An improving housing market may provide a boost to the consumer side of the economy.
By Dirk Hofschire, CFA, SVP, Asset Allocation Research, and Lisa Emsbo-Mattingly, Director of Asset Allocation Research, Fidelity Viewpoints – 09/28/2012
Editor’s note: At any given time, asset price fluctuations are driven by a confluence of various short-, intermediate-, and long-term factors. For this reason, we employ a comprehensive asset allocation framework that analyzes underlying factors and trends across three time horizons: tactical (one to 12 months), business cycle (six months to five years), and secular (five to 30 years). This report, part of a monthly series, will focus primarily on the intermediate-term fluctuations in the business cycle.
The U.S. economy remains in a mid-cycle expansion. Improving fundamentals in the housing market may provide a welcome boost to other sectors much later than usual in the business cycle. However, business investment and manufacturing have slowed. Economic conditions outside the U.S. continue to weaken, especially in the eurozone and China (see Economic indicators scorecard, below).
Recent trends in major categories
The following is a more detailed look at developments in major areas of the economy.
After a long period of adjustment, the recovery in U.S. residential housing has achieved considerable self-sustaining momentum. Since peaking in 2006, new-home construction activity in recent years has fallen below levels necessary to keep up with population growth and housing stock obsolescence, significantly reducing the oversupply created by the bubble.1 Home ownership is back to 1997 rates, inventories of unsold homes have returned to 1990s averages, and “shadow” inventory levels have continued to decline.2 With home prices down by one-third from the 2005 peak, housing prices are back near or below historical averages relative to incomes and rents. And with mortgage rates at historical lows, housing affordability is significantly higher than during the 1970s, 1980s, or 1990s, which potentially provides a supportive backdrop for price appreciation. Home prices have risen in all 20 of the largest metro areas in recent months; this breadth of gains is evidence that the pricing environment is stabilizing (see chart, right).
Typically, the housing cycle mirrors the overall business cycle, growing most rapidly in the early-cycle phase, and eventually falling off in the late cycle when the Federal Reserve (Fed) tightens monetary policy and banks tighten lending standards. This business cycle has been different: Housing never had the typical early-cycle recovery due to tighter bank credit and the aftermath of the bubble. Instead, now well into the mid-cycle phase, the Fed has reaffirmed its zero interest rate policy through 2015 and squarely aimed its policy support at mortgage rates through expanded purchases of mortgage-backed securities (MBS). Banks have been slow to ease credit standards, but on the margin the trend is toward greater easing. With no rate hike looming and the potential for banks to further relax lending standards, many early-cycle dynamics that accompany a housing market recovery may be arriving much later than usual.
Housing’s improvement is providing a welcome mid-cycle boost to the U.S. economy. When housing prices increase, the real mortgage rate—the nominal mortgage rate minus the rate of home price changes—declines, making homes more attractive investments (see chart right). Potential homeowners feel more comfortable purchasing a home in this environment, while banks are more likely to loosen lending standards when mortgage collateral values are at lower risk of eroding. As real mortgage rates have declined, housing starts have begun to rally, growing 29% in August from the prior year (see chart, right). No longer a drag on GDP growth, residential construction activity has contributed positively for four straight quarters since the beginning of 2011.3 Improving building and sales activity has positive knock-on effects for everything from construction employment to home-oriented retail sales, while stable or rising housing values can improve household and bank balance sheets and lead to greater consumer and lending sentiment. The outlook for housing continues to improve with the upward momentum in fundamentals, providing underlying strength across several other sectors of the economy.
On the whole, measures of U.S. employment—though relatively weak recently—have still been consistent with gradual healing of the labor market. Nonfarm payroll gains, at 96,000 in August, came in below expectations.4 And the more timely initial claims have trended up over the past month, bringing the four-week average to 375,000—roughly the average level so far in 2012.5 Surveys indicate that both employers and employees expect a pickup in labor conditions in the future: Consumers are the most optimistic about the employment situation since 1984, and a growing share of small businesses expects to increase hiring in the coming months (see chart, right). The labor market overall remains in a state of gradual but weak improvement.
Consumer spending is still relatively steady, with few signs of major improvement or deterioration. Real disposable income in July grew 2% from a year ago, continuing its slow improvement from the second half of 2011.6 Retail sales growth, at 0.9% in August, was better than expected, although sales were relatively flat excluding volatile auto dealer and gas station sales.7 After several months of weak readings, the University of Michigan’s consumer sentiment index in mid-September bounced up to 79.2, just shy of its post-crisis high in May. Much of the impetus came from rising expectations for business conditions. But recent increases in gasoline prices and concerns about possible tax increases at the beginning of 2013 are key concerns for consumption going forward. Consumer spending growth remains modest, with small signs of improvement potentially offset by rising gasoline prices and uncertainty over the fiscal cliff.
