The U.S. economy remains in a mid-cycle expansion, buoyed by further improvements in both consumer and corporate fundamentals, although the tick-up in inflation represents a potential risk for consumer purchasing power going forward (see U.S. Economic Indicators Scorecard, below).
Globally, additional stimulus may help to stabilize the Chinese economy, but at a weaker pace of growth, while developed Europe continues to improve.
The following is a more detailed look at developments in major areas of the U.S. and global economies, including a special section on low volatility and investor complacency.
Our outlook has been for a disinflationary backdrop in the U.S. amid modest economic growth and lower commodity prices. However, both headline and core inflation rates have ticked up over the course of 2014. Although industrial metals prices tied to Chinese demand have remained muted, supply disruptions of agricultural and energy commodities—due to severe weather and geopolitical events—have contributed to higher commodity prices. As a result, food and energy prices, which account for 14% and 10%, respectively, of the headline CPI, have risen in recent months, causing overall inflation to rise to 2.1% (see chart, right).
Core inflation (excluding volatile food and energy prices) surpassed 2.0% in April mainly due to costs of shelter, which represent 42% of core inflation. A few sectors of the economy have also experienced a pickup in wage growth, but this phenomenon is not widespread. Though late-cycle inflation pressures do not appear imminent, commodity supply disruptions and firmer core inflation pose risks to the benign disinflationary backdrop for the U.S. consumer.
Employment remains favorable
The U.S. labor market continues its trend of slow improvement, providing a positive backdrop for consumer spending. Employment levels have returned to the previous peak, last seen in 2007. Nonfarm payrolls have averaged 198,000 per month over the past year—at the top end of the range during this recovery—and the unemployment rate has held at a post-crisis low of 6.3%.1 Weekly unemployment claims are also at levels last seen in 2007, indicating further progress ahead.2 Other signals bode well for labor market advances. Real weekly earnings are still growing at a slow but steady pace, and hours worked in the private sector have remained solid.3 In the manufacturing sector, hours worked have been rising and overtime hours have returned to their January 2006 peak.4 Small businesses—which constitute a large proportion of U.S. jobs—also continue to exhibit a greater willingness to increase hiring.5 The employment outlook remains favorable amid stable economic growth and improving business confidence.
Consumption on firm ground
Improving fundamentals have bolstered the outlook for the U.S. consumer. Against a backdrop of steady employment gains, real disposable personal income continues to increase at a moderate pace.6 Although consumer confidence measures have softened during the past couple of months, sentiment remains near post-recession highs.7 Consumer credit growth (excluding mortgages) has reaccelerated, rising by an annualized 8.2% in the three months through April, the fastest pace since 2007.8 The U.S. consumer remains on firm ground, supported by an improving employment backdrop, healthier balance sheets, and greater access to credit.
Credit and banking remains buoyant
U.S. credit conditions are still conducive to economic growth. The Bloomberg Financial Conditions Index remains at post-recession highs, as indicators have been positive across bond, equity, and money markets.9 Corporate credit markets have maintained a solid pace of expansion, with year-to-date corporate debt issuance ahead of last year’s pace.10 Residential lending has now risen for four consecutive months, suggesting a slow thawing of still-tight mortgage credit conditions. The U.S. credit cycle remains buoyant, supported by continued accommodative monetary policy.
Corporations remain well positioned
Corporate fundamentals remain healthy amid strong balance sheets and solid profitability. The Institute for Supply Management Manufacturing Purchasing Managers’ Index (PMI) has trended higher in each month of 2014, remaining comfortably in expansionary territory at 55.4 as of the end of May. New orders of durable goods (not including defense and aircraft) and industrial production of business equipment have accelerated since the beginning of the year.11 Recent surveys suggest improved business sentiment, particularly for higher capital expenditures.12 Cyclical productivity growth, which typically occurs during the early cycle, has remained on an upward trajectory, helping profit margins. U.S. corporations remain well positioned as improved sentiment signals a potential increase in capital expenditures.
Housing slowly improving
The housing sector has downshifted into a slow expansion following last year’s swift recovery. Home sales remain lackluster following a weak first quarter, and leading indicators such as housing permits remain muted relative to last year’s brisk pace.13 The recent slowdown can be partially attributed to a continued decline in household formation, which along with still-tight mortgage credit conditions, has hampered first-time buyer activity. The main drivers of household growth—25 to 34 year olds—have experienced a higher unemployment rate of 6.7% versus the national average of 6.3%,14 and first-time home buyers with low credit scores have struggled to obtain financing.
Despite softness that may persist in the near term, we believe housing will provide a modest tailwind for the economy over the next two to three years. Homes remain relatively affordable, banks are slowly easing credit standards for prime borrowers,15 and continued employment gains should add to household formation and housing demand. Activity will likely remain tepid in the near term, but slow improvement in employment and mortgage credit should help the housing sector provide a modest boost to the economy in the medium term.
