Econ update: Softer data, rising risks

BY Dirk Hofschire, CFA, VP, Asset Allocation Research and Lisa Emsbo-Mattingly, Director of Asset Allocation Research, Fidelity Viewpoints — 06/29/11

A monthly look at employment, housing, credit markets, corporate earnings, inflation, and the global economy.

Editors’ note: The editors of Fidelity Interactive Content Services (FICS) selected this article because it offers investors a valuable perspective on the recent weakening in U.S. economic data and the outlook for continued growth.

The tone of U.S. economic data deteriorated in recent weeks, resulting in a spate of negative surprises and indicating a softening in the pace of activity. Previously encouraging trends in manufacturing and employment weakened, and consumer spending momentum downshifted amid higher gasoline prices. However, near-term effects of Japan-related supply-chain disruptions and severe weather (storms and floods in the Southeast and Midwest) may have created temporary distortions in some data. Conditions in several key areas, including the credit markets and corporate activity, remained relatively solid, indicating that the underlying trend of expansion continues despite recent weakening.

Recent trends in major categories.

The following is a more detailed look at developments in major areas of the economy.

Employment
May payroll employment growth came in below expectations, with 54,000 jobs created and a higher unemployment rate (9.1%); this softness was presaged by the upward reversal in initial jobless claims during April.¹ Since then, initial claims, one of the most important leading indicators for hiring activity, have resumed their downward trend, though the four-week moving average stood near 425,000 at the beginning of June—a level not generally associated with robust employment gains.² Nevertheless, corporate profitability and hiring sentiment remain in an upward channel. The broader employment trend remains slow though the labor market has continued to strengthen, albeit slowly.

Consumption
Higher gasoline prices began to crowd out other spending, but overall consumer activity has held up. Excluding the volatile motor vehicle & parts category, retail sales grew 8.7% year-over-year through May, the highest rate since early 2006 (see chart below). Although gasoline accounted for more than one-third of total sales gains in May, a large increase from December, retail sales growth excluding gasoline continued to accelerate. Gasoline purchases have not seized as large a share of overall sales as they did before the 2007–2008 recession, and the energy price pullback over recent weeks may provide some relief. Most consumer sentiment data showed worsening moods since the rise in oil prices, with confidence still well below pre-recession levels. Consumer spending patterns remain broadly steady, with gasoline prices having weakened the near-term momentum.

Housing
Residential home prices fell close to early-2009 cycle lows in March, the ninth straight monthly decline.³ Inventories of unsold homes have trended upwards throughout 2011 as sales levels have remained depressed. New building permit levels surprised to the upside in May, but remain near multidecade lows. However, mortgage delinquencies peaked in early 2010 and have consistently trended downward, and depressed construction activity has limited new supply.⁴ The near-term outlook for housing remains weak, though we believe further declines in prices and activity from these levels should be moderate relative to 2007–2010.

Credit markets and banking
Corporate bond issuance is ahead of last year’s torrid pace as borrowers have taken advantage of strong investor demand and falling Treasury yields. While corporate bond spreads for investment-grade and high-yield have widened  in recent weeks, they remain near their long-term averages at 155 and 565 basis points, respectively.⁵ The Federal Reserve survey of senior bank loan officers demonstrated that banking-sector willingness to lend has improved in most major categories, but aggregate loan growth remained roughly flat and particularly stagnant in mortgage borrowing.

In our opinion, the credit environment remains supportive of growth, particularly with low rates and easy access for the corporate sector.

Corporate
Corporations continued to reaffirm their guidance for second-quarter earnings (14% operating growth year over year), following a first quarter that far surpassed expectations—with solid revenue growth despite a slower economy—though both earnings and revenue growth rates have continued to moderate.⁶ Manufacturing activity remained healthy: purchasing manager surveys continued to show expansion, although supply-chain disruptions were likely the prime culprit for softer May surveys and flat industrial production growth for the second straight month. New orders for durable goods (excluding defense and aircraft) ticked up, underscoring ongoing sturdy capital expenditures. We believe U.S. corporate strength has remained a major bright spot, and the outlook for profits and manufacturing seems solid even as growth rates moderate.

Inflation
Inflationary pressures continued to rise in May as food and energy prices pushed headline consumer prices up 3.4% year-over-year, rising from 3.1% through April. While core inflation remained relatively low, core consumer price index (CPI) edged up to 1.5% year-over-year in May from 1.3% in April.⁷ Producer price index categories for finished and intermediate goods accelerated from the prior month, demonstrating the still-building pressures in the pipeline, but the recent $20/barrel decline in crude oil prices provides hope for moderation in the rates of both producer and consumer prices. Inflationary pressures remain in an upward trend, but the pass-through from commodity inflation into broader measures remained muted.

Global
Global economic indicators have decelerated, with the Organization for Economic Cooperation & Development (OECD) leading economic indicators posting their slowest rate of growth since early 2009.⁸ Although much of the developing world remains in firm territory, the pace of growth in China has slowed, and high inflation in many developing nations is likely to require additional monetary tightening in the weeks ahead. Fiscal austerity across Europe’s periphery and the UK has weighed on near-term growth, though the core led by Germany remains solid. Japan has struggled to begin reconstruction efforts in earnest due to continuing power supply issues, but industrial production looks set to pick up (see chart below). Global economic growth has begun to decelerate, though most of the world remains in solid expansion.

