Download Business Cycle Update Impact of Fed Tightening

Market Perspectives
September 2014
Business Cycle Update:
Will Fed Tightening Pose a Late-Cycle Risk
to the U.S. Economy?
The U.S. economy’s modest, mid-cycle expansion persists, underpinned by
improvement in the labour market. Credit conditions and manufacturing activity
also remain sturdy. Outside the U.S., however, economic conditions are more
sluggish, and divergences exist between countries and regions.
The majority of U.S. economic sectors continue to exhibit incremental improvement,
with the labour markets gaining strength.
U.S. ECONOMIC INDICATORS SCORECARD
The economic indicators
scorecard is an illustrative
framework based on the
analysis summarised in “Recent
trends in major categories”
beginning on page 2. Movement
along the horizontal axis depicts
whether the recent trend has
become better or worse, while
vertical placement indicates
whether the indicator is currently
in a stronger or weaker overall
condition. Shaded trails show
the changes from the previous
reading.
For illustrative purposes only.
Source: FMR Co (Asset Allocation Research Team), as of 20 August.2014.
KEY TAKEAWAYS
Fed policy tightening is a key cyclical
milestone, but our business cycle
framework suggests the most
significant consideration for the
markets is whether U.S. economic
progress begins to raise the risk of
entering the late-cycle stage—
historically a more challenging phase
for asset returns
Despite clear-cut cyclical progress in
recent months, the U.S. economy is
still facing few late-cycle pressures
The benign mid-cycle expansion
currently under way remains
supportive for U.S. equities, with
greater downside risks emanating
from a more uneven global economic
backdrop
The first rate hike in a Fed tightening
cycle has typically occurred nearly two
years before the end of a mid-cycle
phase—far in advance of an asset
allocation rotation to late-cycle patterns
If investors perceive the Fed moving
to a tightening stance faster than
anticipated, it could unsettle markets;
any potential near-term volatility would
not represent a fundamental move
into a late-cycle phase, but rather a
potential tactical buying opportunity
Authors
Dirk Hofschire, CFA
SVP, Asset Allocation Research,
FMR Co
While long-term historical averages provide reasonable baselines for
portfolio allocations, over shorter time horizons asset price
fluctuations are driven by a confluence of various short-, intermediate-,
and long-term factors that may cause performance to deviate
significantly from historical averages. For this reason, we employ an
asset allocation framework that analyzes underlying factors and trends
among the following three temporal segments: tactical (one to 12
months), business cycle (one to 10 years), and secular (10 to 30 years).
This report, part of a monthly series, focuses primarily on the
intermediate-term fluctuations in the business cycle.
Lisa Emsbo-Mattingly
Director of Asset Allocation Research
FKR Co
This document has been written
by Pyramis Global Advisors and
FMR Co. Fidelity Worldwide
Investment is retained as the sole
distributor of their range of
products to the institutional
market outside of North America.
1
40%
Easier Standards
20%
0%
–20%
– 40%
– 60%
– 80%
Tighter Standards
The U.S. labour market is improving at a faster rate, though
gains remain slow enough to avoid provoking broad-based, latecycle wage inflation. Year to date, the economy has added 1.6
million jobs—the 1.9% year-over-year increase in July was the
1
fastest pace of growth since 2006. Moreover, weekly
unemployment claims remain below 300,000, and the number of
job openings in the economy is back to prerecession levels.2
While small businesses continue to report plans to increase
3
compensation, wage pressures are still not widespread—
average hourly earnings are up just 2.0% year to year in nominal
terms. The labour market is experiencing clear-cut
improvements, but late-cycle wage inflation pressures
remain limited.
Inflation
July consumer inflation remained near the upper end of the
range during the past year, but rapid declines in agricultural and
energy commodity prices in recent weeks should help ease
headline inflation in the coming months. Energy prices have
fallen 9% since the late-June spike in geopolitical concerns
4
stemming from the Middle East, while agricultural prices have
5
declined 23% since May, as supply-side shocks have ebbed. In
addition, core consumer inflation (which excludes these volatile
categories) has slowed to 1.9% year over year, as the rise in
shelter costs has steadied. Inflation is firm but in a
decelerating trend due to easing commodity prices, with few
signs of broad-based, late-cycle inflationary pressures.
Our business cycle framework suggests that the
most significant consideration for the asset
markets is whether U.S. economic progress
begins to raise the risk of the U.S. moving into
a late-cycle phase.
Q1-13
Q2-14
Q3-10
Q4-11
Q1-08
Q2-09
Q3-05
Q4-06
Q1-03
Q2-04
Q4-01
Q3-00
Q1-98
Q2-99
Q3-95
Employment
Q4-96
–100%
Q1-93
The following is a more detailed look at developments in major
areas of the economy.