Global economy remains on relatively sound footing
The global economy remains on a trend of slow but steady growth, with an increasingly mixed outlook among countries and regions. About 60% of the world’s 40 largest economies have seen gains in their leading economic indicators (LEIs) over the past six months, down from about three-fourths early in 2014.16 The major division still lies between advanced and emerging economies, with most of the former displaying solid (albeit slow) mid-cycle dynamics with low inflation, while many emerging markets (EMs) continue to struggle with late-cycle headwinds. The tone of data releases has been less negative in EMs in recent months, however, as evidenced by the Citigroup Economic Surprise Index steadily becoming less disappointing. Moreover, the rate hikes implemented by many EMs earlier in the year have helped stabilize their financial situations, lending support to their currencies and moderating inflationary pressures. Nevertheless, most large EMs lack the impetus for a near-term reacceleration of growth, as typical late-cycle factors such as flagging productivity and deteriorating corporate profitability combine with structural headwinds to constrain the cyclical outlook.
China continues to try to balance reining in excessive credit creation with attempting to meet high targets for economic growth. Signs of weakness—particularly a slump in real estate activity17—have prompted China’s policymakers to place a greater emphasis on growth in recent weeks. Policy actions have included a pick-up in government spending on rail and water infrastructure, the urging of local governments to accelerate fiscal spending, a cut in the required reserve ratio for banks focused on small business and rural loans, and targeted lending programs from the central bank channeled through state-owned banks. The shift in focus away from reform and toward supporting growth may provide near-term stabilization, but weakness in the property markets continues to provide substantial downside risk, and China likely remains in a growth recession.
Developed Europe continues on the path of improvement; most countries have boasted positive LEIs and gains in the manufacturing bullwhip.18 Yet, the magnitude of Europe’s expansion remains sluggish and deflationary pressures persist, both of which were major drivers behind the recent European Central Bank (ECB) easing that may further boost financial conditions in the region. The outlook for Japan remains muddled. After the steep drop across most indicators during the consumption-tax hike in April, forward-looking sentiment measures have recently stabilized somewhat. The world economy remains on relatively sound footing, though considerable divergence persists among countries and regions.
Is low volatility breeding investor complacency?
At the beginning of the year, our expectation was that volatility in asset markets could increase in 2014 amid a growing number of global risks. Recently, however, market-level volatility has plummeted to near five-year lows across many equity, foreign exchange, and fixed-income markets (see chart, right).
Muted market-level asset class volatility today may largely be a function of low volatility in economic fundamentals as well as a high level of monetary policy accommodation. On the economic front, stable outlooks in the U.S. and Europe, as well as China’s moves to stabilize growth, have suppressed near-term economic volatility. The chart (below, right) shows the relative magnitude of changes in several weekly U.S. economic indicators. The levels of volatility in these high-frequency indicators spiked during (and immediately following) the 2008 recession, but have trended steadily lower since the U.S. entered its mid-cycle expansion in 2010. From a monetary standpoint, the Fed and the ECB have successfully communicated “low for long” policies, underscored by the ECB’s latest extraordinary easing efforts. By lowering the risk of an imminent move in short-term interest rates, these policies have emboldened risk-taking and carry trades among investors and have provided the liquidity for both risky and risk-free assets to rally.
Notably, although volatility has been low in broader indices, there has been significant churning beneath the surface so far this year. Between February and May, small-capitalization stocks declined by 9.3% from their peak, while high-tech industries like biotechnology and internet software and services fell 20.8% and 17.5%, respectively (see chart, below right). Each of those categories had experienced a long period of relative outperformance, stretching their valuations relative to other sectors of the market. While a correction in the market leaders sometimes presages a downturn in the broader market, there have also been many periods when highly valued sectors lost favor without disrupting the overall upward market trend. For example, small caps have experienced a decline of at least 10% in 83% of the calendar years since 1979, while large caps have only seen large drops in 57% of the years, without a strong correlation in timing. As a result, there are no conclusive signs that the low-volatility environment is about to implode, but higher valuations and muted volatility do signal a potential risk of investor complacency.
Summary and outlook
Global market volatility has been extremely subdued, likely due to the relatively steady economic backdrop and the high level of monetary policy accommodation. The main beneficiaries in recent weeks have been the currencies and equities of EMs, and credit assets around the world.
Regarding the broad outlook for financial assets, the question remains whether cyclical fundamentals will continue to improve and eventually justify these higher asset valuations. We remain concerned about the potential for market complacency with increasingly less risk being priced into assets. We categorize potential risk catalysts into three main buckets. First, boundless high liquidity growth is not guaranteed, as the U.S. and U.K. are moving beyond quantitative easing and monetary moves among EMs are now split evenly between rate hikes and rate cuts. Second, economic and financial risks in Asia remain high. Despite China’s easing measures to stabilize growth, the downturn in the property markets poses a serious risk to its financial stability, and it is unclear whether Japan’s economy will reaccelerate following its spring lull. Third, geopolitical risks continue to accumulate, with the outbreak of hostilities in Iraq adding to the mounting list of concerns.
On an asset allocation basis, our business cycle framework suggests the mid-cycle dynamics in the U.S. and Europe continue to offer a favorable backdrop for equities in those regions (see Typical Business Cycle chart, below). We remain cautious on assets tied to China’s growth trajectory, including those linked to close trading partners in Asia and commodity exporters. From a near-term tactical standpoint, we remain more favorably disposed toward investment-grade bonds than would normally be warranted during the mid-cycle stage. Given rising investor complacency, high-quality fixed-income assets—with their low correlation with stocks—may provide downside protection against a potential spike in equity-market volatility.
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