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June business cycle update

U.S. economy sturdy; global outlook growing increasingly mixed below the surface.

  • By Dirk Hofschire, CFA, SVP, Asset Allocation Research and Lisa Emsbo-Mattingly, Director of Asset Allocation Research,
  • Fidelity Viewpoints
  • – 05/30/2014
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The U.S. economy’s mid-cycle expansion persists, bolstered by a slowly improving pace of hiring, a recovery in consumer confidence, and subdued inflation.

Globally, risks in Asia continue to rise— specifically in China, which has slipped into a growth recession—potentially threatening the stable outlook for the world economy (see U.S. Economic Indicators Scorecard, below).

The following is a more detailed look at developments in major areas of the economy. In addition, this month’s report features a special update on Why U.S. Treasury yields remain so low.

Employment and consumption: improving

Employment trends remain on a path of slow improvement. Recent labor market data has been solid, with ongoing growth in payrolls, a drop in the unemployment rate to 6.3%, and a decline in initial unemployment claims to below 300,000 for the first time since early 2007.1 While hourly wages have recovered at a historically subdued rate of only 2.1% year-over-year,2 a few pockets of wage pressures are evident, including rising intentions by small business owners to increase worker compensation.3 Moreover, aggregate wages—total wage income in the economy—continue to grow at a steady rate, climbing 4.3% during the past year,4 due primarily to the increase in the number of people employed (see chart, right). In this environment of slow and steady gains in wages and employment, consumer purchasing power is rising with only minimal upward inflationary pressure.

Measures of U.S. consumer confidence have returned to near post-recession highs, as consumers’ outlooks on the economy and employment have become more positive. March retail sales bounced back strongly after some softening during the winter, and although April sales were weaker than expected, the overarching trend of personal consumption remains one of slow and steady growth.5 Consumers’ balance sheets have also improved, with the ratio of net worth to disposable personal income climbing to levels not seen since September 2007.6 Improving employment trends and contained inflationary pressures should provide a benign backdrop for personal consumption.

Inflation: remains contained

Inflationary pressures remain relatively subdued, although headline and core consumer prices rose in April at their fastest rates in more than a year. Energy costs increased sharply during the month, which, along with rising food prices helped boost year-over-year headline inflation to 2%.7 Core inflation was 1.8% in April, amid steady increases in housing costs and medical care services.8 The outlook for modest wage growth and global disinflationary pressures suggests inflation should remain contained.

Credit and banking: buoyed by policy and low inflation

Why have U.S. Treasury yields remained so low?

Expectations of Fed tapering and a solid U.S. economy were priced into the market in 2013. Read the full article.

Credit conditions remain favorable, particularly for businesses. Thus far, any negative effect of Federal Reserve (Fed) tapering on interest rates has been more than offset by the global disinflationary backdrop and improving credit fundamentals, among other factors (see “Why U.S. Treasury yields remain so low,”). The latest Fed Senior Loan Officer Survey shows that bank credit has continued to ease across most lending categories.9 Corporate access to credit has been particularly healthy, resulting in low borrowing rates in the bond market and 10% year-over-year growth in commercial and industrial loans from banks.10 Consumer credit access, though improving, has overall remained tighter than corporate. Non-mortgage consumer loans have risen 4% year-over-year, the fastest pace since the recession, but mortgage and credit card borrowing remain relatively weak.11 The credit cycle remains supportive of economic growth, buoyed by accommodative monetary policy and low inflation.

Corporate: sturdy outlook

The corporate sector outlook remains solid amid steady profitability and easy access to credit. S&P 500 companies appear to have surpassed subdued profit expectations, growing year-over-year earnings approximately 6% in the first quarter.12 Business expectations have continued to improve, with planned capital expenditures reported by the Institute for Supply Management, in particular, signaling a potentially significant acceleration in business spending in 2014 (see chart, right). Indicators of current activity, such as durable goods shipments, generally recovered from their winter soft patches.13 Although a few industries must still work through weather-related inventory overhang, the aggregate impact of the recent slowdown is likely to be minimal. Fundamentals for the corporate sector are sturdy, and the outlook for capital expenditures appears to be improving.

Housing: slow expansion

Housing activity has stumbled from its brisk pace one year ago, but a stabilization may be occurring after a disappointing winter. Sales of both new and existing homes remain at low levels but have ticked up slightly. Price gains are decelerating, affordability is less attractive, and mortgage lending remains moribund amid tight credit and muted demand. However, pending home sales and housing starts have recently improved.14 Moreover, inventory levels remain low, continued improvement in labor markets should boost demand, and home-buying sentiment indicators have held near post-recession highs.15 Near-term housing activity remains relatively soft, but fundamentals remain supportive of a slow expansion going forward.

