business cycle update Europe Turning the Cyclical Corner U.S. and eurozone strength bolsters global growth, but market volatility likely to rise Dirk Hofschire, CFA l Senior Vice President, Asset Allocation Research Lisa Emsbo-Mattingly l Director, Asset Allocation Research Joshua Lund-Wilde l Research Analyst, Asset Allocation Research Jake Weinstein, CFA l Senior Analyst, Asset Allocation Research KEY TAKEAWAYS The eurozone is demonstrating clear signs of emerging from its 2014 slowdown into a broader mid-cycle expansion. We continue to favor European equities and believe the economy s uptrend will support the euro. MORE IN THIS ISSUE Slow global growth, lower oil prices, and the stronger dollar are reinforcing the low-inflation, moderate-growth mid-cycle phase in the U.S. A modestly improving global business cycle is supportive of most asset markets. We expect the Fed to begin hiking rates this year, which may lead to higher financialmarket volatility. Fidelity s Asset Allocation Research Team employs a multi time-horizon asset allocation approach that analyzes trends among three temporal segments: tactical (short term), business cycle (medium term), and secular (long term). This monthly report focuses primarily on the intermediate-term fluctuations in the business cycle, and the influence those changes could have on the outlook for various asset classes.
What lies ahead for the eurozone? Europe s long-term secular economic outlook will likely be challenged by aging demographics and high levels of public debt, and near-term political risks in Greece and Ukraine/Russia that are unlikely to disappear. Nevertheless, our business cycle approach posits that what matters most for relative asset performance over the intermediate term is whether cyclical conditions are improving or deteriorating. On this basis, we outlined in our 2015 outlook that we expected the European economy to emerge from last year s mid-cycle slowdown (see Leadership Series article Business Cycle Update: U.S. Economy Sturdy, Global Divergences May Spur Volatility in 2015, Dec. 2014/Jan. 2015). We are now seeing concrete signs that the eurozone is on a cyclical upswing. Monetary and credit conditions shifting from headwinds to tailwinds Boosted by improvement in the ever-important credit and monetary cycles, our Business Cycle Framework suggests that most European economies are currently in the mid-cycle expansionary phase. Eurozone banks that in 2014 focused on deleveraging their balance sheets in response to regulatory stress tests have begun to expand credit activity. Loans to the private sector are rising on a year-over-year basis for the first time since 2012 (Exhibit 1). Further, bank lending standards are becoming easier for all types of credit (Exhibit 2). After a contraction in the European Central Bank s (ECB s) balance sheet during 2014, monetary conditions have also shifted from tight to favorable. The ECB s balance sheet is again expanding, as the central bank s targeted longer-term refinancing operations (TLTROs) have raised 310 billion of ultra-low financing to further boost loan growth (Exhibit 1). The ECB s full-scale sovereign-bond buying program (QE) buoyed investor sentiment by supporting asset prices and a weaker currency. The ECB s 50 billion monthly purchases of sovereign bonds will consume an estimated 227 billion more than the expected total net issuance of eurozone sovereign bonds over the next 12 months, 1 which has helped push more than 2 of the European investment-grade bond universe into negative yields. 2 This is likely forcing investors further out on the risk spectrum, benefiting equity markets. 1 Source: Bloomberg Finance L.P., Fidelity Investments (AART), as of Mar. 20, 2015. 2 Source: Barclays Aggregate Euro Bond Index, as of Feb. 28, 2015. Exhibit 1 ECB Balance Sheet vs. Private Loan Growth After years of decline, loan growth is on the rise and will be further buoyed by a more accommodative ECB Billions ( ) Loan Growth (Year-over-Year %) 800 4% Exhibit 2 Eurozone Bank Lending Standards Eurozone banks have eased their lending standards across household and business sectors Net Share of Eurozone Banks Easing (%) 2 Easier Standards 400 0 400 Private Loan Growth ECB Balance Sheet (6-Month Change) 2% 2% 2 4 6 House Purchase Business Credit Consumer Credit 800 4% 8 Tighter Standards Feb-11 Aug-11 Feb-12 Aug-12 Feb-13 Aug-13 Feb-14 Aug-14 Feb-15 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Source: European Central Bank, Haver Analytics, Fidelity Investments (AART), as of Feb. 28, 2015. Source: European Central Bank, Haver Analytics, Fidelity Investments (AART), as of Jan. 20, 2015. 2
BUSINESS CYCLE UPDATE: Europe turning the cyclical corner Real economy gaining traction Positive cyclical momentum in recent months has been led by Germany and Spain. Manufacturing bullwhips 1 a leading indicator of industrial activity remain soundly positive in Germany, and have shown significant improvement in the periphery over the past two years. Improving business sentiment is also broad based, as a growing number of businesses across the eurozone expect conditions to improve during the next 12 months. The decline in the euro has boosted eurozone exports to the U.S. by 14% year over year. 2 The periphery has become more competitive, with unit labor costs declining more than 1 since 2009 in Spain, Ireland, and Greece. 3 Eurozone consumer confidence has eclipsed pre-2008 levels 4 amid lower oil prices, easier access to credit, and modest improvement in the labor markets. The percentage of Spanish 1 New orders less inventories. 