BANK WILLINGNESS TO MAKE
RESIDENTIAL MORTGAGE LOANS
Q2-94
Recent trends in major categories
Exhibit 1: Although mortgage credit remains relatively
tight, banks reported the broadest rise in more than 20
years in their willingness to make residential loans
during the second quarter.
Net Share of Banks Easing (%)
With the U.S. economy demonstrating clear-cut labour market
improvement and cyclical momentum in recent months, the eyes
of many investors are on the Federal Reserve (Fed) for hints of
when it will begin tightening monetary policy. While Fed
tightening is an important cyclical milestone, our business cycle
framework suggests that the most significant consideration for
the asset markets is whether U.S. economic progress begins to
raise the risk of the U.S. moving into a late-cycle phase from its
current mid-cycle expansion (see ”What does the late cycle
typically mean for asset markets?” page 3). Generally speaking,
mid-cycle economic conditions tend to be benign, with supportive
credit conditions and monetary policy, solid corporate profit
growth, and a healthy inventory backdrop. In contrast, late-cycle
dynamics include rising inflationary pressures, which lead to
credit tightening, more restrictive monetary policy, deteriorating
corporate profitability, and growing inventories.
Gray shading indicates U.S. economic recession. Source: Federal Reserve,
Haver Analytics, FMR Co (AART), as of 15 August 2014.
Consumption
The outlook for the U.S. consumer remains positive. Personal
consumption is still growing at a relatively-modest 4% (nominal)
6
year-over-year pace. Consumer confidence, as measured by
the Conference Board, continues to reach new post-recession
highs, as the improvement in the pace of hiring persists.
Consumer credit is growing at a solid pace of 6.5% year over
year and revolving credit outstanding (i.e., credit cards) is
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accelerating for the first time since the recession ended. The
household debt-service ratio remains near record lows. The
improving labour market, slowing commodity inflation, and
greater access to credit should continue to provide a benign
backdrop for consumption.
Housing
The housing sector remains in a soft patch, although leading
indicators are showing signs of slow improvement. Sales activity
remains range-bound at historically weak levels, and prices have
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flattened over the past three months. Construction starts and
permit issuance remain at low levels, though they rose in July
and remain in an upward trend. Underlying fundamentals of the
housing market have continued to improve: employment gains
have accelerated, homes remain affordable amid low mortgage
rates, and banks recently reported a significant increase in their
willingness to make residential mortgage loans (see Exhibit 1,
above). Housing activity remains soft, but continued
improvements in employment and credit access remain
supportive of a slow expansion going forward.
2
Credit conditions remain supportive for businesses and
consumers. The most recent Senior Loan Officer Survey
indicates that banks have increased their willingness to make
commercial, industrial, consumer, and real estate loans.9
Moreover, long-term interest rates have continued to fall.
Delinquency rates are still falling and/or remain at historic lows
across lending categories, and corporate debt issuance is
10
ahead of last year’s pace. Continued improvements in the
access to and cost of credit suggest the U.S. remains
solidly in a mid-cycle expansion.
Corporate
The U.S. corporate sector remains robust, with rising
profitability and lean inventories. Earnings growth for S&P 500
companies reaccelerated during the second quarter, rising 12%
11
year over year. Profit margins are on track to reach a new
post-recession high during the quarter—suggesting cyclical
productivity gains are outpacing any wage or other cost
pressures. The inventory-to-sales ratio for the economy
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remains in balance, particularly in the manufacturing sector.
Solid profit growth and lean inventories indicate that latecycle pressures are still absent in the U.S. corporate
sector.
Global
The world economy remains relatively steady, but conditions
outside the U.S. are slow and uneven, with risks generally
skewed to the downside. Developed Europe remains in a
modest mid-cycle uptrend, with credit conditions easing for both
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enterprises and consumers during the third quarter, but the
pace of growth has slowed. About 60% of the region’s
economies experienced growth in their leading economic
indicators during the past six months, down from more than
90% at the start of 2014.14 Business and consumer sentiment
has weakened for two consecutive months, and falling bond
yields reflect continued deflationary pressures. While the worst
appears behind Europe from a cyclical standpoint, the
downside risks emanating from the ongoing Russia/Ukraine
conflict and sanctions suggest that Europe may continue to
experience a subdued expansion.
