

The economy has achieved a sustainable level of growth, but there are headwinds that might keep growth from accelerating. The Fed is tightening. Inflation is rising and that could make the Fed tighten more. The housing market still is healthy, but it’s not as strong as it was in early 2016. Wages are rising, which is good for households but reduces business profit margins.

Productivity has been low the past few years and is well below the post-World War II average. Higher productivity has been a major force supporting higher economic growth and higher business profit margins. The stall in productivity is likely to be reversed only with more capital investment by businesses, and they’ve been reluctant to do that.

Adding to the uncertainty and conflicts is the range of policies proposed by the new administration. Reduced regulation, major tax reform and other changes would increase growth. But it will take time to implement the policies and more time for them to affect the economy. Also, it’s not a certainty the policies, as proposed, will be enacted. Another source of uncertainty is that other proposals, such as trade and immigration restrictions, are likely to reduce growth.

While all of this is happening in the United States, growing strength overseas is escaping the attention of most investors.

Exports improved in many of the recent data reports, and there are other data indicating that foreign demand quietly increased and is at its strongest level since the European financial crisis of 2011.

The improvements are broad-based. Growth is higher in Europe, Latin America, Japan and much of Asia. China appears to have righted itself after the troubles of 2015 and 2016.

To be sure, none of these countries and regions is in a boom. Each also has problems to contend with and could slide at any time. But many investors are focused on the problems and the poor performance of the last few years. The result is that expectations and market values are quite low. Investments outside the United States are cheaper than the richly valued U.S. markets, and they have much greater potential for improvement and gains.

I’ve said in recent months that the range of possible economic and investment outcomes is higher now than in some time. Investors should welcome some uncertainty, unpredictability and volatility. Those forces make it possible to earn above-average investment gains by taking advantage of the market opportunities others don’t see.

But for many investments, the potential returns in best-case scenarios are far lower than the potential losses from negative scenarios. We’re looking at asymmetric potential returns.

That’s why we’re not making big allocations to any particular asset or in favor of a likely economic scenario. The strong convictions I have are that interest rates and inflation are likely to rise over the coming year, so we’ve minimized our exposure to interest-rate-sensitive investments.

Other than that, we’re staying well diversified and balanced. We always favor investments with margins of safety, but that’s more important than usual. The margin of safety needs to be coupled with balance and diversification to increase the potential for solid returns while minimizing the risk of large losses