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Economic check-in: What to watch in 2014

From one of our experts: Fed taper, uncertainty overseas may trigger increased volatility.

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After the dramatic stock market gains in 2013, volatility is expected to increase in the opening months of 2014, says Lisa Emsbo-Mattingly, director of asset allocation research at Fidelity. Why? The Federal Reserve will begin to taper its program of quantitative easing. At the same time, the market may be whipsawed by uncertainty overseas, with the largest Asian economies facing potential risks ahead. But the good news, says Emsbo-Mattingly, is that the U.S. economy is still expanding, slowly but steadily.

The Fed will begin tapering its bond-buying program this month. What might that mean for the markets in 2014?

Emsbo-Mattingly: The start of Fed tapering is counterbalanced with a higher commitment to “forward guidance,” and confirmation from the Fed that short rates will stay lower for longer. Although the market has anticipated these moves to some degree, and interest rates have backed up, we’re not complacent. We’ve learned time and again that even though a Fed move may have been priced into the market, this doesn’t necessarily ensure that we avoid volatility when the Fed does take that first step. But the business cycle is in a solid expansion and the markets will likely reflect this benign economic and earnings environment over the coming year, so the Fed taper shouldn’t derail the U.S. economic expansion. Also, the bond markets have already priced in a Fed “taper”—but it may still create volatility and some distress in more liquidity-dependent markets (for example, in emerging markets).

How is the economy shaping up for early 2014?

Emsbo-Mattingly: The employment data has come in stronger than expected. Every year for the last three years, we’ve created basically two million jobs. We’re way below trend, but it’s going in the right direction. So, on the margin, things are improving every year, with employment rising 1.7% per year for the last couple of years.

If we take just hourly earnings, hours worked, and total people employed, we’ve had a 4% nominal increase in wages. Now, not everyone is experiencing those gains. In fact, a recent survey from the University of Michigan found expectations for only a 0.7% increase in median income in the coming year. Before the recession, that was in the 2.0%–2.5% range. So, there is some disconnect between the overall wage number and what people are feeling, which might translate into some caution.

That said, corporate profits are up 5.5% year over year. If you take into account a willingness among corporations to take on debt, capital spending will continue. So those two factors—wages and corporate profits—are a plus. Add in willingness for banks to lend and you have a solid foundation for economic expansion.

How do overseas economies fit into this picture?

About the expert

Global economic checkup: U.S., Europe, China, and Japan
Lisa Emsbo-Mattingly leads the asset allocation research team in conducting economic, fundamental, and quantitative research to develop dynamic asset allocation recommendations.

Emsbo-Mattingly: Europe continues its early cycle recovery. All three legs of the business cycle are kicking in, helping to create a positive trend, after big declines. Profitability is rising, the inventory cycle is improving, and the credit cycle is starting to turn. So that’s good news for Europe. And don’t forget: The European economy is actually larger than the U.S. economy. And if there is any incremental positive demand, quite a few cyclical industries in Europe could turn profitable this coming year. That’s a very important catalyst for the willingness to hire new workers and make additional capital expenditures.

So Europe is on the rebound. What about Japan or China?

Emsbo-Mattingly: Japan is already in the mid-cycle stage of recovery. It definitely is seeing very strong positive demand, due to a combination of its weak yen policy and strong fiscal stimulus policy.

But the fundamental drivers of the business cycle—credit availability, profit growth, and inventories—all look weak in Japan. So I am concerned that the recovery is less solid than what we’ve seen, for example, from Europe. As 2014 unfolds, I’m also wondering whether the extraordinary policy accommodation—both monetary and fiscal—is sustainable.

Another worrisome factor: In April, Japan is going to have the first consumption tax hike since 1997. So these uncertainties out of Japan may also create another catalyst for volatility in the markets.

Does China look in better shape?

Emsbo-Mattingly: The punch line on China is that it’s reaccelerating. Fixed asset investment is reaccelerating, driven primarily by a resurgence in infrastructure and property spending—the same factors that have driven growth in the past.

But unlike Europe and the U.S., where you’ve got those three solid legs of the stool—profitability, inventories, and credit—in China, it’s a very disjointed credit cycle with lots of conflicting signals. The profit cycle is basically nonexistent, and exporters are showing evidence of financial fragility, as are many exporters in other parts of Asia. China’s current accounts surplus has declined substantially, along with many export-oriented Asian countries. Those economies are going to be much more at risk for volatility than the countries that have spent the last five years rebuilding stability, like the U.S.

Those headwinds for export-oriented Asian economies mean that emerging markets as a whole may face greater volatility. While volatility is never good for economic growth, I do not think that it translates into an ending of the U.S. expansion.

So what does this all mean for investors?

Concerned about volatility? Read these Viewpoints.

I don’t think that the fixed-income market is as vulnerable as it was, say, in April of 2013, when bond prices started to fall. I think the market has priced in a lot of what is going on right now.

As for stocks, we don’t expect a market collapse, but we could be in for a bout of volatility. The buoyant market returns of 2013 capped a five-year bull market. And it has been quite some time since we saw a pullback of 5% or 10%. I wouldn’t be surprised if we get a little wake-up call reminding us that the market doesn’t go up every single day.

That said, we finally got a U.S. budget deal. Although the deal may be modest, it seemed necessary to change the tone a bit. And if you could just finally turn off the bad news out of Washington, it could be extremely positive for the markets.

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The information presented above reflects the opinions of Lisa Emsbo-Mattingly as of January 3, 2014. 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 on 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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