Download Business Cycle Update: Steady Global

Market Perspectives
August 2014
Business Cycle Update:
Steady Global Environment
amid Fragile Rebound in Emerging Markets
Overview section: The global economy continues to experience slow and steady
growth, with low risks of recession in the U.S. and Germany. Japan’s outlook is
showing mixed signals between the level of activity and sentiment. The risks of a
growth recession in China remain elevated, but policymakers have helped
stabilise the economy in the near term.
KEY TAKEAWAYS

The global economy remains in a
steady but slow upward trend,
underpinned by stable mid-cycle
expansions in the U.S. and
Europe, accommodative monetary policies, and low inflation.

The tone of global growth has
improved in recent weeks, in part
due to China’s move toward
greater policy easing, though
downside financial and economic
risks in China remain elevated.

Emerging-market (EM) assets
have staged a rebound from a
weak 2013, benefiting from
falling global bond yields and
some stabilisation in EM
economic outlooks, but
persistent late-cycle pressures
remain a headwind.

The business cycle outlook in the
U.S. and Europe favours exposure to equities in those markets,
though the risk of investor
complacency amid low market
volatility is still a tactical concern.
Recession risks remain generally low, with China trying to prevent a growth
recession from taking root
RECESSION RISK SCORECARD
The recession risk
scorecard is an illustrative
framework based on a
quantitative analysis of the
major drivers of economic
activity. Movement along
the horizontal axis
indicates how much the
risk of recession has
increased or decreased,
while vertical placement
depicts the risk of entering
a recession in the near
future. Shaded trails show
the movement since the
previous report. For
China, a growth recession
is a significant decline in
activity relative to a
country’s long-term
economic potential.*
Authors
Source: FMR Co (Asset Allocation Research Team), as at 24 July 2014.
*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.
Dirk Hofschire, CFA
SVP, Asset Allocation Research,
FMR CO
Lisa Emsbo-Mattingly
Director of Asset Allocation Research,
FMR 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.
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Exhibit 1: Current accounts in several EM deficit
countries have improved substantially over the past year
CURRENT ACCOUNT BALANCES FOR
SELECT EM COUNTRIES
6%
Q1 2013
Q1 2014
4 Qtr. Change
4%
% of GDP
2%
0%
–2%
–4%
Brazil
Indonesia
South
Africa
Turkey
–8%
India
–6%
Current account: the sum of net exports, net income from abroad, and net
current transfers from abroad. EM: emerging market. Source: Country
statistical organisations, FactSet, Haver Analytics and FMR Co (AART), as
at 31 March 2014.
Recent trends in the world’s largest economies
The following is a more detailed look at developments in major
economies around the world.
Global
The global economy continues to grow at a steady pace, but
with a diverse outlook across countries and regions. In the
aggregate, the tone of the global expansion has improved in
recent weeks, due to the clear emergence of the U.S. from its
first-quarter slowdown, greater policy easing in China, and
stellar global financial conditions (including the European
Central Bank’s renewed commitment to monetary easing).
Although developed-market (DM) economies continue to exhibit
favourable cyclical dynamics relative to emerging-market (EM)
ones, these divergences have narrowed in recent months as
activity in some EMs has stabilised. One source of this stability
is the improvement in the current account balances of many
deficit countries—such as India, Turkey, and Indonesia—that
suffered from capital outflows during the second half of 2013
(see Exhibit 1, left). With global financial conditions stabilising
and EM countries experiencing smaller financing needs due to
lower current account deficits, EM currencies have stabilised in
2014 and are no longer creating inflationary pressures in their
domestic economies through rapid depreciation. This shift has
allowed some countries to moderate their monetary stances
after a period of rate hikes, with Turkey cutting its benchmark
rate and Brazil and India pausing. Significant policy easing in
China has also been a key ingredient in stabilising the nearterm trends for EM economies (see “China” on page 4).
Nevertheless, most emerging markets continue to face latecycle challenges. Many larger EM economies still have inflation
rates above their central bank targets due to persistent
inflationary pressures from lagging cyclical productivity and
structural bottlenecks. Corporate profitability remains weak, and
bank lending and monetary conditions are tighter than they
were one year ago. Although the switch to more EM policy
easing measures may be positive for near-term growth, these
late-cycle dynamics leave developing economies susceptible to
a potential negative shift in sentiment in global financial
markets (see “Emerging-market assets: Is the rebound
sustainable?” below). The global business cycle expansion
remains slow and relatively steady, with significant
divergences among countries and regions.
