The U.S. Consumer: Outlook Bright But Not Off to the Races

business

cycle

update

The U.S. Consumer: Outlook Bright

But Not Off to the Races

Positive consumer trends bode well for economy and U.S. stocks

Lisa Emsbo-Mattingly l Director, Asset Allocation Research Joshua Lund-Wilde l Research Analyst, Asset Allocation Research Jacob Weinstein, CFA l Senior Analyst, Asset Allocation Research

KEY TAKEAWAYS

• A mix of secular and cyclical trends has

restrained consumer spending relative to past

cycles.

• While the secular forces should continue to limit

consumption growth, the cyclical headwinds are

abating.

• With the consumer on a positive trajectory, the

U.S. economy remains in a solid mid-cycle

expansion.

• Deflationary fears have ebbed and bond

yields have risen, reflecting continued modest

improvement in the global business cycle.

• We expect choppier markets ahead, warranting

smaller asset-allocation bets.

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.

MORE IN THIS ISSUE

Aging baby boomers boosting savings rate PAGE 2

Income inequality inhibits spending growth PAGE 3

Business Cycle: Macro Update PAGE 4

Global progress driven mostly by developed economies

PAGE 5

Sentiment improving along all income tiers PAGE 4

Business Cycle Framework PAGE 6

Household deleveraging largely done PAGE 3

The conditions facing U.S. consumers continue to improve substantially. The economy has added more than three mil-lion jobs during the past year, and new unemployment claims remain at post-war lows relative to the size of the workforce. Gasoline prices are more than 20% lower than one year ago, overall inflation is muted, and the strong dollar supports consumers’ purchasing power. Consumer confidence is rising, and the outlook for real (inflation-adjusted) income is the best in nearly a decade.

Yet, many measures of actual consumption activity have generally been disappointing in 2015. Not only has a clear acceleration in spending remained elusive, but during this multiyear mid-cycle phase the real (inflation-adjusted) per-sonal consumption expenditures have averaged only 2.3% growth—two full percentage points slower than the average of previous mid-cycle economic expansions since 1960.1

Personal savings rates, which often tick down as income and wealth gains pick up alongside cyclical improvements, to the contrary of historical trend have risen during the past two years.

Our thesis is that a mixture of secular (long-term) and cyclical forces have restrained the pace of consumer spending. While we expect the secular trends to continue to cap the rate of upside growth potential for the U.S. consumer, cyclical headwinds should continue to abate and keep the consumer on a positive trajectory.

Secular forces inhibit consumption growth, boost savings The secular trends that have combined to push down

consumption and boost savings include:

Structural changes to the retirement system: The onus for retirement savings has increasingly been placed on individual households, taking up a greater amount of their disposable income. The Pension Protection Act of 2006 has enabled plan sponsors to automatically enroll employees into retirement savings programs, and a growing number of plan participants have been defaulted into annual increase programs. These trends are likely to deepen as

1 Source: Bureau of Economic Analysis, Haver Analytics, Fidelity Investments (AART), as of May 31, 2015.

rising longevity places a strain on both public and private retirement needs in the coming decades.

Worsening demographics: Slower population growth, the movement of the baby boom generation toward retirement, and the aging of the U.S. population all present fewer demographic tailwinds for U.S. consumption than in the past. First, growth in the labor-force population, which tends to correlate closely with consumption rates, is expected to drop, from 0.9% during the past 20 years to just around 0.6% over the next 20 years. Second, as baby boomers moved into the 50- to 64-year-old segment during the past two decades, they made it the fastest-growing age cohort of the overall population, an age group that typically saves a greater proportion of its income as it approaches retirement. This demographic bulge of savers became much larger than

the retirement-age (65+) population that tends to spend more of its income, providing a secular-mix shift that helped push the personal savings rate higher in recent years (see Exhibit 1). Third, the retirement of the baby boomers in the coming years may cap the rise in the savings rate but not necessarily increase the pace of overall consumption. Seniors tend to have much lower incomes than the older

Exhibit 1Age Cohorts’ Share of U.S. Population Increased saving from an aging baby boom generation has inhibited consumer spending

Source: United Nations, Haver Analytics, Fidelity Investments (AART), as of Jul. 12, 2013. 10% 14% 18% 22% 19 9 0 19 92 19 9 4 19 9 6 19 98 2000 2002 200 4 20 0 6 20 0 8 20 10 201 2 20 14 20 16 201 8 2020 202 2 202 4 202 6

Share of Total Population

Age 50–64

Age 65+

Current Savers

working-age populations from 35 to 54, so while they spend a higher percentage of their incomes, any boost to aggregate spending will be limited.

