Persistent cold and inclement weather across much of the U.S. continued to have a depressing effect on economic activity, particularly in housing and some areas of consumer spending. A build-up of inventories in some sectors—a trend that began in the fourth quarter of 2013—may create a larger-than-expected headwind in the months to come. Nevertheless, these developments are unlikely to disrupt the economy’s ongoing slow, mid-cycle expansion.
The following is a more detailed look at developments in major areas of the economy.
Consumption: slower, but still positive
The outlook for consumption remains constructive, despite softer spending data recently. In a sign of the weather’s impact, more weather-sensitive sales (of products such as automobiles, furniture, and appliances) fell sharply while other areas were less affected.1 Furthermore, most measures of consumer confidence have held up reasonably well, overcoming negative headwinds that include not just the weather but also reduced availability of food stamps and unemployment benefits.
Pent-up demand may boost discretionary consumption in the next few months, although residual weather effects such as higher utility bills may dampen any upswing. The consumer outlook remains supported by low household debt-service payments (due to low interest rates),2 a positive wealth effect (due to higher home and stock prices), and improving labor markets. Low inflationary pressures and a favorable employment trend provide a positive outlook for real wage growth, suggesting that the recent slowdown in consumer activity may be short lived.
Employment: slowly improving
Labor market activity has softened recently, but leading indicators have held up well. Over the past three months, payroll gains averaged 129,000 jobs monthly (compared to nearly 200,000 during 2013),3 and average weekly hours worked declined. However, the drops were most pronounced in the weather-sensitive construction and retailing industries, while nearly 60% of industries added to headcount in February, and the household survey data showed strong job gains over the past three months.4
The labor market is likely to maintain positive steady momentum going forward, as most leading indicators are trending positively and near their best post-recession levels. Initial jobless claims fell to their lowest level since November, and more small businesses plan to increase rather than decrease payrolls.5 Consumer perception of employment opportunities continues to improve (see chart, right), and job quits (a sign of optimism about the job market) are near their cycle highs.6 The underlying trend of employment remains one of slow improvement.
Housing: slower but continued expansion
The housing market has downshifted to a more mature expansion following a rapid recovery during the past two years. Weather has negatively affected recent data, with housing starts experiencing their first year-over-year decline since August 2011, but with new building permits (a more forward-looking indicator) showing the highest year-over-year increase in three months.7 However, recent slower activity across the warmer southern and western parts of the country may reflect a market that is still digesting last year’s large increases in home prices and mortgage rates.
A positive outlook remains supported by low levels of inventories, high affordability, and tightening labor markets which typically boost housing demand. Despite a recent softening in activity, favorable supply-demand dynamics should bolster a slower but continued housing expansion.
Corporate: still solid
The U.S. corporate sector remains healthy, with robust balance sheets and solid profitability. Business confidence increased in the first quarter to its highest level since early 2012,8 as CEOs anticipate further expansion in sales, capital spending, and employment over the next six months.9 Demand for industrial equipment rebounded in February, indicating the backdrop for corporate capital expenditures remains solid.10
The overall trend of the manufacturing sector remains positive though slower than in 2013, due to both weather and non-weather factors. The U.S. manufacturing Purchasing Managers’ Index® (PMI®) ticked up slightly in February to 53.2, with new order growth outpacing inventory growth, suggesting a positive outlook.11
However, the inventory-to-sales ratio for all businesses spiked in January—the largest jump since mid-2012—affecting mainly retailers and wholesalers.12 Inventory build-up in the auto manufacturing sector in particular, where the inventory-to-sales ratio has risen to its highest post-recession level (see chart, above), may be a concern. Although higher inventory levels may restrain future manufacturing production, the corporate sector remains solid.
Inflation in the U.S. remains muted. Both headline and core consumer prices were little changed from January to February,13 though headline inflation may rise in the coming months following higher agricultural and natural gas prices due to weather effects. Weather-related commodity inflation may rise in the near term, but overall inflation pressures remain modest.
Credit markets and banking: supportive backdrop
Healthy credit conditions remain supportive of ongoing economic growth. Bank loans to commercial and industrial (C&I) enterprises experienced their highest three-month growth rate since before the 2008 recession, and consumer loan growth remained positive.14 Banks have eased credit standards, as C&I loan delinquencies and charge-offs have fallen to pre-recession levels.15
Loan demand and corporate bond issuance has continued to be strong, as interest rates have fallen from their fourth-quarter highs and credit spreads remained near cycle lows. The monthly $10-billion tapering of quantitative easing by the Federal Reserve (Fed) has not materially affected domestic credit markets. The environment of low inflation amid accommodative monetary policy provides a supportive backdrop for the credit markets.