2 Source: Eurostat, Haver, Fidelity Investments (AART), as of Jan. 31, 2015. 3 Source: Organisation for Economic Co-operation and Development (OECD), Bank for International Settlements, Haver Analytics, Fidelity Investments (AART), as of Dec. 31, 2014. 4 Source: European Commission, Haver Analytics, Fidelity Investments (AART), as of Mar. 23, 2015. Exhibit 3 Spain Consumer Sentiment and Demand A modestly improving economy following years of pent-up demand has led to increased purchases of big-ticket items Year over Year (%) 6 3 3 6 2005 New Car Registrations Consumer Sentiment 2006 2007 2008 2009 2010 Source: Banco de España, Haver Analytics, Fidelity Investments (AART), as of Feb. 28, 2015. 2011 Economic Situation Improving over Next 12 Months (Net %) 2012 2013 2014 2015 6 3 3 6 consumers with a positive outlook for future economic conditions is the highest it s been in at least 30 years. Following years of pent-up demand, Spanish motor vehicle registrations are up 26% over the past year. (Exhibit 3). Risks and limits to Europe s upside potential Despite cyclical momentum, Europe continues to face a number of challenges to its outlook. First, political risks exist, including an escalation of the Ukraine/Russian conflict. Also, concerns about Greece s potential exit from the eurozone have re-emerged, although we do not believe this is the most likely scenario. While still a risk, a Greek exit poses much less of a systemic risk today than it would have during the past few years, with foreign claims on Greek banks down by more than 8 since 2009. 5 Furthermore, the ECB s aggressive policies and emergency liquidity programs serve to limit the contagion of a possible Greek exit. Unlike mid-2011, Spanish and Italian sovereign bond yields have remained stable and low during the recent volatility in Greek assets. Second, there are a number of factors that make incremental improvement a more likely scenario than sharp recovery. Unemployment remains high across the region at 11.2% and stands at 24% in Spain. 6 Public debt levels remain elevated in the periphery, and the household sector has not experienced significant deleveraging. Further, long-term demographic trends remain challenging, with a shrinking working-age population providing a headwind to growth. On a secular basis, our forecast calls for subdued growth over the next two decades. Europe s impact on our asset allocation outlook With the eurozone gaining traction, the world s two largest economies (U.S. and Europe) now have steady outlooks that provide stability to the global economy and support riskier asset classes around the world. Eurozone equities Boosted by QE and better-than-expected economic data, share prices of European equities have risen markedly in early 2015. Nonetheless, positive fundamentals should continue to prop up European equity markets. The outlook for corporate earnings is recovering amid a weaker euro and improving 5 Source: Bank for International Settlements, Haver Analytics, Fidelity Investments (AART), as of Sep. 30, 2014. 6 Source: Servicio Publico de Empleo Estatal, Haver Analytics, Fidelity Investments (AART), as of Feb. 28, 2015. 3
macro backdrop, and valuations remain in line with their historical averages and lower than current U.S. multiples. The euro For U.S.-based investors, the euro s weakness versus the dollar has detracted from European stock performance over the past several months. However, we believe this trend may be coming to an end. The divergence between U.S. and European economic and monetary policy direction is now well recognized, with the 2 decline in the euro since July already pricing in the relative strength of the U.S. economy and a move toward Fed tightening in 2015. Given our outlook for continued improvement in the eurozone, we believe it will be much more difficult for the European economy to negatively surprise relative to the U.S., as well as for the ECB to positively surprise the market with greater-than-expected easing. As a result, a strengthening European economy should start to provide some support to the euro. This pattern would be more consistent with market activity during the past several years, where in contrast with the past several months strong equity performance has generally coincided with positive currency movement (Exhibit 4). Exhibit 4 European Stocks and the Euro The typically positive relationship between European stocks and the euro broke down in 2014 but could normalize in the months ahead MSCI Euro Index (local currency) 1300 1100 900 700 500 2008 2009 2010 2011 Source: Morningstar, Bloomberg Finance L.P., Fidelity Investments (AART), as of Mar. 23, 2015. 2012 EUR/USD Exchange Rate European Stocks 2013 Euro vs. USD 2014 2015 1.8 1.6 1.4 1.2 1.0 Business Cycle: Macro Update Recent U.S. data releases continue to be mildly disappointing, with the stronger dollar, weaker external environment, and plunge in oil prices slowing the pace of manufacturing, exports, and other globally focused sectors. However, these trends serve to reinforce the positive consumer outlook and the low-inflation, mid-cycle expansion. U.S. economic sectors Employment and consumption. The labor market remains on a trend of steady improvement, with forward-looking indicators including initial unemployment claims and the number of job openings 1 suggesting the market will likely continue to tighten. While these trends have yet to translate into significant wage growth acceleration, consumers are now meaningfully increasing their expectations for income growth for the first time during this recovery (Exhibit A). Retail sales have continued to disappoint at least in 1 Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments (AART), as of Mar. 27, 2015. Exhibit A Consumer Expectations for Income Growth Consumer expectations for income growth are now meaningfully rising as the labor market continues to tighten Expected Change over Coming Year (6-Month Average) 3% 2% 1% 2006 2007 2008 2009 2010 Source: University of Michigan Surveys of Consumers, Haver Analytics, Fidelity Investments (AART), as of Mar. 13, 2015. 2011 2012 2013 2014 2015 4
