Do people have unrealistic expectations about the strength of the economy? And does it pose a risk to the stock market?
Market watchers have been asking because something strange is happening in the world of economic data. At issue is major months-long split between "soft" and “hard” measures of the economy that has people wondering if the public’s “animal spirits” have gotten too far ahead of realty.
So, what’s going on here?
In this context, “soft data” refers to survey-based economic indicators such as consumer confidence readings and business surveys, while “hard data” covers things like actual economic growth, retail sales, capital expenditures, and industrial production.
The two kinds of data work together to give us a more holistic picture of the economy. If people and businesses start to grow more confident about growth, we might expect them to splash out a little more by shopping or investing for the future. That can be a positive signal about where the hard data might be headed, as all that extra spending should eventually show up as actual growth. Improving hard data might be expected to make people feel more confident in turn, creating a virtuous cycle that can help drive growth—and give the stock market a boost.
However, this doesn’t always mean the two kinds of data move in tandem.
In recent months, the soft data has been running strong—possibly too strong. The Conference Board’s Consumer Confidence Index is at its highest level since late 2000, the Business Roundtable’s first quarter CEO Economic Outlook Index posted its sharpest jump since late 2009 and the National Federation of Independent Business' Small Business Optimism Index also remains near its highest level in more than a decade.
Some of this likely comes from expectations for potential tax cuts, regulatory reforms and increased fiscal spending following the election in November of President Donald Trump. Improving economic growth prospects both at home and overseas that pre-date the election may also have played a part.
The trouble is that although the economy seems to be ticking along, it hasn’t improved to anywhere near the level you might expect from the survey data. Job growth has been improving over the past year and wages are slowly moving up, which could be good for consumer spending, but overall economic growth has been moderate at best. Recent auto sales and bank lending data have also looked sluggish, and the Federal Reserve Bank of Atlanta has lowered its hard-data-focused GDPNow forecast for first quarter economic growth to just 0.5%.
And the Federal Reserve Board noted in its March minutes that while many businesses remain upbeat about the future, they are still holding back from making longer-term investments until they have a clearer picture of the government’s policy plans.
Stock market moves
The divide between sentiment and reality raises the question of what will happen if the hard data fails to live up to people’s expectations. It’s unlikely that consumers and businesses would maintain their enthusiasm indefinitely, without some fresh reason to cheer on the economy.
This matters for the stock market, too. While sentiment can help drive stocks higher, lasting gains in the market require the kind of economic improvements that drive gains in companies’ bottom lines.
“Historically, wide spreads between soft and hard data tend to narrow in both directions. According to Bespoke Investment Group, when soft data outperforms, hard data usually plays catch up in the following three and six months, while soft data almost always declines. We expect that pattern in this cycle, too,” says Liz Ann Sonders, chief investment strategist for Charles Schwab & Co. “With regards to the stock market, average and median returns have been skewed to the positive over these time frames as well.”
“It’s hard to get too enthusiastic for a major lift in economic growth any time soon,” she says. “The hard data is likely to play a little catchup, but curb your enthusiasm for a more meaningful acceleration.”
Of course, this doesn’t mean you should consider pulling out of the market until the data starts to improve. Timing the market is nearly impossible, and stocks still tend to be the best option for generating long-term returns.
Rather, it’s important to make sure your investment portfolio is structured to match your timeframe and risk tolerance so that you can continue working toward your goals without having to worry too much about potential bouts of short-term volatility.