The U.S. economy continues to be in a mid-cycle expansion, boosted by renewed business investment and a pickup in the manufacturing sector. U.S. consumers are still spending as recoveries in employment and housing gain traction. Though still slow, global growth is on firmer ground, with major economies improving, world trade increasing, and monetary easing ongoing (see U.S. Economic Indicators Scorecard, below).
We expect business investment to become a bigger contributor to economic growth as 2013 unfolds. The structural improvement in U.S. manufacturing helps to fortify the longer-term economic outlook. From an asset allocation perspective, we continue to favor economically sensitive assets such as stocks and credit sensitive bonds, though rising valuations reflect more of the positive outlook.
Recent trends in major categories
The U.S. corporate sector, with healthy balance sheets and steady cash flows, remains one of the economy’s strongest sectors.
Though profit margins may have peaked, businesses have become more willing to invest. February’s industrial production of business equipment grew at the fastest rate since last summer, and January’s new orders of core durable goods (excluding defense and aircraft orders) posted a robust six-month annualized rate of 28% (see chart right). Small business optimism has also climbed steadily from last November’s lows, and the percentage of firms planning to increase capital spending has hit a post-recession high.1
We expect capital expenditures to remain solid throughout the year as peak profit margins and slow productivity rates incentivize additional investment.
The manufacturing sector is currently experiencing a cyclical upswing while the weak global growth and inventory correction during the second half of 2012 have given way to strengthening foreign demand and inventory restocking. The Purchasing Managers’ Index in February hit a nearly two-year high and new order growth has outstripped inventories, which bodes well for the near-term cyclical outlook.2 Additionally, a number of tailwinds are providing a boost to the long-term outlook for the manufacturing sector (see "Secular resurgence of U.S. manufacturing," below).
The corporate sector remains a bright spot for the economy, with capital expenditures picking up and the resilient manufacturing sector continuing to expand.
Secular resurgence of U.S. manufacturing
The U.S. manufacturing sector is in the early innings of a long-term resurgence that will likely have far-reaching effects across the economy. While the sector lost many jobs during the past decade, this period of major adjustment has allowed manufacturing to emerge with greater efficiency and competitiveness.
Since 2002, U.S. manufacturing output has increased 17%, but costs have declined in several areas (see chart below left). Manufacturers reduced their unit labor costs significantly, and when paired with the weakness in the dollar over the same period, U.S. manufacturing labor costs have become much more competitive versus other economies in the global market (see chart below right).
In addition, manufacturing has benefited from dramatically higher energy efficiency and lower energy prices. Even with the increase in output, energy consumption has fallen 16% since 2002, and U.S. prices for natural gas and electricity—which respectively constitute 30% and 13% of manufacturers’ energy needs—are now among the lowest in the world, thanks to technological advancements in shale production that have yielded a natural gas bonanza.3
Despite the sector’s share of GDP contracting from 28% in 1953 to 12% in 2010, manufacturing remains an important contributor to U.S. economic growth.4 Globally, manufacturing employment has tended to fall due to productivity gains and competitive pressures, and the U.S. has been no exception— manufacturing has shed 3 million jobs since 2002.
After the recession, however, U.S. manufacturing employment has slowly improved and should continue to benefit as domestic firms return and foreign firms relocate to profit from the secular improvement in U.S. competitiveness and to avoid the high costs of shipping and stretched supply chains.
Manufacturing may have the largest multiplier effect of any sector in the economy. According to the National Association of Manufacturers, every $1 in final sales supports $1.34 in economic activity in non-manufacturing sectors such as construction and services. Manufacturing also contributes significantly to national productivity growth and provides about two-thirds of private sector research and development.5 And with manufactured goods comprising more than 50% of U.S. exports, a healthy manufacturing sector has broad implications for trade deficit reduction.6 The resurgence in U.S. manufacturing is thus poised to provide a broad-based tailwind for the U.S. economy for years to come.
The labor market has continued to improve at a moderate pace. In February, the unemployment rate fell to a new cyclical low of 7.7% and payroll growth of 236,000 exceeded expectations. On strength in the residential housing market, construction employment grew by 48,000—the largest monthly gain since 2006.7
While the anemic productivity growth experienced by the corporate sector over the past few months may be negative for profitability, it may have encouraged hiring activity. Historically, payrolls tend to rise along with demand when productivity slows, as companies become unable to squeeze more productive capacity from their existing workforce (see chart right). Falling to a five-year low in March, the four-week moving average of initial unemployment claims serves as a leading indicator of ongoing labor market repair.
