After several years of challenging economic news, there are bright spots for the United States and Europe. But there is trouble on the horizon for China’s formerly fast-growing economy, says Lisa Emsbo-Mattingly, director of asset allocation research at Fidelity. She is also concerned about the need for structural changes in Japan. To find out what all this means for investors, Viewpoints recently spoke with Emsbo-Mattingly about recent economic developments in major markets, including the United States, China, and the European Union.
Let’s start with the U.S. economy. Are we heading in the right direction?
Emsbo-Mattingly: I don’t think we’re seeing anything extraordinary in terms of U.S. growth, but we’re not seeing negative signs, either. Consumer spending makes up more than two-thirds of the U.S. economy, so it’s important that consumers are stable and improving. Jobs, which are a key component of the consumer picture, are still rising at a reasonable pace for this type of slow-growth economy. Over the last 12 months, payroll jobs have grown by an average of 190,000 a month.
There’s nominal income growth in the mid-single digits in the United States. And that’s positive for the U.S. consumer—especially because inflation is very much under control. On a year-over-year basis, inflation is up only 1.8%, and on a core basis—which excludes food and energy—it’s up 1.6%. These numbers, along with real income gains and rebounds in the stock and housing markets, are feeding into better consumer sentiment.
How healthy is the U.S. housing market?
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Emsbo-Mattingly: There’s been a very nice rebound in housing, with double-digit gains in housing activity over the past year, and housing prices increasing on a broad basis. In May, however, the Fed started discussing a potential change in policy, which led to some volatility in the bond markets. There was a very significant backup in Treasury rates and mortgage rates. The big question now is whether that will unhinge the housing market. I think it slows the housing market down, but I don’t think it unhinges it. Typically, surges in the housing market last a couple of years and then taper off. I think this cycle will last a lot longer than what is typical, because it’s coming off such a low level.
What other areas of the U.S. economy do you find interesting?
Emsbo-Mattingly: Corporate fixed investment, or capital expenditures (capex), was hurt in 2012 by what was happening in Europe and China, and suffered into 2013 from the uncertainty around global economy and the impact of government policy. But now there’s some rebound in corporate sentiment as reflected in the purchasing manager surveys. So you’re starting to see capex recover somewhat. Take, for example, durable goods orders: As recently as March, they were basically flat year over year. Now they’re up 11% year over year.
What’s driving that growth?
Emsbo-Mattingly: I think companies are starting to feel a little bit more comfortable putting their toes in the water in terms of new capex. The fiscal cliff and debt ceiling debates seem to be behind us, and we’ve had several years of rising GDP. If this had been a normal cycle, I would have expected business confidence and spending to rebound some time ago but this was clearly a more devastating cycle than a typical recession.
Are there signs of improvement in the European Union?
Emsbo-Mattingly: It has been a horrible situation in Europe for the last couple of years. You still have countries with unemployment rates of more than 25%, but I do think there are the signs of an early cyclical recovery, particularly in the peripheral European markets such as Spain, Ireland, and Greece. A lot of these economies had massive adjustments in terms of price and competitiveness. Now I’m starting to see the very first stages of a pent-up demand cycle similar to what the United States experienced in the first half of 2009. Europe also is a very cheap market, which is usually bullish for the stock market. Europe has already seen a big rally since last August, and I think that there’s some continued good news coming.
Still, these are going to be pretty slow-growth economies, because they have a very big demographic headwind. In addition, productivity rates in much of Europe have been hurt by policies that dampen the ability of the economy to evolve and innovate. For example, if you have an inflexible labor market, it creates all sorts of perverse incentives in terms of hiring and firing, and you don’t have people moving in and out of the workforce and being put in the positions where they’re the most efficient. In some of these economies, government, which is one of the lowest—if not the lowest—productivity sectors in the economy, is more than 50% of GDP. All these things really reduce productivity.
Continuing around the globe, what’s your outlook for China?
Emsbo-Mattingly: I’ve been very concerned about China for several years now. In particular, the rise in property prices has been integral to the economic miracle in China over the last five years. When I started seeing weakness in property prices in late 2011 and early 2012, I started to get concerned about a recession in China. A significant tightening of policy around property at that time had led to increases in housing inventories and declines in prices. Of 70 major cities across China, more than 90% were enjoying price increases in mid-2011, just a year later the percentage was below 20%, and the negative knock on effects for China were becoming evident.
But in August and September of 2012, there appears to have been a significant change in policy stance, and an aggressive expansion of what the Chinese government calls “total social financing,” which includes all bank lending plus all sorts of shadow bank lending. The equivalent of more than a third of GDP in new credit was created in the following three quarters. Housing activity and home prices recovered, and infrastructure spending accelerated. All sorts of things started to perk back up.
However, after new leadership came in to the Chinese government in March, it looks like there’s been yet another policy reversal. The most recent lending data show a significant deceleration in new credit creation at the end of the spring and early summer. The second quarter was one of the weakest quarters for lending growth, and that appears to be reflected in the financial markets. I'm also seeing broad-based weakening of domestic industrial production indicators. So it does look like China may be double-dipping.
But with the negatives in China there may be some positives. There have been signs that China is taking incremental steps to reform its financial and economic system, and that it may be laying the foundation for long-term structural reform, which would be positive. While there still may be significant short-term negative surprises because of these policy changes, I think if the changes move China toward a better balance, then that’s good news for the long-term story in China.
Continuing to move eastward, how is the Japanese economy faring?
Emsbo-Mattingly: The Bank of Japan has initiated the most aggressive quantitative easing policy we have seen so far. The result has been a pretty significant devaluation of the yen over the last six months and a very big rally in the Japanese equity markets. That fiscal stimulus and Abenomics (Prime Minister Shinzo Abe’s economic policies) have had a significant positive effect on both consumer and corporate sentiment and spending, and that’s led to accelerating GDP numbers.
But I think that Japan is hitting a difficult area: structural reform. That means, for example, reforming the flexibility of the labor market and the openness of various markets to entry and exit. These are much tougher politically than increasing government spending and easing monetary policy. So I'm watching closely to see whether these structural reforms actually happen, and I'm somewhat skeptical that they will. As a result, I think that the market may be getting set up for some disappointment.
So what does this all mean for investors?
Emsbo-Mattingly: I’m pretty constructive on the stock markets. I think that there’s still expansion going on in corporate profits, although that’s slowing. And I think that the bond markets, while they’re going to be challenged in the coming years, have overreacted to the change in Fed policy. Globally, emerging markets are going to be challenged because of what’s happening in China but I think the European markets may be attractive because they’re inexpensive and are in an early cyclical recovery.
But the markets always seem to set themselves up for disappointment. I think that volatility from policymakers—whether in the United States, Europe, China, or Japan—can rattle the financial markets. Europe may see something called a financial transaction tax, which could have significant impacts on the market, and the markets also may be affected by what decisions are made by Chinese policymakers. And if the folks in Washington decide to have another budget fight, it’s not going to be taken well in the markets. So the potential for volatility is there.