Emerging-market assets:
Is the rebound sustainable?
Following the Federal Reserve’s public signalling of its intent to
taper its quantitative easing programme in mid-2013, emergingmarket (EM) equity and debt asset classes posted negative
returns and underperformed most other asset classes during
2013. However, these asset classes have rebounded this year
and now stand among the top performers so far in 2014. The
turnaround has been a result of a number of factors, including
improved global financial conditions and lower global bond
yields, EM election outcomes that have generally been
perceived as favourable, and some stabilisation in the EM
economic outlook.
subdued expectations. Nevertheless, the late phase of the
business cycle—in which most EMs remain—has not typically
provided a strong backdrop for equity returns. Corporate
fundamentals have generally stagnated in the late cycle, as
weakening cyclical productivity and rising inflation put
pressure on profit margins. Revenue growth has typically
slowed amid decelerating economic activity. Today, the
aggregate earnings per share for EM companies are at nearly
the same level as two years ago. Despite some recent signs
of a modest increase in earnings growth, these late-cycle
dynamics remain a fundamental headwind for EM stocks.
The performance of EM equities started to improve during the
second quarter, boosted in part by China’s policy easing. Low
equity valuations set a low bar for investor sentiment, and EM
economic data has recently begun to surpass
The commitment of developed market central banks to “low
for long” interest rate policies, and the corresponding decline
in DM government bond yields, has helped boost investor
sentiment for EM debt. EM debt is considered a hybrid fixed-
2
Exhibit A: EM assets suffered following last year’s Fed
policy surprise but have rebounded in 2014 after shifts in
global monetary policy
EM DEBT AND EQUITY RETURNS
6%
4%
2%
0%
–2%
–4%
EMD Spread Returns
–6%
EMD Rate Returns
–8%
EM Equities
Q2-14
Q1-14
Q4-13
Q3-13
Q2-13
Q1-13
–10%
Q4-12
The near-term positive momentum in EM equities may continue
amid subdued expectations and low equity valuations, but latecycle dynamics continue to provide a challenging headwind for
corporations in EM economies. For EM debt, our expectation
that interest rates are not likely to increase sharply in the near
term provides a supportive backdrop for our outlook. However,
a potential Fed policy surprise (as in Q2 of 2013—see Exhibit
A) represents a considerable risk to both rates and spreads,
particularly because EM debt yields and spreads have fallen
near record lows. Over a long-term horizon, we believe EM
economies will be the fastest growing during the next 20
years, with EM assets representing considerable growth
opportunities as part of a diversified global portfolio.
Quarterly Returns
income category, with both fixed-income and equity-like
characteristics. Its return profile is affected by movements of
two principal components: U.S. interest rates (Treasury yields)
and sovereign credit spreads (additional yield to compensate
for default risk)—see Exhibit A, right. Roughly three-quarters of
the U.S. dollar-denominated EM debt index is composed of
high-quality investment-grade bonds that are affected more by
changes in U.S. Treasury yields, while the remainder is
represented by lower quality high-yield debt that is more
susceptible to EM economic and credit fundamentals. During
2014, EM debt has benefited both from a decline in U.S. yields
and from a tightening of credit spreads. Credit spreads may be
pressured during the late cycle as credit quality begins to
deteriorate, but the interest-rate component is less tied to the
EM cycle and more heavily influenced by Federal Reserve
(Fed) monetary policy and the U.S. economy.
EMD: Emerging-market debt. Source: MSCI EM Index (EM Equities),
JPM EMBIG Global (EMD), Bloomberg Finance L.P and FMR Co
(AART), as at 30 June 2014.
United States
Europe
The U.S. economy remains firmly in a mid-cycle expansion,
boosted by continued improvements in employment and
corporate fundamentals. Initial unemployment claims have
fallen to their lowest level in eight years, and the number of
workers willingly leaving their jobs each month (a positive
indicator) continues to reach new post-recession highs.1
Employee earnings are slowly trending higher, although the
level of earnings growth remains weak relative to pre-recession
levels.2 Even though inflation rates have ticked up in recent
months and pose a risk to the benign consumer backdrop, they
are not yet strong enough to suggest that late-cycle pressures
on the U.S. economy are imminent.
The majority of economies in developed Europe continue to
improve, although the pace of expansion remains muted.