Global backdrop: generally stable

The global economy remains in a trend of slow but steady growth, though the outlook has softened slightly on the margins. The dichotomy between developed markets (DMs) and emerging markets (EMs) persists. Mid-cycle expansionary phases prevail in DM countries, while many EM countries have been mired in late-cycle conditions. Differing inflationary backdrops have contributed: DMs are experiencing low inflation and slow wage growth, while many EMs face structural headwinds that create stubborn inflationary pressures despite weaker economic conditions.

Conditions in developed Europe have continued to improve. In Germany and the U.K., labor markets and capital expenditure expectations have remained strong. Italy has shown very strong consumer and business expectations, with an inventory bullwhip (new orders less inventories) at post-recession highs.16 Economic growth in France has been positive, albeit weak.

Within the EMs, much of the weakness is centered in Asia. The Citigroup Economic Surprise Index (CESI) for Asia deteriorated further, as economic data has continued to underperform expectations. For EMs in other regions, economic data is now coming in above expectations, signaling that some stabilization may be occurring.

Country-specific risks in Asia have continued to rise as well. Most notably, we believe China has entered a growth recession, suffering a significant negative deviation from its long-term trend rate of growth.17 The real estate sector is now in outright contraction, with sales and construction activity dropping amid still-high levels of inventory (see chart, right). Property has been at the center of China’s extended credit boom, as a major driver of fixed-asset investment, a significant beneficiary of bank and shadow financing, and as collateral for additional borrowing by property developers, state-owned enterprises, and local governments. As a result of property’s interconnections with the primary drivers of the economy, a significant downturn is likely the biggest threat to China’s financial stability. Meanwhile, the outlook for Japan remains muddled. Manufacturing activity went into modest contraction following the consumption-tax hike in April,18 but some confidence indicators have stabilized.19 Trade data from Taiwan and China shows their exports to Japan held up during April,20 but the risk remains elevated that a slower pace from Japan’s domestic economy could add another headwind for the region. Although the global economic backdrop is still generally stable, the downside risks in Asia—and particularly in China—have continued to rise.

Summary and outlook: steady, but mixed outlook below surface

The global business cycle remains steady at an aggregate level, but veils an increasingly mixed outlook beneath the surface. The solid trajectory continues to be supported by most developed economies, particularly the stable U.S. mid-cycle as well as early- and mid-cycle dynamics across Europe. Most emerging economies are still facing late-cycle pressures, while the cyclical and financial risks in Asia—spurred by problems in China and Japan—continue to rise.

Global financial markets remain unusually calm, with extraordinarily low levels of volatility given the mounting list of economic, policy, and geopolitical risks on the horizon. There is some fundamental justification for the quiet market environment, as low inflation, moderate growth, and accommodative monetary policies help keep the macroeconomic backdrop on an even keel. However, global liquidity growth has slowed. Although central banks in Europe and Japan may ease further in coming months, the Fed continues to wind down quantitative easing and emerging markets as a group have been hiking policy rates. Our tactical concern is that low market volatility may be breeding investor complacency.

From an asset allocation standpoint, we remain constructive on risk assets in the U.S. and Europe due to their favorable cyclical backdrops, but we are tactically concerned about rising global risks, slowing liquidity growth, and low market volatility. As a result, our continued outlook—that U.S. interest rates are likely to remain in a trading range—suggests that a healthy allocation to high-quality bonds may be useful as a hedge against potential equity-market volatility, particularly because the absolute return downside of investment-grade bonds appears limited in the near term (see “Why U.S. Treasury yields remain so low,”).

