What s holding back the economy?

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Corey Bryan
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1 Page 1 of 5 What s holding back the economy? BY BILL RALLS, CFA, SENIOR VICE PRESIDENT, INVESTMENT SERVICES, RESEARCH, FIDELITY VIEWPOINTS 09/11/11 An uncertain fiscal situation in the Eurozone has rattled investors. European fiscal woes have piled on top of an already fragile U.S. economy to aggravate market fears of a global economic slowdown. Concerns mounted on Friday that Greece might have difficulty meeting the terms of its financial aid package. This is occurring as evidence is building that economic activity is slowing in the U.S. This unsavory mix of bad news has helped spark an increase in market volatility and a flight to perceived safer havens such as U.S. Treasuries. The Chicago Board Options Exchange (CBOE) Volatility Index (VIX), a widely used measure of expectations for market risk, has been above 30 since August 4 about 50% higher than its average of 20 since Yields on 10-year U.S. Treasuries have pierced the 2% level and fallen to record lows. So are things as bad as the selloff on September 9 seems to indicate? One of the key issues is that the economy simply has a lower margin for error. After only posting real (inflation-adjusted) growth of 0.4% in Q1 and 1.0% in Q2, the U.S. economy has slowed markedly from the 2-4% range of last year. With the precarious sovereign debt situation in Europe, plummeting consumer confidence in the U.S., and the massive overhang of U.S. household debt, the economy has less capacity to absorb shocks be it an economic turn for the worse in the Eurozone, slowing manufacturing activity, or a destructive hurricane. But, is the economy really as bad as recent market volatility might lead you to believe? The economy has undoubtedly weakened and there is heightened risk that an economic slowdown could accelerate into something worse. Escalating concerns about the sovereign debt markets in Europe have shrunk the already thin margin of safety. On the semi-positive side of things, consumer spending trends and manufacturing activity, while certainly mixed, don t seem to be portending economic doom. There is, however, one glaring area that does not have much room to absorb another body blow: household debt. While household debt ratios have come down over the past several years, they are still well above historical averages. Let s take a closer look. Consumer spending jumped in July, but not as strongly as the numbers suggested Real (inflation-adjusted) consumer spending increased 0.46% in July, for the largest monthly gain in two years. Much of July s increase came from spending on big-ticket durable goods. Spending on motor vehicles and parts jumped 5.10% after four consecutive months of decreases. 1 July s increase in real consumer spending followed three months of declines. Consequently, the three-month moving average of consumer spending was only 1.68% (annualized) at the end of July. This is below the 2.10% moving average increase from the 2000s and well below the 3.48% moving average from the 1990s or the 3.37% moving average from the 1980s. Further, July s increase in spending appears to have been partly funded by a drop in the personal savings rate, which fell to 5.0% from 5.5% in June, rather than from gains in real disposable personal income, which actually fell 0.09% during the month. 2 While July s positive consumer spending report was weak based on historical standards, it was nevertheless a welcome sign amidst the swarm of doubt that descended on the capital markets in August.

Page 2 of Manufacturing still in positive territory, if only barely Many investors were anxiously awaiting the August results for the closely followed Purchasing Manager s Index (PMI) from the

2 Page 2 of Manufacturing still in positive territory, if only barely Many investors were anxiously awaiting the August results for the closely followed Purchasing Manager s Index (PMI) from the Manufacturing Report on Business published by the Institute for Supply Management (ISM). The PMI is compiled from a survey of managers and executives at manufacturing firms. Levels above 50% indicate that more manufacturing firms have been growing rather than contracting. The consensus expectation had been for the PMI to fall into negative territory, to Therefore, it was a somewhat (and shortlived) relief when the PMI stayed just barely in expansion territory, at While it stayed above the breakeven level, it was the lowest reading in two years. There were also other concerning signs in the report. The New Orders Index, which had fallen below the breakeven point in July, to 49.2, edged higher but still stayed in contraction territory, at If future orders do contract, this could slow manufacturing activity in the months ahead. Keep in mind that the PMI is a survey, not a gauge of actual manufacturing activity. It is a measure of how managers and executives in the manufacturing industry view current business prospects versus the prior month. Therefore, it is important to also look at indicators of actual manufacturing activity. A key indicator to watch is industrial production, which is one of the measures used by the National Bureau of Economic Research (NBER) to determine when the economy has fallen into a recession. While the ISM report suggested that we could see slowing in the manufacturing sector, July s report on capacity utilization should reduce fears that a severe recession is on the immediate horizon. Capacity utilization in the manufacturing sector ticked up to 75.0% in July, from 74.6% in June. The three-month moving average for manufacturing capacity utilization was 74.7%. While this is below the 79.7% monthly peak reached prior to the recession, it compares favorably to the 75.3% monthly average from the 2000s. However, we have a way to go to reach the 81.4% monthly average from the 1990s.