BUSINESS CYCLE UPDATE: Europe turning the cyclical corner part due to declining nominal prices for many goods and inclement weather but solid real income gains should support a pickup in consumption. Labor market improvements, lower gas prices, muted inflation, and a strong dollar continue to support the purchasing power and real income outlook of the U.S. consumer. Inflation. Inflationary pressures remain muted as a result of global disinflation, the drop in oil prices, and tepid domestic wage gains. Although core inflation measures remain weak, we expect wage growth in the service sector to cause core measures to tick back up during 2015. Late-cycle inflationary pressures are still absent amid global disinflation and incremental wage gains. Corporate and credit. U.S. corporate and credit conditions remain conducive for economic expansion. While the latest Business Roundtable survey of CEO confidence indicates a positive economic outlook, plans for capital spending remain soft, in part due to the stronger dollar and the impact the fall in oil prices is having on energy investment. Meanwhile, banks have continued to increase their willingness to make loans to both consumers and businesses early in 2015, albeit at a somewhat slower pace than during the past several quarters. 1 The dollar s strength and muted global demand may continue to present headwinds for manufacturing activity and multinational profits, but profit margins should remain high due to muted inflationary pressures. Solid corporate profitability and credit access remain tailwinds for the mid-cycle expansion. Housing. The housing market expansion remains subdued but supported by incremental improvements. Leading indicators suggest demand and activity continue to rise despite a recent weatherrelated plunge in housing starts, with both permit activity and pending home sales maintaining a mid-single-digit pace of growth over the past year. The housing market continues on a slow but positive trend, underpinned by the tightening labor market, stilllow mortgage rates, and easing lending conditions. Global China. After a multiyear property and credit boom, China is struggling to absorb excess capacity and avert financial instability in the midst of a cyclical downturn. The property sector a critical cog in the Chinese economy seems to be deteriorating further, with property prices, transactions, and new construction trending negative on a year-over-year basis. 2 Increasingly accommodative monetary and fiscal policies have yet to meaningfully stimulate the economy, as foreign capital outflows are blunting these measures by reducing liquidity in the financial system. China continues in a decelerating trend with an elevated risk of a growth recession. Japan. Japan s economy remains sluggish and will continue to face cyclical headwinds, particularly the lingering negative effects of last year s consumption-tax hike (April 2014) and a large export exposure to slowing China. In the near term, the domestic economy is showing signs of recovery; some corporate and household sentiment indicators have risen during the past three months, and the inventory-to-shipments ratio has also improved. Japan is likely exiting recession alongside weaker oil prices, renewed monetary stimulus, and a boost in exports from a weaker yen. Global summary. Stark divergences punctuate the global landscape, with the strengthening U.S. economy moving toward policy tightening while weakness and disinflationary trends in other major economies have led to increased stimulus measures abroad. The global economy continues to modestly improve, benefiting from falling oil prices, cheaper non-u.s. currencies, and lower bond yields. Leading economic indicators for the world s 40 largest economies have continued to demonstrate incremental progress, with signals from more than half of the countries now stronger on both a six-month- and one-year-trailing basis. 3 Outside the U.S., developed countries appear more able to benefit from changing global conditions. In Europe and Japan, consumers benefit from lower oil prices, while exporters receive a boost from a stronger U.S. dollar and U.S. economy. On the other hand, many large emerging markets remain trapped among various cyclical crosscurrents. The slowing Chinese economy and weak commodity prices are headwinds for many developing countries, as well as for Australia. The advantages of cheaper currencies for Russia, Brazil, and Indonesia have been more than offset by the negative terms of trade impact due to weaker commodity prices. Additionally, foreign capital outflows continue to put downward pressure on currencies, which forces tighter monetary conditions than would otherwise be warranted by their slowing cyclical prospects. The global economy shows signs of modest improvement, with favorable conditions in major developed economies while many larger emerging economies still face recessionary pressures. 1 Senior Loan Officer Survey. Source: Federal Reserve, Haver Analytics, Fidelity Investments (AART), as of Feb. 2, 2015. 2 Source: China National Bureau of Statistics, Haver Analytics, Fidelity Investments (AART), as of Feb. 28, 2015. 3 Source: Organisation for Economic Co-operation and Development (OECD), Foundation for International Business and Economic Research (FIBER), Haver Analytics, Fidelity Investments (AART), as of Jan. 31, 2015. 5