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The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity’s portfolio managers and investment teams. AART is responsible for analyzing and synthesizing investment perspectives across Fidelity’s asset management unit to generate insights on macroeconomic and financial market trends and their implications for asset allocation. Asset Allocation Research Analysts Craig Blackwell, CFA; Austin Litvak; and Jordan Alexiev, CFA, also contributed to this article. Vic Tulli, vice president, senior investment writer, and Christie Myers, investment writer, provided editorial direction.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information.
Generally, among asset classes, stocks are more volatile than bonds or short-term instruments and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Although the bond market is also volatile, lower-quality debt securities including leveraged loans generally offer higher yields compared to investment-grade securities, but also involve greater risk of default or price changes. Foreign markets can be more volatile than U.S. markets due to increased risks of adverse issuer, political, market, or economic developments, all of which are magnified in emerging markets.
Investment decisions should be based on an individual’s own goals, time horizon, and tolerance for risk.
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, credit, and default risks for both issuers and counterparties.
Investing involves risk, including risk of loss.
Past performance is no guarantee of future results.
Diversification does not ensure a profit or guarantee against loss.
All indices are unmanaged. You cannot invest directly in an index.
The Typical Business Cycle depicts the general pattern of economic cycles throughout history, though each cycle is different; specific commentary on the current stage is provided in the main body of the text. In general, the typical business cycle demonstrates the following:
• During the typical early-cycle phase, the economy bottoms out and picks up steam until it exits recession, then begins the recovery as activity accelerates. Inflationary pressures are typically low, monetary policy is accommodative, and the yield curve is steep. Economically sensitive asset classes such as stocks tend to experience their best performance of the cycle.
• During the typical mid-cycle phase, the economy exits recovery and enters into expansion, characterized by broader and more self-sustaining economic momentum but a more moderate pace of growth. Inflationary pressures typically begin to rise, monetary policy becomes tighter, and the yield curve experiences some flattening. Economically sensitive asset classes tend to continue benefiting from a growing economy, but their relative advantage narrows.
• During the typical late-cycle phase, the economic expansion matures, inflationary pressures continue to rise, and the yield curve may eventually become flat or inverted. Eventually, the economy contracts and enters recession, with monetary policy shifting from tightening to easing. Less economically sensitive asset categories tend to hold up better, particularly right before and upon entering recession.
Please note that there is no uniformity of time among phases, nor is there always a chronological progression in this order. For example, business cycles have varied between two and 10 years in the U.S., and there have been examples when the economy has skipped a phase or retraced an earlier one.
1. Source: Bureau of Labor Statistics, Department of Labor, Fidelity Investments (AART), as of April 30, 2014. Initial claims data as of May 10, 2014.
2. Source: Bureau of Labor Statistics, Fidelity Investments (AART), as of Apr. 30, 2014.
3. Source: National Federation of Independent Businesses, Haver Analytics, Fidelity Investments (AART), as of Apr. 30, 2014.
4. Source: Bureau of Labor Statistics, Fidelity Investments (AART), as of Apr. 30, 2014.
5. Source: Census Bureau, Fidelity Investments (AART), as of Apr. 30, 2014.
6. Source: Bureau of Labor Statistics, Fidelity Investments (AART), as of Dec. 31, 2013.
7. Headline inflation is calculated using headline CPI. Source: Bureau of Labor Statistics, Fidelity Investments (AART), as of Apr. 30, 2014.
8. Core inflation is calculated using core CPI. Source: Bureau of Labor Statistics, Fidelity Investments (AART), as of Apr. 30, 2014.
9. Source: Federal Reserve, Haver Analytics, Fidelity Investments (AART), as of May 5, 2014.
10. Source: Federal Reserve, Haver Analytics, Fidelity Investments (AART), as of May 16, 2014.
11. Source: Federal Reserve, Haver Analytics, Fidelity Investments (AART), as of May 16, 2014.
12. Source: Standard and Poor’s, Fidelity Investments (AART), as of May 14, 2014.
13. Source: Census Bureau, Haver Analytics, Fidelity Investments (AART), as of May 15, 2014.
14. Source: Census Bureau (housing starts and permits), National Association of Realtors (pending home sales), Haver Analytics, Fidelity Investments (AART), as of May 16, 2014. Pending home sales data as of Apr. 28, 2014.
15. Source: University of Michigan, Haver Analytics, Fidelity Investments (AART), as of Apr. 25, 2014.
16. Source: European Commission, Markit, Fidelity Investments (AART), as of Apr. 30, 2014.
17. Growth recession is a significant decline in activity relative to a country’s long-term economic potential.
18. Source: Markit, Haver Analytics, Fidelity Investments (AART), as of Apr. 29, 2014.
19. Source: Cabinet Office of Japan, Haver Analytics, Fidelity Investments (AART), as of May 12, 2014.
20. Source: China General Administration of Customs, Taiwan Ministry of Finance, Haver Analytics, Fidelity Investments (AART), as of May 8, 2014.
The Citigroup Economic Surprise Indices (CESI) are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations (measure of variation from mean) of data surprises (actual releases vs. Bloomberg survey median). A positive CESI suggests that economic releases have on balance beaten consensus.
The Consumer Price Index (CPI) is a monthly inflationary indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation.
A Purchasing Managers’ Index (PMI) is a survey of purchasing managers in a certain economic sector. A PMI over 50 represents expansion of the sector compared to the previous month, while a reading under 50 represents a contraction, and a reading of 50 indicates no change. Institute for Supply Management® reports the U.S. Manufacturing PMI®. Markit compiles non-U.S. PMIs.
The S&P 500® Index, a market capitalization-weighted index of common stocks, is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation.
The University of Michigan Consumer Sentiment Index is a consumer confidence index published monthly by the University of Michigan and Thomson Reuters.
Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC.
Fidelity Guided Portfolio Summary (Fidelity GPS) is an enhanced analytical capability provided for educational purposes only.
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