With the global growth trend continuing a gradual upturn, the near-term risk of recession has subsided in most of the world’s major economies. Japan has shown the most dramatic improvement, and its dynamic early-cycle recovery has added some momentum to the global economic environment.
The outlook for recession in the other economies includes a relatively low probability in the U.S. and China, while modest declines in Germany’s risk may indicate an impending emergence from recessionary conditions (see Recession risk scorecard, below).
Recent trends in the world's largest economies
The U.S. economy remains firmly in the mid-cycle expansion phase of the business cycle. Recent data releases have been weaker than expected, in part due to a number of statistical and timing distortions, so the underlying trend of activity could actually be steadier than it appears. Consumer data have softened as the fiscal drag from payroll tax increases and sequestration spending cuts may be having a greater impact. Retail sales fell 0.4% in March, and consumer sentiment in the University of Michigan’s preliminary April survey dropped to a low since last July.1 Part of the softening may be a reversion after better-than-expected consumer activity earlier this year.
Employment and income data have also bounced around, yet appear to be progressing at a slow pace. Private payrolls increased by a surprisingly low 95,000 in March, although upward revisions to January and February brought the three-month average to around 171,000—similar to such averages over the past three years.2 Personal incomes have predictably dropped after surging in late 2012 as bonuses and dividend payments were accelerated in advance of scheduled tax-rate changes.3 Leading indicators showed job openings rising to post-recession highs, unemployment claims falling near post-recession lows, and more small businesses raising worker compensation and planning further increases.4
Moreover, other sectors of the economy are improving. Banks continue to ease lending standards, the Federal Reserve has maintained its extraordinarily accommodative policies, and overall financial conditions remain supportive. Sales have slowed and profit margins may have peaked, but corporate balance sheets are strong, and solid capital spending indicates that businesses appear increasingly willing to invest. Improvement in the housing sector has provided a boost to the economy, with home prices up 8% from last year and housing starts up nearly 47%—the fastest rate since the early 1990s.5 In March, consumer prices rose just 1.5% year-over-year as falling gasoline prices helped keep inflationary pressures modest.6 Core consumer prices gained 1.9%, and inflation expectations—implied by consumer surveys and the breakeven rates for Treasury Inflation-Protected Securities—have remained well contained.7 Fiscal austerity is creating a headwind, but the underlying trend remains a slowly improving U.S. economy.
As the Japanese economy benefits from the tone and impact of new policies and plans outlined by Prime Minister Shinzo Abe’s government, early-cycle dynamics are becoming more firmly entrenched. Export activity has increased on the back of a significantly cheaper yen—down 20% on a real trade-weighted basis since July 2012 (see chart on left below). Confidence has risen dramatically in the consumer and corporate sectors. Meanwhile, the stock market is booming; the Nikkei has jumped 30% in local currency year-to-date.8 Purchasing managers’ indices (PMIs) have followed suit, with March services at 54 and manufacturing above 50 for the first time since early 2012.9 The inventory cycle has turned sharply positive as new orders have exceeded inventories for two straight months, and the inventory-to-sales ratio has fallen steeply since its cyclical peak in September 2011.10 Gains in job offers and overtime hours worked provide evidence that labor market activity has perked up.11 Japan’s early-cycle recovery has gained momentum due to the positive impact that its new policy direction is having on sentiment and financial markets.
Economic conditions across the continent are weak, but there have been tentative signs of stabilization. Germany’s export-reliant economy has generally benefited from the improving global economic backdrop, while sluggish growth in the rest of Europe has muted the pace of recovery. Along with other business and consumer sentiment measures, export expectations in the Ifo survey are higher than at the start of the year, although they have softened recently.13 France, the second largest European economy, still exhibits recessionary characteristics, particularly lagging industrial production and consumption data. Italy has also experienced declines in industrial production, lending activity, and payrolls for some time, but during the past several months, consumer and business sentiment has improved from very low levels.
There are few signs of contagion from the Cyprus banking crisis and bailout. Bank deposits in other eurozone countries have held steady, and periphery sovereign debt spreads have tightened relative to German 10-year bonds over the past few weeks.14 While the stability of Europe’s banking system remains a concern, the Bloomberg financial conditions index for the eurozone remains in positive territory above its long-term average. Europe’s economy is still stagnant, though an underlying trend of gradual stabilization may be taking hold.
