While some economists are still fretting over the risk of a double-dip recession, Fidelity's director of economic analysis Lisa Emsbo-Mattingly is decidedly more optimistic. She argues that the recovery should continue at a faster pace than most expect, propelled by industrial production and capital spending, with some support from housing and the consumer. This should be good news for stocks, she argues, with the likely leaders being capital goods, semiconductors, transportation, and one that may surprise you—real estate investment trusts (REITs). But don't wait to invest in stocks until everyone agrees the economy is recovering, she warns: "By the time the kumbaya moment occurs, the strongest gains likely have been made."

Viewpoints caught up with Mattingly during a recent trip to London, where she briefed fund managers on the economy and the markets. Here are some excerpts from the conversation, plus some telling charts.

Q: Lisa, given your long experience as a market watcher, do you think investors are unusually skittish about stocks during this recovery?

A: I think it's very similar to the 2001 recovery. Many investors had been really hurt by the tech collapse, and they really couldn't accept the recovery. I remember showing people the capital goods sentiment chart, which was just going parabolic in 2003, yet no one could believe there would be global growth again.

The recession of 2008 to 2009 was the worst global downturn since the Great Depression, with a triple whammy of a financial crisis, global trade collapse, and job calamity. But I think we are now in recovery and I think the cyclical dynamics of this recovery are not significantly different from the dynamics of previous recoveries. You have to wean people off the double-dip scenario. Once that happens and the market has priced in a much better prognosis, the story's over. That's the kumbaya moment, when everyone agrees. By the time the kumbaya moment occurs, the strongest gains likely have been made.

Q: In light of recent mixed economic signals, what's your current take on the state of our economic recovery?

A: Over the last few months, we've had a lot of noise in the system. I'm not a big fan of talking about the weather. But the storms in January and especially February were dramatic. We were at extremely low levels of economic activity already. So the bad weather resulted in big disappointing moves in some key statistics, particularly housing. But if you take a step back, you'll see we have hit troughs in almost everything—income, housing starts, consumer confidence, industrial production, and gross domestic product. There are clear signs that the lows are intact, and the economy continues to recover. [See chart below.]

Q: What do you make of the sharp drop in new and existing home sales in December and January?

A: Housing was hit by a triple whammy. The first was the weather. The second was the homebuyer tax credit, which was set to expire in the fall. That deadline led to a big surge of sales, and then a big decline in December and January. Those months have been the absolute bottom of housing activity seasonally—the third effect that accentuated the downward shift in sales.

Q: How do you separate the noise from reality?

A: On the housing front, I like to look at homebuilder sentiment surveys, like ones from ISI and the National Association of Home Builders. Both troughed last year, and although the Home Builders index fell this month, I think both remain in a longer-term upward trend. Now you have the second installment of the homebuyer tax credit, so we may see another surge of activity. As a result, April may be good. The question is what happens in May and June.

Q: What are the keys to a sustainable recovery in housing?

A: There are three big ones. One is jobs. Are people getting jobs? Are people keeping jobs? I think that the leading indicators here are very good. Second is whether houses are affordable. Right now, affordability is excellent. But the third piece is access to credit, which continues to be the big sticking point. If you have a FICO score of 750 or more, you're very likely to have no trouble getting a mortgage. However, anyone with a lower score—which is much of the population—is still having trouble getting access.

Q: Do you see anything on the horizon that could improve credit availability?

A: Right now we have a stalemate. Many borrowers have been unable to get loans. While consumers' views of home buying have improved, they haven't translated into a concomitant rise in home buying. That problem resides with the lenders. Many lenders have been afraid to lend. But I think the latter is about to change for two reasons. One, the Fed, which has been the 800-pound gorilla in the mortgage market, is going to stop buying mortgage-backed securities at the end of March. While the Fed's involvement in the mortgage market has, I think, created very low rates, it also has increased private investors' uncertainty over what the true market clearing price has been in this market. Ironically, even though the Fed's exit will likely lead to incrementally higher mortgage rates, it may encourage the private sector to step in as uncertainty over true prices is resolved. The other key indicator that lenders will reengage in the mortgage market comes from the yield curve. Essentially, the steep yield curve (a large difference between long and short interest rates) signals that there are significant incentives for the financial sector to begin lending. Put more simply, with current mortgage rates in the vicinity of 5%, 10-year Treasuries at 3.6%, the LIBOR rate close to 0%, a queue of very high quality borrowers, and a job recovery, I think the willingness to lend will continue to improve.

Q: Are there any signs yet that the credit freeze is thawing?

