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Economic check-in: Good backdrop for stocks

Consumer buying power and volatility likely to rise, but backdrop for stocks is positive.

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The economic recovery in the U.S. is finally starting to translate into better job prospects and bigger paychecks for a broader swath of workers, says Lisa Emsbo-Mattingly, director of asset allocation research at Fidelity. At the same time, trouble in the major Asian economies should depress demand worldwide—and that combination means stronger purchasing power for U.S. consumers and a better outlook for the companies that serve them. That backdrop is good for U.S. stocks, Emsbo-Mattingly says, but the issues in Asia could also lead to increased market volatility.

What’s happening with the U.S. economy?

Emsbo-Mattingly: I think the big story in the U.S. is the bullish outlook for consumers. The labor market has been weak for many years, but compensation levels are finally starting to rise and there’s some pricing power in the labor markets. If you look at the NFIB [National Federation of Independent Businesses] Small Business Survey, plans to raise compensation have really started to pick up. And consumers’ expectations of their income are also starting to rise.

The upshot is that the purchasing power of the U.S. consumer is poised to increase, probably the most it has since the late 1990s. That’s part of the reason we think the U.S. stock market is in good shape over the next 12 to 18 months. The market’s valuations are still reasonable, and we think earnings are going to rise in the next year. So the overall backdrop for stocks is positive.

But there’s an asterisk to this outlook. Investors need to get ready for a lot more volatility than they’ve experienced in the recent past. While the U.S. and Europe continue to expand, the story in Japan and China is starting to turn sour. The interaction of those two trends has important implications for the markets. For example, the Federal Reserve will likely continue to taper, and, at the same time, the Bank of Japan and the Chinese policymakers will probably have a response to the slowing growth situation there. These moves will create volatility that investors need to prepare for.

Overall, however, the U.S. economy and the U.S. consumer are likely to do quite well. I think those factors will overwhelm the negatives coming from the rest of the world.

Rising wages typically lead to higher inflation. What’s different this time?

About the expert

The Fed’s surprise
Lisa Emsbo-Mattingly leads the asset allocation research team in conducting economic, fundamental, and quantitative research to develop dynamic asset allocation recommendations.

Emsbo-Mattingly: If it weren’t for the situation in Asia, I would be much more worried about higher inflation. However, I think the deflationary shock that we’re going to get from Asia is going to offset any inflationary pressures here in the U.S. I think the reaction to April’s unusually strong payroll report is consistent with this thesis. The payroll number increased 288,000 and the unemployment rate dropped from 6.7% to 6.3%. You’d expect the bond market would react to those kinds of numbers with a selloff that would push up the rate on the 10-year Treasury. But that’s not what happened at all. The 10-year Treasury actually rallied.

I think what’s happening here is a conflict between global zones of expanding and contracting growth. The main result in the U.S. is a benign environment for inflation, which tempers expectations for interest rates. As I’ve said before, U.S. consumers right now are in a nice sweet spot—they’re getting modest wage increases while inflation and interest rates stay low, creating a healthy backdrop for rising purchasing power.

How has the situation in Asia changed since your update in March?

Emsbo-Mattingly: As expected, Japan’s consumption-tax hike boosted demand until the end of March, and then in April, after the increase kicked in, everyone took a spending holiday. You can see that in retail sales, consumer sentiment, small business sentiment, and the economy watchers survey—all of those really U-turned and became significantly negative after the increase went into effect. A major concern with Japan is how it’s going to affect the rest of the global economy, particularly Asia. How does that negative demand shock feed through to Japan’s trading partners? You’re starting to see downgrades for economic growth projections, not necessarily in Japan, but in the rest of Asia.

It looks like China is in a growth recession—that is, growth well below trend GDP. The official data still says GDP is north of 7%, but our measure of industrial activity is up only 1%, and you can see the property sector turning decidedly negative. Industrial production is very weak, and the purchasing manager survey is below 50. So it’s hard for me to fathom that GDP is really above 7% right now.

What does this outlook mean for stock investors?

Emsbo-Mattingly: I’d be cautious about companies with high exposure to Asian weakness, such as globally focused capital goods companies—big construction and engineering companies, construction equipment manufacturers, even consumer vehicles companies and aerospace manufacturers. All of those could be in for some negative surprises. Commodity-intensive emerging markets, such as Russia and Brazil, are also likely to struggle.

The frontier markets, or less-developed emerging-market countries in places like the Middle East and Africa, which have done relatively well all last year and into this year, are by far the most vulnerable. Not only will their fundamentals deteriorate because of weakness in their Asian trading partners, but if they start getting outflows, the illiquidity in these markets could lead to outsized price effects.

Canada and Australia are also places to keep an eye on. They came through the financial crisis relatively unscathed, and it will be very interesting to see how they weather a significant slowdown in China.

Who might the winners be?

Emsbo-Mattingly: Companies that sell to U.S. and European consumers—such as retailers and consumer services companies—should benefit. Emerging markets that are focused on their own domestic economies, like India, could do better than those that count on exports to China. Countries that are more focused on the U.S. or European consumer, such as Mexico and the European emerging market countries, also could be beneficiaries—obviously excluding Ukraine and countries that are affected by what’s happening there.

I also think the deflationary impacts of weakness in China and Japan could take some pressure off emerging markets. It eventually will set them up for a good cycle—not in the near term, but if you go out 12, 18, or 24 months.

When do you expect market volatility to increase?

Emsbo-Mattingly: Short-term market moves are always difficult to pinpoint, but I’d say possibly within the next few months. Anything that tends not to do well with rising volatility is likely to be challenged during that time frame. For example, prices on high-yield bonds and leveraged loans are extravagant, and they don’t like volatility. The pickup in volatility also is likely to be challenging for U.S. stocks, but I think the market’s fundamentals are strong enough that they’ll survive and wind up performing quite well over the next year or so.

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Investing involves risk, including risk of loss.

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

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The information presented above reflects the opinions of Lisa Emsbo-Mattingly as of May 16, 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..

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