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?
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,”).
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917