Page 3 of Debt is a drag While no single element of the economy is a magic elixir that will propel growth, there is one glaring area that continues to affect overall economic growth: household debt.

3 Page 3 of Debt is a drag While no single element of the economy is a magic elixir that will propel growth, there is one glaring area that continues to affect overall economic growth: household debt. One of the main aftershocks of the weak economic recovery has been the indebted fiscal condition of U.S. households. After peaking at $13.9 trillion in the first quarter of 2008, overall household debt has fallen by $608 billion but what really matters is household debt relative to personal income. Measuring debt levels relative to a person s income gives a better indication of the capacity to spend. Using the ratio of total household debt to gross disposable income, it is striking how quickly the average household piled on debt in the 2000s. 4 From 1952 to 1979, the average ratio of household debt to gross disposable income was 57%, but over the past three decades the averages steadily, and then dramatically, climbed higher. In the 1980s, it averaged 69%; in the 1990s it averaged 84%; but then the housing boom hit in the 2000s and the ratio skyrocketed to an average of 112%. The ratio ultimately peaked in Q at 127%, right before the onset of the recession. 5 While the household-debt-to-disposable-income ratio has come down to 113%, there is still a way to go to reach the lower levels of the 1980s or '90s. Given the level of gross disposable income at the end of Q1, overall household debt would need to fall another $3.4 trillion to match the average debt-to-disposable-income ratio of 84% from the 1990s. It will be a long slog to get household debt back to more sustainable levels a process made all the more difficult and painful by the slow growth in personal income. As long as household debt levels remain high, deflationary pressures will likely remain a headwind to consumer spending, and thus to economic growth.

4 Page 4 of What s next? Despite the cacophony of fear and gloom over the past month, the data does not appear to suggest an imminent recession. Recent consumer spending and manufacturing activity indicate that the economy was still growing, albeit at a very sluggish pace. Nevertheless, the odds of a new recession have increased. Given uncertain economic conditions and elevated market volatility, it s more important than ever to take a disciplined approach to your household expenses. Be sure you have clearly defined your investment goals and time horizon, developed a retirement savings plan, and are regularly monitoring your progress versus the plan. Before investing, consider the funds' investment objectives, risks, charges, and expenses. Contact Fidelity for a prospectus or, if available, a summary prospectus containing this information. Read it carefully. The information presented above reflects the opinions of Bill Ralls, senior vice president of research in the Personal and Workplace Investing (PWI) division of Fidelity, as of September 9, 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. Past performance is no guarantee of future results. Investing involves risk, including risk of loss. Stock markets, especially foreign markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

5 Page 5 of 5 In general the bond market is volatile, and bond funds entail interest rate risk. As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities. Bond funds also entail the risk of issuer or counterparty default, issuer credit risk, and inflation risk. ETFs may trade at a discount to their NAV and are subject to the market fluctuations of their underlying investments. The commodities industry can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Commodity-linked investments can be more volatile and less liquid than the underlying instruments or measures, and their value may be affected by the performance of the overall commodities baskets as well as by weather, disease, and regulatory developments. Portfolio Review is an educational tool offered for use by Fidelity Brokerage Services LLC, member NYSE, SIPC. S&P 500 is the S&P 500 Index, which is a registered service mark of The McGraw-Hill Companies, Inc., and has been licensed for use by Fidelity Distributors Corporation and its affiliates. It is an unmanaged index of the common stock prices of 500 widely held U.S. stocks and includes the reinvestment of dividends. The MSCI EAFE Index is the Morgan Stanley Capital International Europe, Australasia, Far East Index (net MA tax), which is an unmanaged market-capitalization-weighted index of equity securities of companies domiciled in various countries. The index is designed to represent performance of developed stock markets outside the United States and Canada and excludes certain market segments unavailable to U.S.- based investors. The index returns for periods after 1/1/1997 are adjusted for tax withholding rates applicable to U.S.-based mutual funds organized as Massachusetts business trusts. The ISM New Orders Index, a subcomponent of the composite ISM Manufacturing Report, asks whether purchasing managers are seeing an increase or decrease in new orders compared with the prior month. Levels above 50% indicate that the majority of survey respondents said that new orders in the current month increased versus the prior month. Levels below 50% indicate that the majority of survey respondents said that new orders in the current month decreased versus the prior month. 1. Sources: Bureau of Economic Analysis, Haver Analytics, as of 9/1/ Source: Bureau of Economic Analysis, Haver Analytics, as of 9/1/ Source: Institute for Supply Management, Haver Analytics, Econoday.com, as of 9/1/ Disposable personal income is the total after-tax income received by individuals; it is the income available to persons for spending or saving. Gross disposable income adds back the household consumption of fixed capital (depreciation). 5. Sources: Federal Reserve Board, Haver Analytics, as of 9/1/2011. Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI Fidelity Investments Institutional Services Company, Inc., 100 Salem Street, Smithfield, RI

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