The mid-cycle expansion of the U.S. economy continues at a moderate pace, supported by advances in housing, employment, and the credit markets. The outlook for the corporate sector remains positive.
Broad improvement in the global backdrop has been tempered by slowed growth for emerging markets, and policy risks in major economies loom (see U.S. economic indicators scorecard below).
Recent trends in major categories
The following is a more detailed look at developments in major areas of the economy.
Residential housing remains constructive to U.S. economic growth, despite a recent slowdown in activity. Though permit issuance and starts have moderated from paces set earlier in the year, both continue to post high year-over-year gains.1 The recent deceleration may be due to the significant rise in home prices and mortgage rates: year-over-year price increases for existing single-family homes were in the double digits for the fourth consecutive month in June, while 30-year conventional fixed mortgage rates have risen 100 basis points since the beginning of the year.2 Although housing affordability remains favorable relative to historical averages, the recent decline may rein in activity.
While the rapid rate of price appreciation is likely to slow, tight supply and demand conditions underpin a longer-term positive outlook. Household formations plummeted after the 2008 recession and have been below the long-term average for several years, suggesting significant pent-up demand. With the rise in employment, household formations outpaced housing starts (see chart, right). The supply of existing homes, at 5.1 months in July, remained near cycle lows; continued employment gains may spur additional home construction to meet demand.3
Rising rates may create some drag for the housing market, but improvements in mortgage availability from extremely tight levels may offset some of that effect. For the fourth straight quarter, the Senior Loan Officer Survey from the Federal Reserve (Fed) showed banks easing lending standards for residential mortgage loans (see chart, right). Although recent growth has slowed, tight supply-demand conditions, the continued rise in employment, and a thawing in mortgage credit suggest that the housing expansion may continue.
The labor market continues to improve gradually. Both the four-week moving average of unemployment claims and the unemployment rate have fallen to new post-recession lows.4 In July, the establishment survey gain of 162,000 was softer than expected but the household survey data showed more than 200,000 new jobs for the third time in four months.5 Survey results from the Institute for Supply Management suggested that hiring has resumed across the majority of industries. The National Federation of Independent Business reported an increase in the percentage of small businesses planning to increase their employment rolls, though that figure is still below the average in the previous mid-cycle expansion. The U.S. labor market appears to be poised to continue its modest pace of repair.
Credit markets and banking
U.S. financial conditions have improved markedly, following a brief period of increased volatility in the second quarter. The Bloomberg Financial Conditions Index has reached record highs, with broad-based improvement in indicators across money, bond, and equity markets. Corporate bond spreads have tightened significantly after spiking wider in June; following a slight increase since mid-July, stable and supportive demand has held spreads near first-quarter levels.6 In addition to mortgages, banks have continued easing credit standards for all types of loans while experiencing increased demand, according to the latest Fed survey. Ongoing improvement in U.S. financial conditions continues to provide a boost for the overall economy.
Consumer spending has been growing at a steady but subdued pace. As interest rates have risen, confidence indicators have softened mildly but remain near post-recession highs. Core retail sales (excluding the volatile auto, gasoline, and building materials sectors) grew 3.3% year-over-year in July.7 Vehicle sales moderated slightly on a sequential basis but held close to pre-recession levels. Nonrevolving credit (e.g., auto loans) grew at roughly 8% year-over-year in June, indicating continued expansion of credit to this consumer segment.8 Revolving credit growth remained slow, as consumers continued to repair their finances by paying down credit card debt; during the second quarter, the proportion of balances more than 90 days delinquent fell below 10% for the first time since 2008. Consumer spending has continued to grow moderately, buttressed by ongoing improvements in underlying credit fundamentals, the labor market, and housing.
Pricing pressures remain relatively modest. The headline consumer price index rose 2.0% on a year-over-year basis in July, up from 1.1% in April largely due to higher gasoline prices.9 Core inflation held steady, with the CPI excluding food and energy up 1.7% year-over-year.10 Improving wages and the recovery in housing are likely to exert mild upward pressure on core prices going forward. Inflationary pressures are rising gradually but remain low and well contained.
The corporate sector has remained solid, appearing to hold up amid weak global growth and the U.S. government’s fiscal tightening. At 2.2% year-over-year, earnings growth of S&P 500 companies was slightly below expectations for the second quarter.11 Slowing sales growth and flattening profit margins put pressure on earnings, and sectors more sensitive to global demand or commodity prices (e.g., materials and energy) reported disappointing profits. However, new orders for core capital goods grew by 7.2% year-over-year, and planned capital expenditures in the Philadelphia Federal Reserve’s Business Outlook Survey were near cyclical highs, demonstrating corporations’ improved willingness to invest (see chart, right). The July manufacturing purchasing managers’ index (PMI ) revealed a rebound in new orders, and the overall index improved noticeably to 55.4—the strongest showing for manufacturing since June 2011.12 Although earnings growth slowed, improved outlooks for both capital spending and manufacturing form a constructive backdrop for the corporate sector overall.
