Consumers may “have their cake and eat it too” in 2014, says Lisa Emsbo-Mattingly, director of asset allocation research at Fidelity, as she looks out over the coming year. The reason: Economic weakness abroad should keep inflation low in the U.S. and, help boost households’ purchasing power. Also, U.S. corporate earnings are still on an upward trajectory, and downward pressure on inflation and interest rates props up stock valuations. But, she warns, uncertainty overseas—particularly in Japan and China—poses risk.
What is your outlook for the economy?
Emsbo-Mattingly: I think the U.S. is still in a slow mid-cycle expansion. Right now the consensus forecast for U.S. GDP growth in 2014 is 2.7%; I think it’s more likely to be in the range of 2%, on par with the last few years. Payrolls are now rising by about 160,000 to 180,000 jobs per month, and I think that’s the new normal. I don’t think we’re going to get back to the old normal of 220,000 to 250,000 jobs a month. The reason is the composition of the labor market. There’s been a big decline in the rate of growth of the working-age population as more people have reached their 50s, 60s, and 70s and fewer young people enter the work pool. A lot of people think participation in the labor market will rise as the U.S. economy recovers, but I disagree. I don’t think participation will rise much for a couple of decades, because of the decline in the working age population.
We are at the point in the economic cycle when one typically starts to worry about inflation. But I don‘t see any signs of it picking up meaningfully in the United States in the near term. While we are seeing the very first tentative signs of some acceleration in wage gains, cyclical productivity has remained high as businesses have maximized efficiencies, so there has not been much downward pressure on profitability or upward pressure on overall inflation. Also, a very weak emerging-market environment has continued to put downward pressure on imported goods prices. We may see a little bit more inflation from food and energy due to weather and supply disruptions in the near term, but commodity inflation remains subdued overall.
In the U.S., continued modest wage gains coupled with a very weak inflation rate should boost the purchasing power of the household sector. That’s extremely positive for the economy. And without upward pressure on inflation, it will likely keep interest rates subdued. So, suppressed rates and rising earnings should be a positive backdrop for U.S. stocks.
Did the bad weather hurt the economy?
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Emsbo-Mattingly: The weather did play a role in the winter slowdown. Industries that are especially sensitive to weather—brick-and-mortar retailers, homebuilders, and auto dealers—really took a dive. Sectors that are not as affected by weather, such as online retailers, catalogue retailers, and even liquor stores, held up fine.
We’re probably going to see a little bit of a bounceback from the first quarter, but I don’t think it’s going to be huge. Some spending has been deferred, like on home starts and auto purchases—but other kinds of spending just won’t happen. If I decide not to buy my daughter a sweater in January, I’m not going to buy her one in April—although this April I might if it doesn’t warm up soon.
How do you expect the housing market to perform in 2014?
Emsbo-Mattingly: I have a benign outlook for housing for three key reasons: Inventories are well contained, we continue to see job formation—which leads to household formation—and affordability, while not as high as it was a year ago, is still extremely high. Is housing going to experience double-digit growth? I don’t think so. Could it grow in the mid-single digits? Yes. And that be quite positive for the U.S. economy.
Japan is trying to get its economy to produce growth and inflation. How might this affect U.S. investors?
Emsbo-Mattingly: I call Japan the sleeping giant in the capital markets. It has a massive bond market, with a very high correlation to the U.S. bond market. I am watching it carefully. The Japanese central bank has initiated a very aggressive asset purchase program that appears to be keeping risk in the bond market contained. But I worry that while the central bank may be able to control the bond market, they may lose some control of the currency market.
If the yen weakens substantially, it will hurt many of its Asian trade competitors. Volatility in the yen may also translate into volatility in other major currencies where we have historically not seen much movement, such as the Chinese RMB.
What do you expect from China’s economy in 2014?
Emsbo-Mattingly: Simplified greatly, the three main ingredients of the U.S. financial crisis were excessive leverage, a mismatch in the duration of borrowing and lending, and problems with various participants’ incentives. China has all three of those ingredients right now. Moreover, China’s property sector is experiencing a big slowdown, and it is intertwined with almost every aspect of the Chinese economy. I am watching developments there very closely.
As we go through the next year, I’ll also be watching China’s policy responses to these issues. I think they probably will be different than the approach the U.S. took—they’re likely to involve more forbearance and evergreening [i.e., rolling over] of loans, bailing out bad financial structures and so on. Regardless, any attempt to rein in credit is not positive for growth.
I see China as very vulnerable, and I am spending an immense amount of time trying to understand whether it’s tipping into recession. My models do not currently indicate that it is in recession.
If a crisis did occur in China, what would it mean for the U.S.?
Emsbo-Mattingly: The impact wouldn't be as far-reaching as the 2008 crisis, because the global financial system is not as integrated into the Chinese system. A China crisis would slow global growth, particularly emerging-market growth. But that might not be all bad for the U.S.—it could help keep inflation low.
How would you characterize Europe’s economy at this point?
Emsbo-Mattingly: Some parts of Europe, especially peripheral Europe, are strongly in the early part of the business cycle. Germany, on the other hand, is already in mid-cycle. Pent-up demand is the story in Europe right now. Consumers haven’t been purchasing capital goods, household durables, and vehicles for years. Now we’re finally starting to see the macro environment stabilize. That’s when you usually see a snap-back in consumer purchases, which can drive a very positive earnings cycle. On a long-term basis, I think Europe will experience slow growth, but cyclically the continent looks very strong.
What does your economic outlook mean for asset allocation?
Emsbo-Mattingly: I still favor stocks, because low inflation is likely to support current price-to-earnings [P/E] multiples, so modest earnings growth can still lead to overall gains. But the story is not as compelling as over the past few years. In addition, there are some scary knowns out there, from a potential China crisis to the standoff over Crimea. With the yield curve very steep, the bond market is basically paying you go out further on the yield curve and essentially take out insurance against a crisis. Maintaining a balanced, diversified portfolio of stocks and bonds is a really good idea, this year in particular.
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