A Tough Spring Ahead for Stocks?

Last week, we got a slew of new evidence that the U.S. economy has decelerated in recent months from last fall’s strong growth.

Fourth-quarter GDP growth and personal consumption were revised down, and durable goods orders fell for a second consecutive month for the first time since 2011. Meanwhile, a key leading indicatorthe Chicago Fed National Activity Index (CFNAI)fell to a six-month low, suggesting a further slowdown in U.S. economic growth.

Yet last week, U.S. stocks rallied into record territory, equity market valuations climbed, credit spreads tightened and volatility returned to low levels not seen since January.

Why the disconnect between market performance and economic reports? As I write in my new weekly commentary, investors seem to be ignoring the negative economic news and remaining optimistic that the Fed will keep policy accommodative and that the economy will rebound once the weather improves.

In other words, if we needed any more evidence that many economists and investors alike are blaming the weather for recent weak economic numbers, we got it last week.

However, as I wrote last week, while weather is certainly responsible for at least some of the recent economic slowdown, there are other factors to blame, including the still soft job market and a long-term trend of slow income growth.

To be sure, it’s not as if the economy is falling off a cliff; rather, it’s simply growing more slowly than many had hoped. Yet despite the weakness, equity market valuations have been climbing. U.S. large caps are now trading at more than 17x trailing earnings, close to the multi-year high recorded late last year.

Meanwhile, beyond stocks, spreads on U.S. high yield bonds have tightened considerably, meaning investors are willing to accept ever smaller yield premiums for the additional risk of holding high yield debt. In short, for now, investors seem to be making an implicit bet that the spate of weak data will be temporary and that the economy will resume its acceleration when the spring thaw hits.

While this may be a reasonable bet, if the economic data doesn’t start to improve in coming months or if the geopolitical situation worsens, stocks and other risky assets may become more vulnerable and face a tough spring ahead.

Source: Bloomberg, BlackRock research

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