The U.S. economy remains in mid-cycle expansion amid improvements in employment and manufacturing, a solid corporate sector, and generally benign credit and inflation backdrops.
Globally, expansion in most of the world’s developed economies and stabilization in China have underpinned a trend of slow improvement (see U.S. economic indicators scorecard, below).
The following is a more detailed look at developments in major areas of the economy.
Recent trends in major categories
Global growth continued its trend of modest improvement, with developed economies still showing better cyclical dynamics than emerging markets. Leading indicators in 64% of the world’s 37 largest economies have registered growth over the past six months.1 Global manufacturing has picked up, with August purchasing managers’ indices (PMIs) improving month-over-month in 82% of the world’s major economies.2 Solid readings in the PMI bullwhips (new orders minus inventories) suggest that the manufacturing momentum could continue in many larger economies (see chart, right). Most European countries remain in an early-cycle recovery, helped by further stabilization in financial markets and an increase in manufacturing output. Japan has held steady in a mid-cycle phase, with monetary and fiscal policy bolstering economic activity. Risks of a growth recession in China receded amid a combination of increased monetary support, acceleration in state-led spending on infrastructure and investment, and an apparent policy shift toward stabilizing growth.
Many emerging markets have experienced significant financial pressures since May, when the Federal Reserve (Fed) signaled the possibility of tapering asset purchases in its quantitative easing (QE) program. QE had spurred interest rate declines across developed markets in recent years, encouraging carry trades and driving yield-seeking investors toward emerging-market bonds. With expectations of tapering and higher U.S. Treasury yields, carry trades have unwound since May, and capital outflows from emerging markets caused sharp currency depreciation and higher borrowing costs for many developing economies.
The impact has been most pronounced in emerging-market countries with current account deficits that rely on foreign portfolio flows for financing, including India, Indonesia, Brazil, Turkey, and South Africa. Central banks in many of these countries sought to stabilize their currencies and to contain capital outflows by tightening liquidity, raising interest rates, and selling their foreign exchange reserves. However, while these moves were intended to attract foreign capital, the tighter monetary conditions may create additional drag on economic growth. As weaker currencies have spurred inflationary pressures—exacerbated by rising oil prices in oil-importing nations such as India—stagflationary conditions have set in.
Although the Fed’s decision to maintain QE asset-purchase levels has alleviated some of the pressures on emerging-market economies, the risks of lower growth, rising inflation, and higher borrowing costs hold emerging markets in a late-cycle phase. Having failed to implement structural reforms in an environment of ample foreign financing, these economies face significant cyclical challenges. The global economy continues to gain traction, with steady improvement in developed economies and stabilization in China, but emerging markets still face an array of headwinds.
Credit markets and banking
Credit and banking conditions in the U.S. are generally benign. Market volatility has subsided after spiking in June following the Fed’s warning that it might begin to taper QE as early as this year, and the September announcement postponing tapering was greeted warmly by financial markets. Historically low interest rates continued to strengthen personal and corporate balance sheets, as indicated by further declines in bank-loan delinquency rates.3 Although high-yield bond issuance has slowed, investment-grade issuers continued to borrow despite higher rates, as highlighted by the record $49 billion Verizon issue. Credit conditions continue to support economic expansion, though uncertainty over the Fed’s tapering outlook is likely to persist as a potential source of volatility.
The U.S. labor market maintains its slow rate of recovery. The pace of job creation remained modest over the summer months, with private payroll growth slower than expected in August, reported gains for the prior two months revised downward, and unemployment dropping to a new cyclical low of 7.3%.4 The Beveridge curve, which tracks the relationship between unemployment and job openings, suggests slow, ongoing healing in the labor market following the financial crisis. In the early stages of the recovery, structural problems such as limited labor mobility and skill mismatches led to different vacancy rates than the curve would suggest; recent data show that openings are remaining high while unemployment declines (see chart, right). Leading indicators continue to represent labor market improvement: initial unemployment claims have been gradually falling for much of 2013, and the four-week moving average dropped to new post-recession lows in mid-September.5 The National Federation of Independent Business survey reported a dramatic increase in the percentage of firms planning to increase employment, to the highest level since January 2007. Workers’ quit rates continued to trend higher, suggesting a growing confidence in job prospects.6 Labor markets continue along a path of gradual repair.
Consumer spending growth remained steady despite experiencing a slight deceleration over the course of the year. August core retail sales (excluding autos, gasoline, and building supplies) exhibited an unimpressive 0.2% growth month-over-month, though longer-term growth, at 3.2% year-over-year, is still relatively encouraging.7 Sales of autos, housing, and household durables have increased rapidly, a trend that may be partially attributed to consumers pulling forward large purchases in expectation of rising interest rates. The University of Michigan Survey of Consumer Confidence index declined to a five-month low, with participants citing higher rate expectations and a less optimistic employment outlook. Despite this recent weakening, consumer confidence remains near the upper end of the post-recession range. Overall, consumption remains modestly positive, but could be pressured by concerns over rising interest rates, low income growth, and continued fiscal tightening.
The U.S. housing sector continued to improve, though the pace of recovery has decelerated. Home prices have steadily appreciated, rising 12% over the past year as of June, though the rapidity of increase may be peaking.8 Housing affordability, though still high relative to history, has continued to drop as mortgage rates climb and home prices rise.9 Mortgage loan applications for purchase have weakened by 13% since the beginning of June, as higher rates may keep prospective applicants on the sidelines and put downward pressure on the sector.10 Nevertheless, housing activity remains solid as housing starts and permits continue to grow at double-digit rates.11 The housing supply remains relatively tight, with the inventory of new and existing homes standing at 5.1 months, which is below the average since 1995.12 According to recent survey data released by the National Association of Home Builders, demand has held firm and may grow further as rising employment provides a boost to new household formation. The rise in mortgage rates and home prices has slowed, and the overall housing recovery remains in a fundamentally sustainable upward trend.