Elsewhere, Japan’s outlook remains uncertain. Gross domestic
product—and, in particular, consumption—were much weaker
than expected during the second quarter, underscoring the
negative impact from April’s consumption tax hike. Although
more forward-looking sentiment indicators have continued to
improve, they remain below the levels seen before the
consumption-tax hike.15 Meanwhile, China’s policymakers
continue to try to buoy growth while maintaining financial
stability amid severe imbalances in real estate and credit. The
reacceleration in lending stoked by stimulus policies in recent
months cooled in July, but overall, easing measures appear to
have stabilised many economic indicators. The major exception
is the property market. Racked by falling home sales and
What does the late-cycle typically mean for
asset markets?
The benign economic conditions during the mid-cycle
phase—supportive credit, solid profit growth, inventories
balanced with demand—typically help economically sensitive
assets such as equities and high-yield corporate bonds
outperform investment-grade bonds and cash. During the
late-cycle phase, however, inflationary pressures tend to
mount, putting corporate earnings under pressure at the same
time growth begins to moderate.
Across asset classes, the late-cycle phase has the most mixed
performance of any phase of the business cycle. The indefinite
frequency and magnitude of relative asset performance implies
that asset allocation weights should be more neutral during this
phase. Typically, the leadership of economically sensitive
assets often falters, as stocks do not consistently outperform
cash or inflation, and widening credit spreads often cause highyield corporate bonds to underperform high-quality bonds. As
interest rates rise due to inflationary pressures, cash and shortduration bonds tend to hold up better than longer-duration
bonds (see Exhibit A, below).
It is important to note, however, that the beginning of the Fed
monetary tightening cycle is not synonymous with the
beginning of the late-cycle phase. In fact, during the past 12
Exhibit A: Leadership of economically sensitive asset
classes tends to falter during the late cycle, causing a
much more mixed relative performance outlook.
ASSET CLASS PERFORMANCE
ACROSS BUSINESS CYCLE PHASES
1950–2010
16%
Absolute Annual Return (Average)
Credit and banking
Mid
Late
14%
12%
10%
8%
6%
4%
2%
0%
Stocks
High Yield
Bonds
Cash
Source: FMR Co proprietary analysis of historical asset class
performance, which is not indicative of future performance. Asset
class total returns are represented by indexes from the following
sources: FMR Co, Bank of America Merrill Lynch, Ibbotson
Associates, Barclays, as of 31 July 2014.
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Summary and outlook
The U.S. remains in a solid, albeit slow, mid-cycle expansion.
Late-cycle risks are still low, as inflationary pressures remain
muted, credit availability is strong, corporate profitability is
sturdy, and inventories are in check. The global business cycle
also remains relatively steady, although cyclical trends vary
widely among the world’s largest economies (see Typical
Business Cycle, page 5). Falling global bond yields underscore
the sluggish pace of growth across most regions of the world.
Together, incremental growth, low inflation, and
accommodative monetary policies have continued to provide a
supportive outlook for global equities.
The greatest risks to the outlook include possible downside
surprises outside the U.S. Among the overseas risks are
potential financial instability in China and weaker growth in
Japan, while geopolitical risks present challenges for Europe
(Ukraine/Russia) and the Middle East. Investor complacency
amid low volatility and higher asset valuations also creates a
lower threshold for a potential negative surprise. The steadier
cyclical outlooks in the U.S. and Europe create a more
favourable environment for equity exposure in those areas,
while a tactical allocation to high-quality bonds should continue
to provide protection in the event of a pick-up in market
volatility.
With the Fed’s extraordinary policies of near-zero interest rates
and “low for long” guidance boosting investor risk-taking, the
major U.S.-centric threat of market volatility is the possibility of
faster-than-expected monetary tightening. If investors perceive
that the Fed is moving to a tightening posture earlier than
expected (current market perception assumes an initial rate
hike in mid-2015), it could create volatility in the asset markets.
A sell-off in riskier assets might have a late-cycle flavour,
precipitated and accompanied by concerns about higher
interest rates, similar to mid-2013 conditions. However, with the
U.S. economy displaying a low probability of late-cycle risk, any
near-term market volatility may, in fact, only be a late-cycle
scare, but not a fundamental move into a late-cycle economic
phase (see “What does the late cycle typically mean for asset
markets?” starting on page 3). Our base-case scenario is that
the U.S. economy has a high probability of remaining in the
mid-cycle, suggesting any near-term correction may be a
potential tactical buying opportunity.
Fed tightening cycles since 1950,* most of the initial Fed rate
hikes (seven, or 58%) took place during the mid-cycle (four
occurred during the early cycle, one during the late cycle).