Roughly 80% of developed European economies have
experienced growth in their leading economic indicators (LEIs)
during the past six months, suggesting that the expansion
remains broad-based (though this percentage is down from
roughly 95% at the start of the year).4 Manufacturing
bullwhips—the difference between new orders and
inventories—remain generally positive and signal a constructive
outlook for continued expansion in industrial activity. Financial
conditions remain in an improving trend, although the
deflationary pressures that contributed to the European Central
Bank’s unveiling of new monetary policy measures have
persisted; the headline consumer price index rose just 0.5%
year-over-year as of June.5 The escalating violence in Ukraine
presents a growing risk to Europe’s outlook, and tougher
European Union sanctions on Russia may have negative
implications for European companies as well.
The slow-but-steady pace of the U.S. expansion continues to
provide a stable outlook for corporate revenues. Cyclicallyadjusted productivity levels are still rising and interest expenses
remain low, suggesting corporate profit margins are under
minimal pressure. Business sentiment has continued to
improve, and corporate capital expenditure plans remain in an
upward trend.3 The housing market remains in a soft patch,
however, as demand continues to adjust to the rapid price
appreciation and higher mortgage rates during the past year.
The U.S. economy continues to grow at a steady pace,
underpinned by incremental gains in employment.
At the country level, the U.K. remains a major driver of the
current European expansion, with industrial production, retail
sales, and housing permit issuance continuing to accelerate on
a year-over-year basis. On the other end of the spectrum of
large economies, France is experiencing an extremely slow
recovery. Germany, while still solidly in a mid-cycle expansion,
3
has seen its pace of growth ebb in tandem with broader
developed Europe. Though most peripheral economies have
seen sluggish growth, they have generally retained their earlycycle dynamics, with unemployment no longer rising and
manufacturing bullwhips continuing to improve. Despite a
subdued magnitude of expansion, Germany and most of
developed Europe remain in a mid-cycle expansion.
Japan
Japan remains in the late-cycle stage of its expansion, with an
uncertain outlook in the aftermath of the April consumption-tax
hike. Evidence of weaker activity since April is broad-based, as
industrial production growth continues to slow and both the
Service Purchasing Managers’ Index (PMI) and construction
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activity remained in contraction. The manufacturing PMI has
moved back into expansionary territory, although the level is
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much lower than it was earlier in the year.
Although current conditions remain difficult, some forwardlooking indicators have shown signs of recovery. Business
8
sentiment surveys have rebounded, while consumer
confidence has risen to its highest level in 2014 but remains
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well below levels reached in 2013 (see Exhibit 2, below). The
outlook for Japan remains muddled; sentiment indicators
show a large gap between higher future expectations and
weak current activity.
Exhibit 2: Japan’s data following the consumption-tax
hike has shown a recovery in sentiment despite stilldifficult current conditions
60
50
40
30
Jun-14
Dec-13
Jun-13
Dec-12
Future Conditions
Jun-12
Dec-11
Jun-11
Dec-10
Current Conditions
Jun-10
20
Dec-09
Diffusion Index (50=neutral)
JAPAN ECONOMIC SENTIMENT
Source: Cabinet Office of Japan, Haver Analytics and FMR Co (AART), as
at June 2014.
China
Policymakers in China have helped stabilise recent activity with
a variety of easing measures. Incremental monetary stimulus
and easier borrowing conditions have generated a reacceleration in the pace of money supply and in the growth of financial
institution lending during the past four months. Money supply is
now rising at a 22% annualised pace, compared to 14% a year
ago. Financial institution loans are growing at 16%, versus a
10
year-ago pace of 14%. This incremental stimulus has helped
push the HSBC China Manufacturing PMI bullwhip solidly into
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expansion territory for the first time this year.
Policy easing and stimulus measures have reduced the
probability of a growth recession somewhat over the past two
months, but recession risks remain elevated amid pronounced
late-cycle pressures. Most significant among these pressures is
the overcapacity in the real estate sector, which has been the
centre of China’s credit and investment boom during the past
several years. Incremental easing of lending and purchasing
conditions geared toward residential property markets may
provide some near-term stability, but most measures of real
estate activity remain weak, including new construction activity,
home price trends, sales, and rising inventories. As such, the
continued weakness in the economy’s property markets
remains a substantial downside risk to the financial and
economic stability of both China and the broader Asian
economy. China’s near-term outlook has stabilised
somewhat following recent policy easing actions, but
greater credit creation will not eliminate the risks of
China’s formidable credit and property imbalances.
Summary and outlook
The benign global backdrop—incremental growth, stable
inflation, and accommodative monetary policies—remains intact.
This environment has been underpinned by steady, mid-cycle
trends in the U.S. and Europe (see “Typical Business Cycle” on
page 5). The cyclical outlooks in Japan and China, as well as in
many large emerging markets, remain more challenged.
