Economic check-in: Time to pay attention to inflation

A pickup in inflation may surprise investors—it can have varying effects on stock and bonds.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

The U.S. economy has shrugged off fears of recession and looks healthy, while rising wages are pushing inflation higher. These dynamics suggest rising odds that we have begun a transition to the late phase of the business cycle, says Lisa Emsbo-Mattingly, Fidelity’s director of asset allocation research.

In her latest economic check-in, Emsbo-Mattingly notes that the late cycle can be lengthy and rewarding for stock investors, but may be more challenging for returns from bonds and other income-based investments.

Q: In the first quarter the stock market lost a lot, then gained it all back. Why?

Emsbo-Mattingly: I think three major things were happening in January and February. Investors were concerned that China was starting a hard landing, that the United States might somehow fall into recession, and that the financial system was becoming dysfunctional. Each of those situations improved midway through the quarter, and the stock market recovered.

This situation in China is still not very positive, but it appears the economy has stabilized, at least for the short term. The property sector and infrastructure investment have started to rebound, thanks to the easing of some government policies.

Fears about a possible U.S. recession resulted from very weak data coming out the industrial side of the economy, due to the trade recession that happened in 2015. But the consumer continued to be strong, and manufacturing, while still very weak, started to show some positive signs. For example, the regional purchasing manager surveys rebounded, the national ISM Purchasing Manager’s Index (PMI) rose back above 50, and new orders started outpacing inventories. So recession seems unlikely.

The third concern was the financial system. A lot of developments fed those worries, but one of the biggest was the Bank of Japan (BOJ) initiating a negative interest rate policy after claiming for years they would never do that. Then Fed Chair Janet Yellen, in her testimony just after the BOJ’s move, left the door open for negative rates. That’s when the market started discounting negative things happening in the financial system. In late February and during March we saw a lot of backing away from policies like the Bank of Japan’s. For example, European Central Bank Chairman Mario Draghi initiated a negative rate structure, but it was less aggressive than had been expected. He seemed to pivot away from negative rates as a key policy tool, and instead moved toward purchasing real assets. These moves, and the Fed’s saying that it intended to raise rates more slowly than it had previously announced, relieved investors’ fears about the financial system.

These three things—China appearing not to have a chaotic crash landing, the United States not going into recession, and the financial system not being crippled, helped the market rebound and recover.

Q: What's your economic outlook from here?

Emsbo-Mattingly: Chair Yellen has signaled a slow-growing economy, but under the surface we’re starting to see some initial inflationary pressures. In recent months, core CPI (consumer price index) has been rising above an annualized rate of 2%. That’s primarily because of tightening of the labor market, and from wage gains. So I think we could see some financial market volatility as Janet Yellen goes back and forth between trying to keep the economy growing and responding to higher inflation.

Q: The last employment report showed another big increase in labor market participation. What does that mean for the economy?

Emsbo-Mattingly: It tells us that the workers who gave up looking for jobs are coming back in. That gives a nice little kick to economic activity and growth, and it keeps the labor market from tightening too quickly. I think the participation rate going up is a very, very bullish sign for the U.S. economy. We think we’re getting close to a normal participation rate based on demographics. That would mean we’re approaching the point where lack of participation no longer puts downward pressure on labor pricing.

Q: Where are we in the business cycle, in your estimation?

Emsbo-Mattingly: We’re seeing increasing signs that we’re in the late phase of the cycle. The dynamics in the labor market are classically late cycle. There are other signs—such as the easing of bank lending standards for mortgages—that still look more mid cycle. But we think that, over the course of 2016, the signs of late cycle will keep rising, particularly the gains in pricing power in the labor market, meaning people get raises.

A lot of people think late cycle means imminent recession; it doesn’t. In fact, the late phase historically lasts one to two years, on average, and this one could be longer. Usually the housing market is further along at this stage, and the consumer is more exuberant. This time around, household saving is unusually high, and debt is unusually low. That could help extend the cycle.

Late cycle just means things are different than they were earlier in the cycle. For example, the corporate sector has to pay more for labor, so profit margins tend to move down. But at the same time, households see their spending power rise, which can drive sales growth.

Q: What might all this mean for investors?

Emsbo-Mattingly: Somewhat higher inflation, and the Fed’s response to it, could provide more of a headwind for bond returns. My team also thinks that high-dividend-yielding stocks, which tend to trade like bonds, may have a tougher time this year.

It’s also important to keep perspective on the outlook for high-yield corporate bonds. In the short to intermediate term, positive surprises coming out of China could help energy prices keep firming, which probably would be good for high-yield bonds. But high yield generally doesn’t do very well the further the economy moves into the late-cycle phase, because credit spreads and defaults tend to move up.

On the other hand, historically investments that provide a degree of inflation protection, like materials and energy stocks, tend to do well late in the cycle. So have shares of companies that generate stable earnings, like those in consumer staples. Investors also tend to pay up for companies that can deliver stable growth.

Late cycle is not recession. In fact, it’s the opposite of recession. The late part of the cycle is when things get hot, with wages and inflation picking up and interest rates rising. In recession, things cool down—people worry about falling inflation, the job market weakens, and the Fed lowers rates. For those investors who remember 1999, that was a late-cycle year. At this point, I would worry more about protecting against inflation than against negative growth.

Learn more

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

Views expressed are as of the date indicated and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the speaker or author, as applicable, and not necessarily those of Fidelity Investments.

Keep in mind that investing involves risk. The value of your investment will fluctuate over time, and you may gain or lose money.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation risk, liquidity risk, call risk, and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible.

High-yield/non-investment-grade bonds involve greater price volatility and risk of default than investment-grade bonds.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

Votes are submitted voluntarily by individuals and reflect their own opinion of the article's helpfulness. A percentage value for helpfulness will display once a sufficient number of votes have been submitted.

Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917

758541.1.0
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.