Higher inequality: The greater accrual of income growth and wealth gains to the most-well-off households has been a mul-tiyear trend that appears to have deepened since the 2008 recession, with the top quintile of households capturing a vast majority of the income gains since 2009 (see Exhibit 2). Upper-income households tend to have a lower marginal pro-pensity to consume than do lower-income segments, imply-ing that income gains are less likely to be spent. For instance, the upper quintile of U.S. households spends only about 60% of their pretax income, while the other four quintiles on aver-age spend nearly all their income. Gains in wealth amid the rise in real estate and financial asset prices in recent years may be further exacerbating these trends, and a continued skew of bigger income gains to wealthier households implies a higher savings rate in the aggregate.

Post-crisis behavioral shift to higher savings rate: Some psychological scars from the financial crisis may take a long time to heal. While it is difficult to generalize across the entire population, recent memories may linger—including the wave

of housing foreclosures, and the sharp rise in long-term unemployment. Having a more conservative consumer (in terms of personal finances), perhaps compounded by greater insecurity about long-term job and retirement prospects, may imply that the savings rate hit a secular low in the mid-2000s. Today’s unique business cycle: Delayed improvement, but getting better

Some unique characteristics of the current cycle have inhibited the consumer rebound relative to prior economic expansions. While these conditions offer a backward-looking explanation for the muted pace of consumer spending, they also provide positive reinforcement for the idea that con-tinued improvements will serve to support the overall solid consumer outlook. These cyclical factors include:

Prolonged balance-sheet hangover from the global financial crisis: After a historic rise in household debt amid the housing boom, many households were forced into deleveraging in the aftermath of the financial crisis. While more conservative management of personal finances has persisted several years into the cycle, debt levels remain high on an absolute basis, and personal incomes have been slow to recover. During the past two years, however,

debt-to-Exhibit 2Average U.S. Household Income Lopsided gains to upper-income households have contributed to higher savings rates

Source: Bureau of Labor Statistics, Haver Analytics, Fidelity Investments (AART), as of Sep. 9, 2014.

Exhibit 3Household Debt and Credit Growth

The bulk of the post-crisis deleveraging of the U.S. consumer has already occurred, and credit growth has improved

Source: Federal Reserve Board, Haver Analytics, Fidelity Investments (AART), as of Mar. 31, 2015. 234%124% 96% 80% 61% $0 $50,000 $150,000 $250,000 $350,000 19 8 5 19 87 19 8 9 19 91 19 93 19 95 19 97 1999 2001 200 3 20 05 20 07 20 0 9 20 11 201 3 Income Consumption % of Pretax Income $100,000 $200,000 $300,000

Bottom QuintileFourth Quintile Third Quintile Second Quintile Top Quintile M ar-9 0 Se p -91 M ar-93 Sep -9 4 M ar-9 6 Se p -97 M ar-9 9 Sep -0 0 M ar-02 Sep -0 3 M ar-05 Sep -0 6 M ar-0 8 Sep -0 9 M ar -1 1 Se p -1 2 M ar -1 5 85% 95% 105% 115% 125% 135% –5% 0% 5% 10% 15%

Household Credit Growth (Year-over-Year) Liabilities-to-Disposable Income 90% 100% 110% 120% 130% Deleveraging

headwinds should continue to dissipate, providing a strong outlook for real incomes amid balance-sheet improvements that should allow the U.S. consumer to remain on a positive tra-jectory. Recent upward revisions to retail sales and other data suggest that perhaps we are already witnessing the resumption of stronger consumption trends after a disappointing start to the year. This solid outlook suggests to us that the U.S. economy is on firm footing, and that U.S. stocks tied closely to the improve-ment in the household sector should continue to benefit from a positive fundamental backdrop.

income ratios have generally stabilized, and consumer credit has begun to grow again, suggesting that the worst of the deleveraging has already occurred (see Exhibit 3). Meanwhile, debt-service obligations are near 35-year lows. Continued balance-sheet improvement boosts the consumer outlook, even as credit growth remains slow by historical standards. Delayed improvement for lower-income households: The unequal distribution of household income gains may be a secular trend, but lower-income households have also faced headwinds unique to this mid-cycle phase of the U.S. economy. Roughly 17% of mortgages remain underwater,1 _{and mortgage lending}

standards remain tight for households with weaker creditworthi-ness. However, continued improvement in the labor and housing markets and easing in mortgage lending should keep spreading the positive cyclical benefits to a greater number of households. Consumer confidence among all income tiers has now reached pre-recession levels, and more bottom-tercile income house-holds expect a raise over the next year than at any point in the past decade (see Exhibit 4).

Uncertainty around gasoline prices: Previous episodes of declin-ing gas prices suggest that it is common for savdeclin-ings to spike initially, then for the rate of savings to dissipate as households feel a longer-lasting effect on their incomes. We expect gas prices will stabilize below last year’s levels, and consumers will ultimately gain confidence to spend more of the savings windfall. Outlook for the U.S. consumer

We believe the secular restraints on the U.S. consumer will persist and keep the pace of consumer spending well below the peak pace of prior mid-cycle expansions. Nevertheless, cyclical 1 Source: Zillow, Haver Analytics, as of Dec. 31, 2014.