During the mid-cycle, the Fed typically neutralises
accommodative monetary conditions by raising rates around
150 basis points (bps) on average, and continues tightening
during the late cycle by approximately 75 bps (see Exhibit B,
below). Moreover, after the Fed has implemented its initial
rate hike, it has taken an average of roughly two years before
the economy has entered the late cycle. History, therefore,
suggests that the commencement of Fed tightening is
typically not a signal of imminent late-cycle risk and is thus far
too early to spur the implementation of an asset-allocation
rotation to late-cycle positioning.
Today, an eventual Fed shift to tightening mode may be
somewhat different than during previous cycles. The Fed has
remained far more accommodative for a longer period than
during most previous episodes, it has communicated a
tolerance for potentially higher inflation, and market sentiment
during the multiyear rally in risk assets has been, at least in
part, supported by these extraordinarily accommodative
monetary policies. Nevertheless, it is important to keep in
mind that the more lasting market rotation is likely to occur not
at the onset of monetary tightening, but rather when the U.S.
economy moves into the late-cycle phase of expansion.
*A Fed tightening cycle is defined as a period when the target rate
(N.Y. Fed discount rate prior to 1972) increased more than 100 basis
points over a period of longer than six months.
Exhibit B: The Fed’s move to a tightening stance has
most often occurred during the mid-cycle, typically
nearly two years before the economy drifts into a latecycle expansion.
FED FUNDS RATE CHANGE PER BUSINESS CYCLE
1950 - 2010
150
100
Basis Points
prices, the housing market remains a downside risk to China’s
financial and economic stability. Conditions are varied and
mixed across other emerging markets, with some stabilization
in outlooks but with many markets still facing late-cycle
headwinds (see Leadership Series article, “Business Cycle
Update: Steady Global Environment amid Fragile Rebound in
Emerging Markets,” Aug. 2014). Outside the U.S., the global
business cycle remains in a slow upward trend, with
significant variation across countries and regions.
50
Average
Median
0
–50
–100
–150
–200
–250
Frequency
of First
Rate Hike
Early
Mid
Late
33%
58%
8%
Recession
0%
Source: Federal Reserve, Haver Analytics, FMR Co (AART),
as of 31 July 2014.
4
The U.S. and Germany remain in the mid-cycle stage, while Japan continues to face late-cycle pressures. The risks of a
growth recession in China remain elevated, despite some stabilization from recent policy actions
TYPICAL BUSINESS CYCLE
Inflationary Pressures
Red = High
EARLY
MID
LATE
RECESSION
Activity rebounds (GDP, IP,
employment, incomes)
Growth peaking
Growth moderating
Falling activity
Credit growth strong
Credit tightens
Credit dries up
Credit begins to grow
Profit growth peaks
Earnings under pressure
Profits decline
Profits grow rapidly
Policy neutral
Policy contractionary
Policy eases
Policy still stimulative
Inventories, sales grow;
equilibrium reached
Inventories grow;
sales growth falls
Inventories, sales fall
Inventories low; sales
improve
Germany U.S.
Japan
CONTRACTION
China*
+
Economic Growth
–
RECOVERY
EXPANSION
Relative Performance
of Economically
Sensitive Assets
Green = Strong
Note: This is a hypothetical illustration of a typical business cycle. There is not always a chronological progression in this order, and there have been
cycles when the economy has skipped a phase or retraced an earlier one. Economically sensitive assets include stocks and high-yield corporate
bonds, while less economically sensitive assets include Treasury bonds and cash. *A growth recession is a significant decline in activity relative to a
country’s long-term economic potential. We have adopted the “growth cycle” definition for most developing economies such as China because they
tend to exhibit strong trend performance driven by rapid factor accumulation and increases in productivity, and the deviation from the trend tends to
matter the most for asset returns. We use the classic definition of recession, involving an outright contraction in economic activity, for developed
economies. Please see endnotes for a complete discussion. Source: FMR Co (AART).
Authors
Dirk Hofschire, CFA
SVP, Asset Allocation Research, FMR Co
Lisa Emsbo-Mattingly
Director of Asset Allocation Research, FMR Co
The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation
recommendations for FMR Co’s portfolio managers and investment teams. AART is responsible for analysing and synthesizing investment
perspectives across FMR Co’s asset management unit to generate insights on macroeconomic and financial market trends and their implications
for asset allocation.
Asset Allocation Research Analysts Austin Litvak and Jacob Weinstein, CFA, also contributed to this article.
FMR Co Thought Leadership Associate Editor Kevin Lavelle and Investment Writer Christie Myers provided editorial direction.
5
Views expressed are as of the date indicated, based on the information
available at that time, and may change based on market and other conditions.
Unless otherwise noted, the opinions provided are those of the authors and not
necessarily those of FMR Co or its affiliates. FMR Co does not assume any
duty to update any of the information.