Overall, the global economy continues to grow slowly. Leading indicators in two-thirds of the world’s largest economies have shown gains over the past six months.13 Although expansion in global manufacturing remains sluggish, now nearly 60% of purchasing managers indices for the world’s major economies have reported improvement, up from a slim majority last month as the recovery continues to broaden.14 However, beneath the aggregate improvement lies a clear divergence between developed and emerging economies. For example, the manufacturing bullwhip (the difference between the PMI subindices for new orders and inventories) has strengthened over the course of 2013 for many developed economies while weakening for major emerging markets (see chart below, right).
In advanced economies from Europe to Japan, conditions have generally improved. Most European economies are now firmly in early-cycle recovery. Stronger-than-expected growth in Germany and France led to the first eurozone expansion in nearly two years, and eurozone manufacturing grew in July. Consumer confidence measures in the major economies beat expectations, while leading indicators for peripheral European countries have improved significantly since the start of the year.15 Japan’s recovery continues to broaden, entering the middle phase of the business cycle. Economic growth hit a healthy 2.6% annualized rate for the second quarter, benefitting from the strong consumer sector, growing exports, and pro-growth government policies.16 However, weak business investment and disappointing gross domestic product (GDP) growth suggest the need for structural reforms to sustain the expansion.
Downside risks in emerging markets have multiplied. China’s economy is in a late-cycle phase, and the risk of a growth recession has increased. Credit conditions have tightened since the spring, with small and medium-sized enterprises finding it harder to obtain financing. Domestic activity has been trending downward for several months amid low utilization rates and historically slow industrial production growth.17 Recent export data improved slightly, but the external sector holds a considerably smaller share of China’s economy now than during most of the last decade.
China’s decelerating growth has weighed on its Asian trading partners and many major commodity exporters. Much of the developing world has also suffered from higher borrowing costs, persistent inflationary pressures, and greater political instability. In particular, the civil war in Syria and growing crisis in Egypt have cast a pall on the regional prospects for the Middle East and North Africa. The global economy continues to bifurcate, with most of the advanced economies improving in early- or mid-cycle phases while many emerging markets exhibit some late-cycle characteristics and rising recession risks.
Summary and outlook
The U.S. and global economic backdrops remain relatively benign, maintaining an aggregate trend of steady improvement. While overall growth has been slow, incremental progress in developed economies may boost global trade over the next several months, with the U.S., Europe, and Japan representing more than half of the world’s GDP. Commodity prices remain in a trading range that is solid enough to support commodity producers but low enough to benefit consumers. Some emerging economies face stagflationary conditions, but overall inflationary pressures are relatively muted. Although monetary policies have become more divergent, the generally nonthreatening inflationary environment has allowed most central banks around the world to remain accommodative.
The cyclical backdrop continues to favor equities, but in the near term we anticipate that a number of policy-related risks will likely add to volatility in the coming months. Risks include:
- U.S. monetary policy The Federal Reserve appears likely to begin normalizing monetary policy by tapering its bond purchases by the end of the year, and uncertainty around the pace of policy change will likely grow over time. The prospect of a new Fed chairman and several new voting members in early 2014 will add another layer of uncertainty. Our assumption is that the expanding economy can weather the end of QE and an eventual move toward tightening, but volatility in the capital markets could increase in anticipation.
- U.S. fiscal policy The latest fiscal deadlines loom this autumn, as the government must fund a budget before October 1 and will likely need to raise the debt ceiling before the end of the year. Either (or both) could be grounds for a partisan battle that may rattle the markets. Fortunately, the deficit has fallen much more quickly than expected and the short-term fiscal outlook has greatly improved, making this issue less urgent for the markets—unless a government shutdown or default becomes a reality.
- China’s economic policies The new Chinese leadership is signaling its intent to reform the economy by tempering the credit-heavy, construction-driven activity that has propelled growth in recent years. However, reining in shadow financing and local government spending may also cause some tightening in growth sectors such as real estate, and the challenge will be to facilitate offsetting growth from smaller businesses, services industries, and consumer spending. Structural reforms are never easy, and the additional demands of a slower economy with several areas of overcapacity may raise the risk of greater volatility in China’s economic outlook.
- Japan’s economic policies The first two arrows in Prime Minister Abe’s program (monetary and fiscal stimulus) have boosted confidence and activity. To sustain this momentum, Japan likely requires progress on shooting the third arrow, structural growth reforms. With Abe’s party now in complete control of the Diet after July’s elections, the clock is ticking on enacting some of these crucial reforms. The most immediate question is how to handle the fiscal drag in 2014 from a legislated sales tax hike, balancing the need to manage Japan’s immense government debt through fiscal consolidation with the need to encourage economic growth. Japan’s outlook may become more mixed, and its deep government bond markets have the potential to transmit volatility into interest rate movements around the world.
In the near future, a comparatively benign global economic backdrop may mitigate the enduring effects of uncertainty around these policy challenges. Nevertheless, these policy risks bear close attention because they are likely to provoke higher financial-market volatility while they play out.
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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.