Global: broadly positive, but rising risks
The global economy continues to expand, with leading economic indicators (LEIs) rising in approximately 80% of the world’s largest economies over the past six months.16 The divergence between developed and emerging markets persists. All developed markets have had positive LEIs over this period, and manufacturing PMIs are now rising in 90% of developed Europe, the highest percentage since early 2011.17 In contrast, just 60% of emerging-market countries have positive LEIs over the past six months (see chart, right), with roughly two-thirds of those within Europe, highlighting the relative weakness of emerging economies in Asia and Latin America.18
Risks in Asia continue to rise. In China, reports of loan defaults hint at growing stress within the financial system, although interbank rates have come down recently. China continues to struggle to balance the competing objectives of tamping down excessive credit growth, preventing financial instability, and maintaining a fast pace of economic growth (see Fidelity Viewpoints - Keep an eye on China’s economy Jan. 2014).
Meanwhile, Japan’s looming consumption-tax hike in April represents a key risk, as negative real wage growth19 has prevented the Japanese consumer from finding a stable footing during the current expansion. Consumer planned expenditures on durable goods have declined sharply in anticipation of the tax increase, a similar downturn in sentiment to one that preceded Japan’s last consumption tax hike in 1997 and the ensuing steep dive in consumer spending (see chart, below).
Commodity prices have been mixed against this backdrop of shifting global growth drivers and evolving areas of potential risk. As China’s demand has slowed, prices for industrial metals (such as copper and iron ore) have waned.20 However, harsh weather in the U.S. and Brazil has led to a recent surge in prices for U.S. natural gas, hogs, coffee, and other agricultural commodities.21 Heightened political uncertainty surrounding Russia and Ukraine has contributed to sizable price increases in wheat and gold, and a higher risk premium in oil prices.22
Overall, the commodity disinflation trend is likely to continue amid lackluster emerging-market demand, but supply risks in specific energy and agricultural goods may keep some prices higher in the coming months. The trend in global growth remains broadly positive, but risks to the outlook are rising.
Outlook: supportive for stocks, but volatility ahead
Despite weaker-than-expected data over the past two months, the underlying trend of the U.S. economy remains a slow, midcycle expansion. Harsh winter weather has probably been the major culprit behind the recent slowdown in activity, but residual effects and other factors may dampen the prospects for a rapid acceleration. Consumers are expected to face higher food and utility prices in the months ahead, and manufacturers are likely to encounter elevated inventory levels. Nevertheless, the business cycle in the U.S. remains relatively benign.
The global environment, particularly rising risks in Asia, continues to present a number of potential catalysts for greater market volatility. April’s consumption-tax hike in Japan will severely test its cyclical momentum, with the potential to spread a negative demand shock throughout Asia and incite volatility in global currency markets. China’s attempt to balance reining in credit excesses with maintaining a fast pace of growth carries inherent risks of either hindering expansion or fostering financial instability over time.
Alongside these country-specific risks, general risks to economic growth in developing economies arise from the Fed’s tapering of quantitative easing. Moreover, heightened political risks across many emerging markets—most notably in Ukraine—are unlikely to dissipate soon.
From an asset-allocation perspective, the business-cycle backdrop continues to favor developed countries with better cyclical dynamics and steadier outlooks, including the U.S. and Europe. While the equity bull market in the U.S. has posted impressive returns over the past five years, valuations are not extreme, and the cyclical environment remains supportive for stocks (see “The five-year bull market,” below). On a tactical, near-term basis, rising risks in Asia may increase the potential for greater market volatility, which enhances the benefits of high-quality bonds within a diversified portfolio.
The five-year bull market: looking backward and forward
On March 9, 2014, the S&P 500 Index reached the fifth year of the bull market, rising a cumulative 178% since it bottomed during the global financial crisis (see chart, right). This is an important milestone: Of the 13 bull markets since 1928, only four have made it to their fifth anniversary, and only two went on beyond a sixth. The combined length and strength of the current bull market places it in the top five bull markets by both duration and cumulative performance—causing trepidation in some investors who worry the market might be nearing its peak.
However, it is important to put the current bull market into context. Although today’s bull market has been strong, it follows the third-worst bear market: a drop of 57%, compared to the bear-market average of 37%. It also took much longer for this bull market to return to the previous peak: more than four years, compared to a two-year average (and four-year lifespan) for all bull markets. On a round-trip basis (i.e., measuring performance since the previous bull market peak), the current market is 20% above its peak in 2007—slightly higher than the median round-trip return (though lower than the average). However, the bull markets that survived beyond their five-year anniversaries went on to post much higher returns.
Although historical averages may provide some context, we believe that the economic backdrop—as understood through our business cycle approach—offers much better clues about the outlook for stocks in the near term. Historically, different business cycle phases have tied closely to market returns (e.g., the early-and mid-cycle phases have shown the strongest economic growth and strongest market performance). Since the market peak in 2007, the U.S. economy suffered through a deep recession and has grown at a much slower rate than usual. Real GDP is now only 7% above its previous peak, while in previous bull-bear roundtrip cycles, the U.S. economy has ended an average of 24% higher.
The slow pace of expansion is probably prolonging the current business cycle. Some early-cycle sectors such as housing and financials took a long time to build momentum, and now provide more of an economic tailwind than usual at this mid-cycle stage. With the economy firmly in mid-cycle expansion and very few signs of late-cycle pressures, our outlook is for this business cycle to be unusually prolonged. If so, the U.S. economy’s fundamental support for the stock market may outlast historical averages.
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