Summary and outlook

We believe the past month’s economic data have generally confirmed a deceleration in U.S. growth. But the overall trend is still consistent with the mid-cycle phase of expansion, characterized overall by a steadier but more modest pace of growth and a low risk of recession. The volatility and statistical noise in the near-term data are highlighted by the Conference Board’s index of leading economic indicators, where eight of the 10 leading indicators rose on a one-month basis in May after only four rose in April, while seven were up in March. The more important underlying six-month trend was still strong, with eight out of 10 indicators higher and the growth rate showing solid though decelerating activity (see chart below). In summary, this macro environment has historically favored more economically sensitive assets such as stocks and corporate bonds (relative to less sensitive ones such as cash and government bonds), though the current soft patch in economic data may provide a more difficult backdrop in the near term (see the U.S. economy remains in mid-cycle expansion chart below).

The major anomaly relative to a typical historical cycle is the lack of monetary tightening that would usually occur sometime during this mid-cycle phase. Instead, the Federal Reserve has provided extraordinary support through its second round of quantitative easing, which is scheduled to end in June. Core underlying inflationary pressures, albeit rising, remain low by historical standards at this point in the expansion. Due largely to the Fed’s zero-interest-rate policy, the yield curve is unusually steep for this stage of the business cycle. We believe the major risks to the economic expansion fall into two main categories. First, the risk of policy error has risen, particularly in regard to the backdrop of severe sovereign debt problems among developed economies. Specifically, we are watching Europe very closely, since any potential mishandling of the Greek debt situation could result in the spread of financial contagion more broadly into European and U.S. credit markets.

In the U.S., monetary and fiscal policies remain broadly supportive of growth despite near-term uncertainty surrounding the debt ceiling and the upcoming end of QE2. Second, inflationary pressures in China and other emerging economies, especially from the sharp rise in commodity prices, may pose a risk to global growth. We believe monetary tightening in these economies is appropriate given current inflationary pressures, but managing a soft landing in China will be a challenge. If sustained, the recent drop in oil prices is a welcome development, though we are closely monitoring the potential for tight supply conditions or political developments in the Middle East to reverse this trend.

The risks to the economic expansion have risen in recent weeks, and the magnitude of potential reward to more economically sensitive asset categories has moderated after more than two years of strong performance.

© 2011 Fidelity Investor's Publications

The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop dynamic asset allocation recommendations for the Asset Allocation Division of Fidelity Asset Management (FAM).

Past performance is no guarantee of future results.

The information presented above reflects the opinions of Dirk Hofschire, CFA, VP, Asset Allocation Research, and Lisa Emsbo-Mattingly, Director of Asset Allocation Research as of June 29, 2011. Miles Betro, CFA, Analyst, Asset Allocation Research, also contributed to this article. These opinions do not necessarily represent the views of Fidelity or any other person in the Fidelity organization and are subject to change at any time based upon market or other conditions. Fidelity disclaims any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Fidelity fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any Fidelity fund.

Diversification does not ensure a profit or guarantee against loss. Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest-rate, currency-exchange-rate, economic, and political risks, all of which are magnified in emerging markets. These risks are particularly significant for funds that focus on a single country or region.

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 risk and credit and default risks for both issuers and counterparties. Unlike individual bonds, most bond funds do not have a maturity date, so holding them until maturity to avoid losses caused by price volatility is not possible. Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.

All indices are unmanaged and performance of the indices include reinvestment of dividends and interest income, unless otherwise noted, are not illustrative of any particular investment and an investment cannot be made in any index.

1. Source: Bureau of Labor Statistics, Haver Analytics, FAM (AART) as of May 31, 2011.

2 . Source: Department of Labor, Haver Analytics, FAM (AART) as of June 11, 2011.

3. Home prices represented by the S&P/Case-Shiller Composite 20 Home Price Index, seasonally adjusted. Source: S&P, Fiserv, MacroMarkets LLC, Haver Analytics, FAM (AART) as of May 31, 2011.

4. Permit data-Source: Census Bureau, Haver Analytics, FAM (AART) as of 5/31/11. Mortgage data–Source: Mortgage Bankers Association, Haver Analytics, FAM (AART) as of March 31, 2011.

5. Investment-grade bonds represented by BC U.S. Corporate Bond Index.

High-yield bonds represented by Bank of America Merrill Lynch High-Yield Bond Master II Index. Source: FAM (AART) as of June 16, 2011.

6. Operating earnings growth estimate for S&P 500 Index. Source: FactSet Estimates, FAM (AART) as of June 17, 2011.

7. Source: Bureau of Labor Statistics, Haver Analytics, FAM (AART) as of May 31, 2011.

8. Source: OECD, Haver Analytics, FAM (AART) as of April 30, 2011. The S&P/Case-Shiller®Home Price Indices are designed to be a reliable and consistent benchmark of housing prices in the United States. Their purpose is to measure the average change in home prices in a particular geographic market. They are calculated monthly and cover 20 major metropolitan areas (Metropolitan Statistical Areas or MSAs). The S&P 500®, a market capitalization-weighted index of common stocks, is a registered service mark of the McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation. Barclays Capital®(BC) U.S. Corporate Bond Index – Publicly issued U.S. corporate debentures and secured notes that meet the specified maturity, liquidity, and quality requirements. To qualify, bonds must be SEC-registered.

The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

The Organization for Economic Co-operation and Development (OECD) countries include: Australia, Austria, Belgium, Canada, Czech Republic, Denmark, Finland, France, Germany, Greece, Hungary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Poland, Portugal, Slovak Republic, Spain, Sweden, Switzerland, Turkey, United Kingdom, United States. The Purchasing Managers Index is based on five major indicators: new orders, inventory levels, production, supplier deliveries, and the employment environment. The Industrial Production Index covers production in mining, manufacturing and public utilities (electricity, gas and water), but excluding construction.

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, Fidelity has not verified and cannot verify the accuracy of such information. The information contained herein is subject to change without notice. Fidelity 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.