The mid-cycle expansion of the U.S. economy continues at a moderate pace, thanks to ongoing improvements in employment, housing, and consumer sentiment. There are signs, however, that growth in the U.S. manufacturing sector is slowing.
Financial market volatility and disappointing data from developing countries have weighed on global economic conditions (see the U.S. economic indicators scorecard below).
Recent trends in major categories
A spike in volatility has been the hallmark of global fixed income, currency, and equity markets this month, highlighted by rising global bond yields and falling emerging-market currencies. The elevated volatility reflects concern about the potential impact of economic slowing in China, greater market volatility in Japan’s financial markets, and the prospect that the easy monetary policies of the Federal Reserve (Fed) could dry up sooner rather than later.
China’s sluggish recovery may be faltering, with signs of a liquidity crunch diminishing the outlook. The latest reading of the manufacturing Purchasing Managers’ Index (PMI) indicated not only current contraction but also a worrisome dip in leading indicators such as new orders.1 Export growth was negative over the past three months and only 0.6% on a year-over-year basis—the slowest rate since the global financial crisis.2 This weakness underscores China’s inability to gain economic traction despite a massive surge in credit since the summer of 2012.
More recently, authorities have acted to rein in excessive growth in nonbank credit through wealth management products and other forms of shadow financing provided through nonbank entities. This triggered the dramatic rise in overnight interbank lending rates—a sign of financial system stress (see the chart above). China’s economy may be slipping into the late-cycle stage.
Japan remains firmly in the early-cycle phase of the business cycle, though the ambitious policies of the Abe government have likely contributed to global financial market volatility. Export demand continues to recover, benefiting from the generally weak yen, while the improving labor market and buoyant consumer expectations bode well for the domestic sector. Leading economic indicators have improved dramatically and are now back to levels not seen since 2007, reflecting the broad-based pickup in economic activity.
Dramatic moves in the equity and bond markets highlight the risks ahead, as the government’s initial policy recommendations for structural economic reform—the “third arrow” of Abe’s stimulus strategy—have generally been a letdown for investors. Nevertheless, Japan’s economy remains in a solid upturn (see the chart, right).
Europe remains stagnant, but there have been signs of broad-based stabilization and early-cycle dynamics in some areas. The region has experienced widespread improvements in manufacturing, as evidenced by the difference between manufacturing new orders and inventories, which is known as the bullwhip.
The eurozone bullwhip experienced its strongest—and only the second positive—reading since June 2011, underscoring the steady gains from last December (see the chart below). Germany’s strong leading economic indicators, rising construction activity, and improving exports to other European countries are all signs of its transition into the early stages of a cyclical recovery. The eurozone periphery has increased competitiveness (due to falling unit labor costs), moved into current account surplus, and seen indications of financial system stabilization—all of which suggest that the worst of the recession has passed.
While leading indicators suggest positive momentum for most of the world’s advanced economies, the outlook for developing countries may be deteriorating. Japan’s export resurgence has weighed on its competitors in South Korea and Taiwan, and the Bloomberg Asian Financial Conditions Index (ex Japan) has dropped significantly amid tighter interbank lending conditions in China.
Recent market volatility has caused investors to liquidate emerging-market bond and currency positions, making it more difficult for countries with large trade deficits, such as India and Turkey, to finance their current accounts. Meanwhile, commodity exporters, such as Brazil, are exhibiting economic deceleration attributable—at least in part—to stagnating growth in resource sectors.
Nevertheless, many developing economies have been able to ease monetary policy to counteract these negative factors, as inflationary pressures generally remain muted. The trend of gradual, uneven global economic improvement continues, with more positive momentum in developed than developing countries.
Credit markets and banking
The Fed provided more detailed guidance that as long as the economy continues to improve, the pace of stimulus may be moderated later this year and ended in mid-2014. These comments were a contributing factor to the spike in bond market volatility and the rise in interest rates (see the chart, right).
With credit spreads widening, issuance in corporate debt markets has moderated. The Bloomberg U.S. Financial Conditions Index has deteriorated but remains near its post-2007 highs. On the bright side, banks report increasing loan demand amid loosening credit standards, leading to healthy growth over the past year in business and consumer credit (excluding mortgages) of 6.6% and 6.0%, respectively.3 Despite increasing volatility over the past few weeks, credit conditions remain supportive of further U.S. economic expansion.
Corporate profitability remains solid, helping to keep the corporate sector one of the strongest in the U.S. economy. Yet disappointing revenue growth and peaking profit margins point to a slower pace of earnings growth, which is typical of a mid-cycle economic expansion.
Prospects for capital expenditures have firmed as industrial production of business equipment and new orders for core capital goods have both picked up recently.4 For the first time in six months, the manufacturing PMI fell into contractionary territory, but the slowing in manufacturing appears to be more tied to sluggish global growth and the government’s sequestration cuts than broad-based weakness in domestic demand.5 Despite slower earnings growth and manufacturing activity, rising capital spending has helped to keep the corporate sector healthy overall.
The U.S. job market continues a slow but steady healing process. Employment in May mostly met expectations—private payrolls increased by 178,000, which is about average over the past three years.6 With 60% of industries increasing employment over the previous month, the gains have been relatively broad-based. The job openings rate has improved, and quit rates hit post-recession highs in April, highlighting growing confidence in the labor market. Initial unemployment claims have averaged around 345,000 over the past four weeks, near the lowest levels since the recession. The employment outlook remains constructive, as private-sector job gains have more than offset the federal government contraction.