The outlook for employment remains moderately positive as weak productivity growth in the corporate sector and recovery in the housing market have combined to offset the drag from tighter government budgets.
Residential housing has become a significant tailwind to U.S. economic growth as activity continues to gain steam. Home prices ended 2012 up 6.9%—the best year-over-year pace since 2006— but remain far below pre-crisis peaks, and the National Association of Realtor’s measure of affordability is still near all-time highs.8 With January sales growing 9% from the prior year, the inventory of unsold homes fell to just 4.2 months of supply—the lowest since 2005.9 Foreclosure activity dropped dramatically over the past year, and delinquencies hit new cyclical lows. Expanding at a 17% annualized rate in the fourth quarter, residential construction activity accounted for 0.4 percentage points of the meager growth in U.S. GDP.10
Increasing prices and low supply, along with high levels of pent-up demand and affordability, have provided a strong fundamental backdrop for housing’s ongoing recovery.
Consumer spending activity has held up fairly well, despite the drag from rising gasoline prices, higher taxes, and lower government spending. February core retail sales (excluding volatile auto, gasoline, and building supplies categories) exhibited strength, advancing by 3.7% year-over-year or 5.8% on a 3-month annualized basis.11 Households’ net worth is near all-time highs after gaining an impressive $5 trillion during 2012, a positive wealth effect from rising stock prices and home price appreciation.12 However, consumer sentiment dropped to a 14-month low in March as ongoing government sequestration cuts may be weighing on expectations.13
U.S. consumer activity has held up well amid the improvement in employment and housing, though continuing fiscal austerity will likely dampen the upside.
The rising cost of gasoline caused February consumer prices to increase more than expected, to 2% year-over-year, but inflationary pressures have remained well contained.14 Our oil demand outlook implies limited inflationary pressures for energy in 2013.
Less volatile core consumer prices (excluding energy and food) also rose 2%, in line with market expectations, with only housing showing upward pressure as rental vacancy rates reached 10-year lows.15 Consumer surveys and breakeven rates for Treasury Inflation-Protected Securities (TIPS) have been firmly range-bound since October, indicating that inflation expectations are still well anchored.16
Though the recent rise in gasoline pushed up consumer prices, limited wage growth has kept underlying inflationary pressures subdued.
The outlook for the global economy continues to show signs of improvement. Leading indicators suggest that among the world’s major economies, Japan is emerging from recession into the early phase of the cycle, and Germany is beginning to pick up. Business and consumer sentiment measures for Japan have risen in anticipation of policy measures—including monetary and fiscal stimulus—supported by the new government. In addition, the recovery in global trade over the past several months has provided a boost to the export sectors in both Japan and Germany. While some parts of Europe remain recessionary, activity in many eurozone peripheral countries appears to be bottoming.
Meanwhile, China’s early-cycle recovery continues, largely driven by increases in non-bank credit (see “China’s Reacceleration: Near-term Positive, Medium-term Concern” for further details).17 Global manufacturing activity has picked up, with 59% of the largest countries showing expansion in that sector.18 The leading indicators for other major economies have also exhibited broadbased gains, with 60% of countries increasing over the past six months.19 Further supporting economic growth, Asian and European financial conditions have improved markedly during the past few months.
While still slow, global growth has found firmer ground as conditions in the major economies improve, world trade increases, and monetary policies remain loose.
Credit Markets and Banking
U.S. financial conditions have served as an important tailwind for the economy, with several different metrics improving steadily to post-financial-crisis highs.
The latest Senior Loan Officer Survey from the Federal Reserve (Fed) showed rising demand and easing lending standards for mortgage, consumer, and business loans. A quarterly report from the New York Fed revealed a slight increase in household debt outstanding due to stabilization in mortgage debt and expansion in non-housing debt. This reversal in the downward trend since 2008 suggests consumers may be in the latter stages of their deleveraging cycle. Corporations have continued to enjoy easy access to credit markets, and with healthy demand for investment-grade and high-yield bonds, spreads have trended lower to hover near levels last seen in 2007.20
Overall credit conditions remain supportive, buoyed by the Fed’s accommodative monetary policy.