Overall, the global economy remains in an uneven trend of slow growth and gradual improvement. Recent data releases have been generally disappointing. The Citigroup Economic Surprise indices for most developed and emerging markets have rolled over and are now in negative territory (see chart on left below). Despite weaker-than-expected near-term data, the outlook remains relatively stable, with the percentage of major economies registering gains in their leading indicators over the past six months at 83%—the highest since 2010 (see chart on right below).
The trends in developing economies and commodity prices underscore the decidedly mixed nature of the global landscape. China’s first-quarter GDP growth, at 7.7% year-over-year, came in below expectations.15 But the ongoing massive surge in credit has placed the economy firmly in the early-cycle phase of the business cycle. Leading economic indicators, such as loan demand and new orders for manufactured goods, continue to point to gradual improvement despite weak corporate profits and a generally lackluster pace of recovery.
Many commodity prices have weakened in recent weeks amid faltering expectations for Chinese and global growth. While copper and gold futures hit their lowest levels since 2011, the CRB Spot Raw Industrials Index has been relatively flat over the past three months.16 This suggests that some of the declines have resulted from supply overhangs or market technicals rather than a fundamental downtrend in global demand. The lack of commodity inflation pressure supports ongoing stimulative monetary policies across most developed and emerging markets, though Brazil recently hiked rates to help counteract rising domestic inflation. Global growth is still sluggish, but the outlook points to general improvement.
For more than a decade, Japan has experienced aging demographics, stagnant GDP growth, persistent deflation, and rising public debt levels. High domestic savings rates and other factors have allowed Japan’s government debt-to-GDP ratio (debt/GDP) to rise to an astronomical 233% without creating financial turmoil.12 But a contracting population makes the long-term outlook for public finances increasingly untenable. The government of newly elected Japanese Prime Minister Abe has promulgated a three-pronged strategy to attack Japan’s growth and debt problems more forcefully.
- Monetary policy by the Bank of Japan aims to end deflation by targeting a 2% inflation rate and employing an ambitious quantitative easing program intended to lower long-term bond yields and double the monetary base over the next two years.
- Fiscal policy will focus on increasing near-term stimulus and raising the deficit to more than 11% of GDP, while putting in place a longer-term program to bring the budget back into balance.
- Structural reforms will seek to jumpstart growth; these could include deregulation in key service sectors, increased trade through free-trade agreements, and reforms to labor markets, corporate taxes, and immigration.
So far, only changes to monetary policy have been implemented, but those changes and the ambitious agenda have boosted expectations and stock prices while weakening the currency.
Whether Japan is able to put itself on a more sustainable growth path will likely depend on the more difficult task of enacting sweeping fiscal and structural economic reforms. Our research shows that, assuming no change in today’s interest rates or projected economic growth rates, reaching the 2% inflation target would stabilize debt/GDP over the next 20 years only if the budget deficit is completely eliminated (see chart in Japan section above). In fact, using the current primary fiscal deficit and projected growth rates, stabilizing debt/ GDP would take about 9% inflation coupled with no significant interest rate changes—a highly unlikely scenario.
There are a number of risks associated with Japan’s aggressive policies. The policies could fall short of their goals. Generating positive inflation rates with a contracting population is especially difficult, and political opposition to structural reforms may make it hard to generate enough growth to produce the necessary wage inflation. Market disappointment could lead to reversals in both stock prices and yen depreciation. Even if the 2% inflation target is achieved, rising interest rates may accompany higher inflation. Then the government debt service burden would increase, potentially worsening the fiscal situation and limiting the ability to attract bondholders for Japan’s massive debt. Any signs that yen depreciation or inflation may overshoot could lead to a currency crisis.
Japan’s aggressive policies may signal the beginning of the end of its sleepy, low volatility economy and debt market. Whether or not the planned policies are successful, Japan’s new path is likely to transmit greater volatility to global financial markets in coming years, particularly through the impact on currency values and capital flows.
Summary and outlook
Recent economic reports have given investors reasons to worry about the possibility of another summer slowdown. Yet the general trend in the global business cycle has been more disappointing than downward, as higher expectations have been met with mixed data. Seasonal adjustments that were thrown off by the 2008 autumn nosedive may be partly to blame for the subsequent pattern of disappointing data in the spring. Overall, most major economies are in more secure positions in the business cycle now than at any time during the past two years.