The U.S. housing sector continues to provide a significant tailwind to economic growth. Home prices in all major metropolitan areas have increased 12% on average from a year ago.7 Despite rising mortgage rates, housing affordability is still near historic highs.8 As more sellers have been enticed into the market, the supply of new and existing homes expanded from a cyclical low of 4.3 months in January to 5.2 months in April, which could slow the pace of price appreciation going forward.9 The National Association of Home Builders Housing Market Index posted a sharp increase in June, reflecting robust housing market activity and expectations for ongoing improvement. Amid rising prices, strong demand, and historically high affordability, the U.S. housing backdrop is still fundamentally strong.
Inflationary pressures in the U.S. have been well contained, with headline and core consumer prices increasing only 1.4% and 1.7%, respectively, over the past year.10 Reflecting recovery in the housing market, the shelter index accounted for more than half of May’s increase. However, low wage growth and range-bound commodity prices have acted to counterbalance any upward pressures. Inflation expectations remain modest, as offsetting forces should help to keep inflationary pressures relatively muted for the rest of the year.
Consumer spending trends have been a positive force for the overall economy, despite recent headwinds from the government’s fiscal consolidation efforts. Core retail sales—at 3.4% year-over-year excluding the volatile automobile, gasoline, and building materials components—expanded more than expected in May.11 Buoyed by the healing labor market and the general rise in net worth as housing and financial markets have rebounded, consumer sentiment remains near cyclical highs. Consumers continue to benefit from the environment of steady job gains, rising home prices, and low inflation.
Summary: causes of volatility
The spike in market volatility began in global bond and currency markets, and by mid-June had spread into equity markets. The turmoil has three principal causes. First, the Fed’s more explicit communication of the possible timetable for winding down its quantitative easing program helped to precipitate an upward move in U.S. interest rates.
Second, Japan’s bond and currency markets—which had been steady entities that served as funding sources for global carry trades into other riskier investments— have experienced significant volatility.
Third, China’s unexpectedly weak economic growth, along with a liquidity crunch caused by a move to curb nonbank credit growth, has dampened the outlook for the world’s second largest economy as well as commodities and many other developing countries.
The first two of these underlying causes of volatility are related to a perceived unwinding of liquidity and a shift in expectations for various assets that had thrived under the Fed’s quantitative easing and Japan’s financial stability. The perception that the Fed would move to tightening earlier than expected has boosted the U.S. dollar and government bond yields. Investments in emerging markets have suffered from the pressure on their currencies and the unwinding of carry-trade positions that had been predicated on cheap funding and low volatility during most of the past decade.
The third cause—China’s economic weakness and apparent willingness to tighten nonbank credit—has proved a double whammy for many emerging markets and other countries tied to the Chinese growth story through the commodity markets or trade linkages.
On a fundamental basis, the slow but steady mid-cycle growth in the U.S. economy—with little inflationary pressure and still accommodative monetary policy—continues to provide support for economically sensitive asset classes in the U.S. Rising interest rates do have some negative effects on economic momentum, but a strengthening economy would likely be the precursor to any reduction in the Fed’s stimulus, which could be a positive development for the U.S. stock market. Similarly, the solid recovery in Japan and the incipient signs of early-cycle momentum in Europe imply that most of the world’s largest advanced economies are on an improving trend.
On the other hand, the inability of China’s economy to reaccelerate after a long period of rapid credit expansion—along with the apparent move by authorities to dampen shadow financing—casts a cloud over much of the developing world. Though any action to rein in the unsustainable growth of nonbank credit is a positive development for China’s long-term stability, the risk of policy miscues and unintended consequences has risen. At the very least, slower credit growth implies a diminished outlook for China, which in turn reinforces the weakness among commodity producers and emerging Asia.
From an asset allocation perspective, we expect higher volatility to persist in global bond, currency, and equity markets as uncertainty around monetary policies in the U.S. and Japan contributes to greater fluctuations in asset prices. This may create a difficult environment for many bond categories in the near term, particularly those that have benefited from significant spread tightening in recent months. However, cyclical improvement in the U.S. continues to support the outlook for the U.S. equity market, and European equities may now be pricing in excessive near-term pessimism.
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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 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.
2. Source: China Customs, Haver Analytics, Fidelity Investments (AART) as of May 31, 2013.
3. Source: Federal Reserve Board, Haver Analytics, Fidelity Investments (AART) as of May 6, 2013. Business and consumer credit data as of Mar. 31, 2013.
4. Core capital goods new orders defined as capital goods excluding defense and aircraft orders. Source: Federal Reserve Board, Census Bureau, Haver Analytics, Fidelity Investments (AART) as of May 31, 2013. Core capital goods data as of Apr. 30, 2013.
5. Source: Institute for Supply Management, Haver Analytics, Fidelity Investments (AART) as of May 31, 2013.
6. Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments (AART) as of May 31, 2013.
7. Home prices represented by the S&P/Case-Shiller® Home Price Index. Source: Standard & Poor’s, Haver Analytics, Fidelity Investments (AART) as of Apr. 31, 2013.
8. Source: National Association of Realtors, Haver Analytics, Fidelity Investments (AART) as of Apr. 30, 2013.
9. Source: Census Bureau, Haver Analytics, Fidelity Investments (AART) as of Apr. 30, 2013.
10. “Headline,” “core” (excluding food and energy), and “shelter” (housing) consumer prices represented by the Consumer Price Index. Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments (AART) as of May 31, 2013.
11. Source: Census Bureau, Haver Analytics, Fidelity Investments (AART) as of May 31, 2013.