Corporate profitability has been high and continues to grow (but at a slower rate, which is typical of this stage of the business cycle), and the U.S. corporate sector remains solid. According to a recent Duke University/CFO magazine corporate survey, CFOs continue to feel more optimistic about their own companies and the economy overall. Echoing those results, the Small Business Optimism Index in August remained near cyclical highs.13 New orders for core capital goods were weaker than expected in July, though the trend in capital expenditures remains supportive, up 7.4% from a year ago.14 The manufacturing sector remains in expansion, with the PMI hitting a robust 55.7 in August. Although seasonal statistical adjustments may have contributed, the improvement appears broad-based, with 83% of industries reporting growth and manufacturers citing healthy production figures and increased new orders.15 A strengthening manufacturing sector and buoyant sentiment continue to support a solid corporate sector.
Inflation remains well anchored, posting levels below the Fed’s target rate of 2.0%. The headline consumer price index (CPI) fell from 2.0% in July to 1.5% in August, mainly due to a year-over-year decline in gasoline prices.16 Supported primarily by higher home prices, August’s Core CPI (which excludes volatile energy and food prices) rose modestly for the second month in a row, reaching 1.8% on a year-over-year basis.17 Despite continued expansion in the labor market, wage growth has not contributed meaningfully to inflation. Inflation remains stable overall, as improvements in the labor market have not been strong enough to induce the wage growth that might kindle inflation pressures.
Summary and outlook
The global business cycle continues to indicate a steady upward trend despite the relatively slow pace of overall growth. Most of the world’s developed economies—including Europe, the U.S., and Japan—remain in the more favorable early or mid-cycle phases. Despite late-cycle dynamics, China’s outlook has stabilized as authorities have eased policies. The Federal Reserve’s surprise decision to postpone the tapering of its QE program helped arrest the upward movement in bond yields, which could reduce pressure on emerging markets beleaguered by foreign capital outflows. The prospect of a settling period for global interest rates amid positive economic momentum provides an overall benign investment climate.
Nevertheless, a number of risks persist, and the global cyclical upside appears limited. The Fed’s decision not to pull back on its QE program was an acknowledgement that the U.S. economy continues to grow slowly. Despite improvement in developed economies, the recovery in Europe overall remains tepid, and the sustainability of Japan’s expansion likely depends on implementing difficult structural reforms alongside the present monetary and fiscal easing. China’s growth outlook is hampered by weak corporate profitability, excessive credit creation, and overcapacity in sectors related to real estate. Other large emerging economies such as India and Brazil face the need to implement structural reforms to reignite from their stagflationary conditions. Oil prices could spike further amid supply and geopolitical risks (see below), monetary policy uncertainty persists across multiple regions, and the U.S. faces fiscal deadlines over the next month that could provoke political brinkmanship and negative headlines.
Because these risks occur within the context of an improving global business cycle, this environment continues to favor allocation to more economically sensitive assets, such as equities. European stocks in particular may stand to benefit from an early-cycle dynamic and discounted valuations. Despite the likely upward pressure on interest rates over time, a potential respite from the recent increase in global yields may benefit bonds.
Upside risks to oil prices may be underappreciated
Recent events in Syria have overshadowed a significant drop in oil supply from many nations in the Organization of the Petroleum Exporting Countries (OPEC). Outages in Nigeria, Iran, Iraq, and most recently Libya have reduced production by nearly 1.5 million barrels per day (bpd) over the past year.18 Libya alone accounts for more than two-thirds of the decrease, as civil conflict has driven production back toward the low levels seen during the overthrow of Gaddafi (see chart, below left). In response, Saudi Arabia has boosted its output by close to one million bpd, and is now producing at its fastest pace in 30 years (see chart, below right). By our estimates, effective OPEC spare capacity is at its lowest level since 2004, when Brent prices rose almost 70% in just 10 months.19
Amid tightening fundamentals, rising geopolitical risk has helped to drive Brent crude from its trading range of $100 to $105 to a peak of almost $117 in August, settling at around $110 recently.20 The decreased likelihood of a U.S. attack on Syria removed upward pressure on the oil market in the near term. However, renewed geopolitical tensions in various OPEC member nations are beginning to emerge. For example, in Algeria—a country that produces more than one million bpd—recent government attempts to consolidate power ahead of April elections risk reigniting political protests and disrupting supply. During previous periods of heightened geopolitical tensions in the region (e.g., Egyptian unrest and Libyan civil wars in 2011 and the sanctions of Iran in 2012), the risk premium pushed average Brent prices 30% higher than the level justified by supply-and-demand fundamentals.21
The rapid tightening of fundamentals supports the recent rise in Brent prices, but brewing geopolitical concerns imply upside risk to the price of oil. Although retail gasoline prices have lagged Brent prices due to seasonal changes in regulatory standards, a $10 increase in Brent prices in general approximates a 0.5% additional tax on the disposable income of U.S. consumers. Higher oil prices often lead to a short-term spike in inflation, and a shift in consumer spending from discretionary goods to energy tends to result in slower economic growth.22
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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.