4
Source: Goldman Sachs, Haver Analytics, FMR Co (AART), as of 19 August
2014.
5
Source: Goldman Sachs, Haver Analytics, FMR Co (AART), as of 19 August
2014.
6
Generally, among asset classes, stocks are more volatile than bonds or
short-term instruments and can decline significantly in response to
adverse issuer, political, regulatory, market, or economic developments.
Although the bond market is also volatile, lower-quality debt securities
including leveraged loans generally offer higher yields compared to
investment grade securities, but also involve greater risk of default or
price changes. Foreign markets can be more volatile than U.S. markets
due to increased risks of adverse issuer, political, market, or economic
developments, all of which are magnified in emerging markets.
Investment decisions should be based on an individual’s own goals, time
horizon, and tolerance for risk.
In general the bond market is volatile, and fixed-income securities carry interest
rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This
effect is usually more pronounced for longer-term securities.)
Fixed-income securities also carry inflation, credit, and default risks for both
issuers and counterparties.
Source: Bureau of Economic Analysis, Haver Analytics, FMR Co (AART), as of
15 August 2014.
7
Source: Federal Reserve, Haver Analytics, FMR Co (AART), as of 15 August
2014.
8
Source: Core-Logic, Haver Analytics, FMR Co (AART), as of 15 August 2014.
9
Source: Federal Reserve, Haver Analytics, FMR Co (AART), as 15 August
2014.
10
Source: Bloomberg, Haver Analytics, FMR Co (AART), as of 15 August 2014.
11
Source: Standard & Poor’s, FMR Co (AART), as of 15 August 2014.
12
Source: Census Bureau, Haver Analytics, FMR Co (AART), as of 15 August
2014.
Source: European Commission, Haver Analytics, FMR Co (AART), as of 15
August 2014.
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14
Investing involves risk, including risk of loss.
Past performance is no guarantee of future results.
Diversification does not ensure a profit or guarantee against loss.
All indices are unmanaged. You cannot invest directly in an index.
The 15 developed-European economies include Austria, Belgium, Denmark,
Finland, France, Germany, Ireland, Italy, the Netherlands, Norway, Portugal,
Spain, Sweden, Switzerland, and the United Kingdom. Source: Organisation for
Economic Co-operation and Development (OECD), Foundation for International
Business and Economic Research (FIBER), Haver Analytics, FMR Co (AART),
as of 19 August 2014.
15
The Typical Business Cycle depicts the general pattern of economic cycles
throughout history, though each cycle is different; specific commentary on the
current stage is provided in the main body of the text. 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, characterised 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.
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 one and 10 years in the U.S., and there have been
examples when the economy has skipped a phase or retraced an earlier one.
Endnotes
1
Source: Bureau of Labour Statistics, Haver Analytics, FMR Co (AART), as of
15 August 2014.
2
Source: Department of Labour, Bureau of Labour Statistics, Haver Analytics,
FMR Co (AART), as of 15 August 2014.
Source: Cabinet Office of Japan, Haver Analytics, FMR Co (AART), as of
19 August 2014.
Index definitions
The S&P 500® Index is a market capitalization–weighted index of 500 common
stocks chosen for market size, liquidity, and industry group representation to
represent U.S. equity performance. S&P 500 is a registered service mark of
Standard & Poor’s Financial Services LLC.
The Consumer Price Index (CPI) is a monthly inflationary indicator that measures
the change in the cost of a fixed basket of products and services, including
housing, electricity, food, and transportation.
Third-party marks are the property of their respective owners; all other marks are
the property of FMR LLC.
Important Information
Information presented herein is for discussion and illustrative purposes only and
is not a recommendation or an offer or solicitation to buy or sell any securities.
Index or benchmark performance presented in this document do not reflect the
deduction of advisory fees, transaction charges, and other expenses, which
would reduce performance.
Certain data and other information in this research paper were supplied by
outside sources and are believed to be reliable as of the date presented.
However, Pyramis has not verified and cannot verify the accuracy of such
information. The information contained herein is subject to change without notice.
Pyramis does not provide legal or tax advice, and you are encouraged to consult
your own lawyer, accountant, or other advisor before making any financial
decision.
These materials contain statements that are “forward-looking statements,” which
are based upon certain assumptions of future events. Actual events are difficult
to predict and may differ from those assumed. There can be no assurance that
forward-looking statements will materialise or that actual returns or results will not
be materially different than those presented.
3
Source: National Federation of Independent Businesses, Haver Analytics,
FMR Co (AART), as of 15 August 2014.
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Important Information
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