A: Credit card offer mailings were up in January. Credit spreads and the Fed's senior loan officer survey are signaling a significant turn in sentiment toward providing new money into the system. The high-yield loan market and the investment-grade corporate loan market are seeing a strong rebound in new issuance. I think we're just beginning to see a turning point in the willingness to lend. This is really important for a sustainable recovery.

Q: What's your take on employment?

A: This is another situation where the winter storms created a lot of noise. But I think we are likely to see a pickup in hiring in March. In February, there was a 10-point jump in the Monster Index, which tracks job listings across the Internet. That's the biggest one-month jump ever, and a sign that we are beginning to see hiring recover. As I'm fond of saying, there are no blizzards on the Internet. So I think it is likely we'll get job growth. Will we get the 110,000 jobs or more a month that are needed to continue bringing the unemployment rate down? I believe so. [For more on Lisa's employment views, read The Case for a "Job-Full" Recovery.]

Q: Consumer spending has typically led economic rebounds. Will that pattern recur?

A: In this recovery, the consumer is in the backseat. Consumer sentiment surveys are still very low. One reason is that we've had a huge wealth-destruction event. Another is that wages and household income have been hammered. While incomes are now rising again, the pace is slow. For spending gains, we need income gains. So we will see spending continue to climb, but the gains are likely to be much slower than in previous recoveries. 
 
Q: If the consumer is in the backseat, who's the driver?

A: I'd say capital spending. Fourth-quarter profits from companies in the S&P 500^® Index have been absolutely spectacular. There are continuing signs that the strong profit recovery will run into 2010, though not at the rates we saw in 2009. Profits have historically been the best leading indicator for job growth and capital spending.

Another big rebound I see progressing is global trade [see the chart below]. The percentage of the 39 largest economies that saw their leading indicators improve on a six-month basis hit 100%. That's a 100% improvement from the levels we saw at the depths of the crisis a year ago. So I think the drivers will be capital spending and global trade. And I actually think housing will also be a contributor, as will the consumer, particularly when it comes to auto sales.

Q: Why are you bullish on auto sales?

A: Over the last 10 years, on average, just under 12% of the working population bought a new vehicle every year. Currently, only 8% are buying cars. If every year 9% to 10% of the working population buys a new car, that implies sales of 13 million to 14 million units a year. In February, annualized sales were 10.3 million, which is horrifically low. That's what we were running during the 1982 recession. Since then our employed population has grown by more than 50 million. If 11 million to 12 million in sales is the new normal, as the consensus expects, that's very scary. I just think it's overly pessimistic.

Q: Are your concerned about a resurgence of inflation?

A: With bank lending continuing to decline (despite loan officers' improved willingness to lend), the money supply running barely above a zero percentage rate over the last three months, and wage expectations close to zero, I think that the fear should be tilted more toward deflation than inflation. We've had a massive destruction of the total wealth of the country and a horrible decline in economic activity and jobs. This will break any type of robust recovery in pricing power.
 
Q: Are you worried about mounting federal deficits?

A: The numbers can be very upsetting. Over the long term, we must deal with the massive mismatch between revenues and spending. Greece and Japan are cautionary tales of the cost of an out-of-control fiscal policy. But in the short term, all that spending has been an important stabilizer.

Q: What are the major takeaways for investors?

A: I think equities are still extremely compelling. Using what I consider somewhat conservative valuation measures, my price/earnings ratio for the stock market is around 15 or 16. This, coupled with what I think will be a continued—albeit slower—improvement in corporate earnings, should translate into continued upside for equities. I'm less excited about Treasuries. I think they are pricing in a very low-growth scenario. I'm also becoming more cautious on investment-grade and high-yield credits; the spreads are much less compelling than a year ago. Over the coming year, I think growth is likely to be higher than the consensus expects. So I'd favor equities over all other asset classes at this point.

Q: Within the equity markets, where do you see the best opportunities?

A: I like parts of the market that do well as the economy moves from recovery to full expansion, including capital goods, Real Estate Investment Trusts (REITs), and transportation. That said, I still think there's value in some of the early recovery plays. I still like some early cyclicals like semiconductors, consumer durables, and auto companies. Even though the snapback has already been spectacular, I think the potential earnings in some of these sectors is still extremely high. Assuming the economy continues to recover—as I expect—I would avoid most defensive sectors such as consumer staples and utilities. And as this cycle progresses, it may be worth starting to look at health care.

Q: What are the risks to your still bullish scenario?

A: By September, it could be a very different environment. I think slow inflation coupled with gains in corporate profitability, employment, and GDP will be priced into stocks within the next half-year or so. We may have to revisit my optimistic view when that happens.

The information presented above reflects the opinions of Lisa Emsbo-Mattingly, the director of economic analysis for Fidelity's Global Asset Allocation team, as of March 23, 2010. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based upon market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.

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