Corporations remain healthy, but there has been little recent improvement. Second quarter earnings, now fully reported, were below expectations for the fifth consecutive quarter (7.5% actual vs. 8.6% expected EPS growth), and nine out of 10 sectors missed revenue growth estimates.8 In an uncertain economic and political environment, corporations have reined in spending, with new orders for core durable goods (nondefense excluding aircraft) contracting 6%—the largest drop since late 2009.9 The Institute for Supply Management Purchasing Managers’ Index (ISM PMI) registered roughly flat manufacturing activity for the third straight month in August. An unexpected buildup of inventories accompanied continued declines in new orders—an unhealthy combination generally associated with more late-cycle dynamics. The drop in manufacturing export orders suggests that weak global economic activity may be to blame, while the ISM non-manufacturing index still points to expanding domestic business activity (see chart, right). This is similar to the late 1990s, when the Asian financial crisis caused manufacturing exports to fall even as U.S. domestic activity remained solid. Despite weakness in manufacturing, and decelerating corporate earnings and revenue growth, the corporate sector continues to be an important contributor to economic growth.
With relatively little change over the past month, the global economic backdrop has remained weak. Contracting global trade and manufacturing activity, and rising inventory levels reflect the ongoing softening in demand. Leading economic indicators for most major economies have decelerated in recent months, providing further evidence that activity is slowing. Some central banks have responded with additional stimulus aimed at spurring growth. This includes new quantitative easing programs in the U.S. and Japan, the announcement of a potentially open-ended bond-buying program by the European Central Bank (ECB), and interest-rate cuts by emerging-market countries such as Brazil and Turkey. The outlook for global growth remains weak even as monetary policy has become more aggressively accommodative.
Credit markets and banking
U.S. financial markets have improved steadily from the soft patch in early summer, as evidenced by the upward trend in the Bloomberg Financial Conditions Index to its highest level since mid-2007. Bond issuance has been strong as corporations take advantage of the low interest rate environment and healthy investor demand. Investment-grade and high-yield bond spreads have continued to narrow: High-yield spreads have tightened 190 basis points since early June and fallen below their long-term average for the first time since August 2011.10 Bank loans are growing at a healthy 4.8%, thanks to easing lending standards and greater demand for business and consumer loans.11 U.S. credit markets and borrowing conditions have continued to improve, contributing to a generally supportive financial backdrop.
Headline consumer prices increased the most in three years as the cost of gasoline surged in August, but year-over-year core inflation remained relatively muted at 1.7% as limited employment and wage growth has exerted little upward pressure.12 The Fed’s announcement of quantitative easing (QE3) helped push 10-year inflation expectations—derived from Treasury Inflation-Protected Securities (TIPS)—near the top of their historical range at around 2.5%.13 Commodity prices have stabilized after three months of steady increases as the drought and other seasonal demand factors generated upward pressure. Overall, the global economic slowdown remains a significant source of downward pressure on prices. Underlying inflationary pressures are contained despite recent increases in gasoline and other commodity prices.
Summary and outlook
The U.S. economy remains in a slow mid-cycle expansion, but there is growing risk that it could shift into the late-cycle phase in the coming months (see Typical Business Cycle, below). There are two factors behind the rising late-cycle pressures: First, manufacturing inventory levels have begun to build, most notably due to ongoing weakness in the global environment. Second, business investment has weakened, possibly because of uncertainty about the looming fiscal cliff at the beginning of 2013. On the other hand, most U.S. indicators are still in mid-cycle territory. Lending standards have been easing for consumers, overall credit growth has continued to be positive, and monetary policy is highly accommodative. Corporate profits have decelerated but remain in positive territory. Slower external demand and business spending have yet to translate into weaker front-end economic activity such as housing and consumer spending.
The most significant recent development has been an escalation of monetary policy support by central banks around the world. The U.S. Federal Reserve announced a new round of quantitative easing, with open-ended asset purchases that could make this more aggressive than prior rounds. Both the Bank of Japan and European Central Bank also announced new bond buying programs during the past month. Asset markets have been buoyed by the promise of increasing global liquidity, and financial conditions in the eurozone have improved significantly.
While additional monetary easing is an incremental positive for growth assets, we remain concerned on two fronts. First, we are somewhat skeptical whether the renewed stimulus is sufficient to counteract the persistent economic weakness in the eurozone and China. Europe is confronting fiscal austerity and structural reform issues in the midst of a worsening recession, while China is struggling with how much stimulus to deploy when it still faces overcapacity, high property prices, and inflationary pressures. Second, the risk of going off the fiscal cliff in the U.S. may already be dampening business sentiment and activity. Because U.S. policymakers are unlikely to take action prior to the November elections—and there is a chance that no action will occur before the end of the year—this uncertainty may increasingly weigh on business and consumer sentiment during the fourth quarter.
As a result, we remain somewhat cautious from a tactical asset allocation standpoint. The risk-return outlook for stocks and other economically sensitive asset categories has improved on the margin due to large-scale global monetary easing, but the potential for renewed volatility heading into the end of the year remains uncomfortably high. This warrants a relatively neutral outlook between economically sensitive and more defensive asset classes.
• 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.