Russ discusses why stocks can still thrive when consumers are confident, but frugal.

As the Queen in Alice in Wonderland famously observed, “I’ve believed as many as six impossible things before breakfast.” In that spirit, investors can be forgiven for being confused by this week’s economic data: U.S. consumers have rarely been this optimistic, and they are celebrating by spending less.

On Friday, the University of Michigan released their preliminary reading for March’s consumer sentiment. The indicator rose to 102, the highest reading in 14 years. But earlier in the week, investors received a somewhat different message:

Retail sales fell in February. In fact, February did not represent a single bad month; on a year-over-year basis retail sales have been decelerating since late 2017.

Which raises the question: How to reconcile an American consumer who is both ebullient and frugal?

1. Inflation is ticking higher, wages less so.

Inflation has been firming and it is likely to continue to do so. Based on work by the BlackRock Investment Institute, core inflation is set to accelerate in the coming months. The evidence is more mixed on wages. After a surge in January, average hourly wages decelerated in February. At 2.6%, hourly wages are growing at around the same pace they’ve been at since mid-2016. Without an acceleration in wages, higher inflation simply cuts into consumer purchasing power.

2. Consumers came into 2018 stretched.

Late last year, the household savings rate fell to 2.5%, close to the lows witnessed in 2005. At the same time, consumers are borrowing more, particularly with credit cards. With many households increasingly reliant on debt and a lower savings rate, some families may need to bank the incremental income from the recent tax cut.

3. Not everyone enjoyed a tax cut.

While marginal tax rates were cut, so were deductions, specifically for state and local taxes. This means that many higher earners in high tax states are actually contending with higher effective tax rates.

Interestingly, for investors optimism may eclipse behavior. As many investors know, although an extreme lack of growth is generally associated with weak markets, outside of recessions there is a very weak relationship between stock market performance and economic growth. This is true whether you’re looking at overall growth or more focused on just the household part of the economy.

However, during the past 40 years there has been a significant and positiverelationship between consumer confidence and equity multiples. In other words, the S&P 500 Index tends to trade at a higher multiple when consumer confidence is high. One explanation is that consumer optimism indicates a greater willingness to take risk and own equities. The takeaway: In a period of heightened valuations, an optimistic consumer may be more important for the stock market than a spendthrift one.

Russ Koesterich, CFA, is Portfolio Manager for BlackRock’s Global Allocation team and is a regular contributor to The Blog.

Investing involves risks, including possible loss of principal.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of March 2018 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader. Past performance is no guarantee of future results. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

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