Summary and outlook
The U.S. economy is solidly in mid-cycle expansion after the latecycle risks experienced at the end of 2012 have dissipated.
The overall pace of activity is still slow, yet business investment and manufacturing have reaccelerated since the global slowdown and uncertainty surrounding the fiscal cliff in the second half of last year. Residential construction spending offset declines in other parts of the economy during the fourth quarter, and improving housing and employment markets continue to underpin U.S. consumer spending.
Though there are policy risks in many areas of the world—plans for a new tax on bank deposits in Cyprus triggered the latest bout of market volatility related to eurozone debt concerns—U.S. and global monetary conditions remain highly accommodative.
Additional fiscal austerity introduced by the U.S. sequester will likely place a further weight on consumption. It is the restrained pace of overall growth—in the U.S. and elsewhere—that has kept inflationary pressures reasonably well contained and allowed monetary policy to remain extraordinarily loose. This leaves the U.S. and much of the world in a sweet spot of supportive monetary policies and incrementally improving economic trends—typically a solid foundation for more economically sensitive assets.
The sharp rally in riskier assets over the past several months has been justified by improving economic conditions. While we continue to favor economically sensitive assets, asset valuations now reflect more of this positive cyclical outlook. Riskier credit-sensitive fixed income assets have become more fully valued—though still attractive relative to government bonds. Near all-time index highs, U.S. stocks nevertheless remain at reasonable valuations. If the global economy continues to gather steam as we expect, emerging market equities could gain more traction during 2013.
The Typical Business Cycle depicts the general pattern of economic cycles throughout history, though each cycle is different and specific commentary on the current stage is provided in the summary and outlook section. In general, the typical business cycle demonstrates the following:
• During the typical early-cycle phase, the economy bottoms 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.
2. Source: Institute for Supply Management, Haver Analytics, Fidelity Investments (AART) as of Feb. 28, 2013.
3. Source: Energy Information Administration, Fidelity Investments (AART) as of 2010.
4. Source: Bureau of Economic Analysis, Haver Analytics, Fidelity Investments (AART) as of Dec. 31, 2010.
5. Source: Bureau of Economic Analysis, National Science Foundation, Fidelity Investments (AART) as of Dec. 31, 2009.
6. Source: Census Bureau, Haver Analytics, Fidelity Investments (AART) as of Dec. 31, 2012.
7. Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments (AART) as of Feb. 28, 2013.
8. House prices represented by the S&P/Case-Shiller Home Price Index. Source: Standard & Poor’s, Haver Analytics, Fidelity Investments (AART) as of Dec. 31, 2012.
9. Source: Census Bureau, Haver Analytics, Fidelity Investments (AART) as of Jan. 31, 2013.
10. Source: Bureau of Economic Analysis, Haver Analytics, Fidelity Investments (AART) as of Dec. 31, 2012.
11. Source: Census Bureau, Haver Analytics, Fidelity Investments (AART) as of Feb. 28, 2013.
12. Source: Federal Reserve Board, Haver Analytics, Fidelity Investments (AART) as of Dec. 31, 2012.
13. Source: University of Michigan, Haver Analytics, Fidelity Investments (AART) as of Mar. 15, 2013.
14. See endnote 7.
15. See endnote 7.
16. Source: Federal Reserve Board, Haver Analytics, Fidelity Investments (AART) as of Mar. 15, 2013.
17. “China’s Reacceleration: Near-term Positive, Medium-term Concern,” Fidelity Leadership Series, February 2013.
18. Source: JPMorgan, Markit, Haver Analytics, Fidelity Investments (AART) through Feb. 28, 2013.
19. The major economies include: Austria, Belgium, Brazil, Canada, China, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, India, Indonesia, Ireland, Italy, Japan, South Korea, Luxembourg, Malaysia, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Russia, Slovakia, South Africa, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, United States, United Kingdom. Source: OECD, The Foundation for International Business and Economic Research, Institute for Supply Management, Haver Analytics, Fidelity Investments (AART) as of Jan. 31, 2013.
20. Source: FactSet, Fidelity Investments (AART) as of Mar. 15, 2013.