Amid the slow pace of growth and heavy involvement of economic policymakers, policy risks are still present, but systemic risk concerns have been subdued. The banking crisis in Cyprus and inconclusive elections in Italy failed to upset the tendency for calmer financial conditions in Europe—there may even be growing action to temper fiscal austerity efforts. The U.S. debt ceiling deadline may provide another opportunity for Washington politics to generate volatility this summer, but the trend so far in 2013 has been toward reduced brinkmanship and less heated debates. Moreover, weaker commodity prices have further mitigated already modest inflationary pressures, which should benefit global consumers and serve to reinforce and extend the commitment to the extraordinarily accommodative monetary policies that have helped fuel asset price appreciation worldwide.
From an asset allocation perspective, incremental progress in the global economy and stimulus policies from central banks continue to support a generally favorable backdrop for economically sensitive assets. However, strong performance across many asset categories has raised valuations and made the risk-return outlook less attractive than before.
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The Typical Business Cycle depicts the general pattern of economic cycles throughout history, though each cycle is different and specific commentary on the current stage is provided in the summary and outlook section. In general, the typical business cycle demonstrates the following:
• During the typical early-cycle phase, the economy bottoms and picks up steam until it exits recession, then begins the recovery as activity accelerates. Inflationary pressures are typically low, monetary policy is accommodative, and the yield curve is steep. Economically sensitive asset classes such as stocks tend to experience their best performance of the cycle.
• During the typical mid-cycle phase, the economy exits recovery and enters into expansion, characterized by broader and more self-sustaining economic momentum but a more moderate pace of growth. Inflationary pressures typically begin to rise, monetary policy becomes tighter, and the yield curve experiences some flattening. Economically sensitive asset classes tend to continue benefiting from a growing economy, but their relative advantage narrows.
• During the typical late-cycle phase, the economic expansion matures, inflationary pressures continue to rise, and the yield curve may eventually become flat or inverted. Eventually, the economy contracts and enters recession, with monetary policy shifting from tightening to easing. Less economically sensitive asset categories tend to hold up better, particularly right before and upon entering recession.
2. Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments (AART) as of Mar. 31, 2013.
3. Source: Bureau of Economic Analysis, Haver Analytics, Fidelity Investments (AART) as of Feb. 28, 2013.
4. Source: Bureau of Labor Statistics, Census Bureau, National Federation of Independent Businesses, Haver Analytics, Fidelity Investments (AART) as of Mar. 31, 2013.
5. Source: Standard & Poor’s, Census Bureau, Haver Analytics, Fidelity Investments (AART) as of Mar. 31, 2013. Housing prices as of Jan. 31, 2013.
6. Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments (AART) as of Mar. 31, 2013.
7. Source: Bureau of Labor Statistics, Federal Reserve Board, Haver Analytics, Fidelity Investments (AART) as of Apr. 19, 2013.
8. Source: Nihon Keizai Shinbun, Haver Analytics, Fidelity Investments (AART) as of Apr. 19, 2013.
9. Source: Markit, Haver Analytics, Fidelity Investments (AART) as of Mar. 31, 2013.
10. Source: Japan Ministry of Economy, Trade & Industry, Haver Analytics, Fidelity Investments (AART) as of Feb. 28, 2013.
11. Source: Japan Ministry of Internal Affairs and Communications, Haver Analytics, Fidelity Investments (AART) as of Feb. 28, 2013.
12. Source: Bank of Japan, Haver Analytics, Fidelity Investments (AART) as of Sep. 30, 2012.
13. Source: Ifo – Institut für Wirtschaftsforschung, Statistisches Bundesamt, Haver Analytics, Fidelity Investments (AART) through Apr. 24, 2013.
14. Source: Financial Times, Haver Analytics, Fidelity Investments (AART) as of Apr. 19, 2013.
15. Source: China National Bureau of Statistics, Haver Analytics, Fidelity Investments (AART) as of Mar. 31, 2013.
16. Source: Commodity Research Bureau, Haver Analytics, Fidelity Investments (AART) as of Mar. 31, 2013.