Outlook/Asset allocation implications The trend of modest improvement in the global business cycle remains generally favorable for asset markets. The benign, mid-cycle backdrops in both the U.S. and Europe lay a foundation for moderate global growth, muted inflation, and low interest rates. These conditions support equities but have yet to present late-cycle inflation that would threaten bond returns. European equities may have the most cyclical upside due to their relatively attractive valuations and still-muted investor expectations for economic activity. We still expect the U.S. Federal Reserve (Fed) to begin to raise rates this year, and though the tightening process should remain gradual, it is likely to provoke greater volatility in the currency and broader financial markets. The biggest risk to our outlook for global improvement comes from emerging markets, where Fed tightening and the strong dollar will likely make financial conditions more difficult at a time when economic activity has decelerated substantially. China is our biggest concern, though our base case is that it will avoid significant financial instability. We expect a modestly improving global backdrop in 2015, but one that takes place within an environment of higher financial-market volatility (Business Cycle Framework). Business Cycle Framework The mid-cycle expansion persists in Germany and the U.S., while China and Japan face late-cycle and recessionary pressures Cycle Phases EARLY Activity rebounds (GDP, IP, employment, incomes) Credit begins to grow Profits grow rapidly Policy still stimulative Inventories low; sales improve MID Growth peaking Credit growth strong Profit growth peaks Policy neutral Inventories, sales grow; equilibrium reached LATE Growth moderating Credit tightens Earnings under pressure Policy contractionary Inventories grow; sales growth falls RECESSION Falling activity Credit dries up Profits decline Policy eases Inventories, sales fall Inflationary Pressures Red = High CONTRACTION Germany U.S. + Economic Growth Japan RECOVERY EXPANSION China # Japan Relative Performance of Economically Sensitive Assets Green = Strong Note: The diagram above is a hypothetical illustration of the business cycle. There is not always a chronological, linear progression among the phases of the business cycle, and there have been cycles when the economy has skipped a phase or retraced an earlier one. # 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: Fidelity Investments (AART). 6
BUSINESS CYCLE UPDATE: Europe turning the cyclical corner Authors Dirk Hofschire, CFA l Senior Vice President, Asset Allocation Research Joshua Lund-Wilde l Research Analyst, Asset Allocation Research Lisa Emsbo-Mattingly l Director, Asset Allocation Research Jake Weinstein, CFA l Senior Analyst, Asset Allocation Research The Asset Allocation Research Team (AART) conducts economic, fundamental, and quantitative research to develop asset allocation recommendations for Fidelity s portfolio managers and investment teams. AART is responsible for analyzing and synthesizing investment perspectives across Fidelity 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, Caitlin Dourney, and Ilan Kolet also contributed to this article. Fidelity Thought Leadership Vice President Kevin Lavelle and Thought Leadership Director Christie Myers provided editorial direction. 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 Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. 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 carry inflation, credit, and default risks for both issuers and counterparties. Investing involves risk, including risk of loss. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. All indices are unmanaged. You cannot invest directly in an index. The Business Cycle Framework 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, 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. 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. Index definitions The Barclays Euro Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, euro-denominated, fixed rate bond market, including treasuries, government-related, corporate and securitized issues. MSCI Euro Index is a market capitalization-weighted index that is designed to measure the investable equity market performance for global investors of the developed-market countries in the European Monetary Union. If receiving this piece through your relationship with Fidelity Financial Advisor Solutions (FFAS), this publication is provided to investment professionals, plan sponsors, institutional investors, and individual investors by Fidelity Investments Institutional Services Company, Inc. If receiving this piece through your relationship with Fidelity Personal & Workplace Investing (PWI), Fidelity Family Office Services (FFOS), or Fidelity Institutional Wealth Services (IWS), this publication is provided through Fidelity Brokerage Services LLC, Member NYSE, SIPC. If receiving this piece through your relationship with National Financial or Fidelity Capital Markets, this publication is for institutional investor use only. 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