However, the tone of the global business cycle has improved
recently due to even better sentiment in global financial markets
as well as a move to greater policy stimulus in China.
The risks of a disruption to this supportive cyclical climate are
several. China, as well as many other emerging economies,
faces significant late-cycle pressures after years of rapid credit
growth and a lack of structural reform. Many economies remain
vulnerable to a potential slowdown in global liquidity growth,
which becomes more likely as economic improvement in the
U.S. and U.K. pushes them closer to monetary tightening.
Geopolitical risks abound; in particular, Russia’s involvement in
Ukraine and the potential impact on oil supplies from instability
in the Middle East.
From an asset allocation standpoint, the stable mid-cycle
outlook in the U.S. and Europe favours exposure to equities in
those markets. In the near term, emerging markets may
continue to benefit from stabilisation amid subdued
expectations and low equity valuations, but persistent late-cycle
pressures threaten the sustainability of their outperformance.
On a tactical basis, the risk of investor complacency amid low
market volatility—alongside elevated valuations after the multiyear rally in risk assets—suggests high-quality fixed-income
assets may provide protection against a potential spike in
equity-market volatility.
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 stabilisation from recent policy actions
TYPICAL BUSINESS CYCLE
Inflationary Pressures
Red = High
EARLY
MID
LATE
RECESSION
 Activity rebounds (GDP, IP,
employment, incomes)
 Growth peaking
 Credit growth strong
 Growth moderating
 Credit tightens
 Falling activity
 Credit dries up
 Credit begins to grow
 Profit growth peaks
 Policy neutral
 Earnings under pressure
 Policy contractionary
 Profits decline
 Policy eases
 Inventories, sales grow;
equilibrium reached
 Inventories grow;
sales growth falls
 Inventories, sales fall
 Profits grow rapidly
 Policy still stimulative
 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
synthesising 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 Senior Investment Writer Vic Tulli provided editorial direction.
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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 selfsustaining 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.
3
Source: Federal Reserve Bank of Philadelphia, Haver Analytics and FMR
Co (AART), as at 17 July 2014.
4
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 and FMR Co (AART), as at 21 July 2014.
5
Source: Eurostat (European Union), Haver Analytics and FMR Co (AART),
as at 17 July 2014.
6
Source: Industrial production – Japan Ministry of Economy, Trade &
Industry, Haver Analytics and FMR Co (AART), as at 22 July 2014. Service
Purchasing Manager’s Index – Markit Economics, Haver Analytics and FMR
Co (AART), as at 2 July 2014; construction activity – Japan Ministry of
Land, Infrastructure and Transport, Haver Analytics and FMR Co (AART),
as at 30 June 2014.
7
Manufacturing Purchasing Manager’s Index. Source: Markit Economics,
Haver Analytics and FMR Co (AART), as at 30 June 2014.
8
Source: Bank of Japan (business conditions, as at 1 July 2014), Sentix
Behavioral Indices (sentiment, as of 22 July 2014), Haver Analytics,
Bloomberg Finance L.P. and FMR Co (AART), as of 22 July 2014.
9
Source: Cabinet Office of Japan, Haver Analytics and FMR Co (AART), as
at 10 July 2014.
10
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.
Endnotes
1
Source: U.S. Bureau of Labor Statistics, Haver Analytics and FMR Co
(AART), as at 18 July 2014.
2
Source: U.S. Bureau of Labor Statistics, Haver Analytics and FMR Co
(AART), as at 3 July 2014.
Source: The People’s Bank of China, Haver Analytics and FMR Co
(AART), as at 15 July 2014.
11
Source: HSBC/Markit Economics, China National Statistics Bureau,
Haver Analytics and FMR Co (AART), as at 30 June 2014.
Index definitions
JPM® Emerging Markets Bond Index (EMBI) Global is a market valueweighted index of U.S. dollar-denominated Brady bonds, eurobonds, traded
loans, and local-market debt instruments issued by emerging markets
sovereign and quasi-sovereign entities.
MSCI Emerging Markets (EM) Index is a market capitalisation-weighted
index that is designed to measure the investable equity market performance
for global investors in emerging markets.
A purchasing managers’ index (PMI) is a survey of purchasing managers in
a particular economic sector. A PMI over 50 represents expansion of the
sector compared to the previous month, while a reading under 50
represents a contraction, and a reading of 50 indicates no change. Markit
compiles non-U.S. PMIs.
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