Exhibit 4U.S. Consumer Sentiment

Sentiment has noticeably improved among all income tiers during the past 18 months

Relative scores: the percent giving favorable replies minus the percent giving unfavorable replies plus 100. Source: University of Michigan, Haver Analytics, Fidelity Investments (AART), as of Jun. 12, 2015.

Business Cycle: Macro Update

Recent U.S. data releases have been less disappointing, due in part to some stabilization in external-oriented sectors following a sharp deceleration caused by the stronger dollar, weaker external environment, and plunge in oil prices. The mid-cycle expansion continues to be bolstered by a healthy domestic backdrop underpinned by the positive real income outlook for the U.S. consumer.

U.S. economic sectors

Inflation. The recovery in crude-oil prices has translated into a slight uptick in headline inflation rates across the globe, but these pressures remain subdued. We expect core inflation in the U.S. will move toward 2% by the end of the year, as continued labor market improvement translates into accelerating wages and service prices. Wage gains should support a modest pickup in inflation, but late-cycle inflationary pressures remain absent.

50 60 80 100 110 20 0 4 20 05 20 0 6 20 07 20 0 8 20 0 9 20 10 20 11 201 2 201 3 20 14 201 5

Index Level Relative Score (6-Month Moving Average)

70 90 Bottom Tercile Middle Tercile Top Tercile

Corporate and credit. U.S. corporate and credit conditions

generally remain solid. Corporate profitability is high, small business confidence is back to pre-recession levels, and there are signs that industrial activity is stabilizing after a sizable deceleration during the first quarter. Manufacturing and business investment have softened amid a weaker energy sector and a strong U.S. dollar, but ample credit availability and solid non-energy corporate profitability continue to be supportive of the mid-cycle expansion. Housing. The housing market expansion remains subdued but is supported by incrementally improving fundamentals. New and existing home sales and housing permits have reached multiyear highs, indicating a steady uptick in demand. The housing sector continues on a slow but positive trend, underpinned by the tightening labor market, still-low mortgage rates, and easing lending conditions.

Global

China. A downshift in growth at the end of a cyclical boom has left China with a credit overhang and a need for economic restructuring. While aggressive easing is helping stabilize the near-term economic outlook, still-declining corporate profitability1 _and persistent overcapacity suggest that a more sustainable economic upturn remains elusive. China’s economy has fallen back into growth recession, but increasingly aggressive policy easing is helping stabilize near-term conditions.

Japan. The Japanese economy continues to experience an uneven recovery, supported by extensive monetary easing. Machine tool orders are at their highest levels since 2008—suggesting that business investment is solid—but real wage growth for workers remains elusive, which indicates that the household sector has yet to turn around.2 _{Japan has entered a tepid early cycle alongside} renewed monetary stimulus, a boost to corporate profits from a weaker yen, and a slowly improving global backdrop.

Europe. Europe continues to regain cyclical traction amid improving credit and monetary conditions. Domestic demand remains the primary driver of the current reacceleration, with eurozone retail 1 Source: China National Bureau of Statistics, Haver Analytics, Fidelity

Investments (AART), as of May 28, 2015.

2 Source: Japan Ministry of Health, Labour and Welfare, Haver Analytics, Fidelity Investments (AART), as of Jun. 2, 2015.

Exhibit AOil Prices vs. U.S. Inflation Expectations The improved outlook for developed economies has led

to higher energy prices and inflation expectations

Oil prices based on West Texas Intermediate crude. TIPS: Treasury Inflation-Protected Securities. TIPS Breakeven: the difference between the yield on 10-year Treasurys and the real yield on 10-year TIPS. Source: Energy Information Administration, Federal Reserve, Haver Analytics, Fidelity Investments (AART), as of Jun. 19, 2015.

sales growing 3% year over year—the fastest pace since 2008. Accommodative monetary policy, a weaker euro, and a healthy credit cycle continue to serve as significant tailwinds for the eurozone’s mid-cycle reacceleration.

Global summary. The global economy remains on a slow, steady growth trend bolstered by extremely accommodative monetary policies. Leading economic indicators (LEIs) for the world’s 40-largest economies suggest this incremental progress is likely to persist, with roughly 60% of those countries reporting a rise in their LEIs on a six-month trailing basis. Progress continues to be heavily driven by developed economies, with many benefiting from the lagged effects of cheaper commodity prices, weaker currencies, and monetary stimulus. After the steep drop in 2014, oil prices and inflation expectations have stabilized year to date (see Exhibit A). The global expansion remains sluggish, but better conditions in several major developed economies underpin a modestly improving economic outlook.

1.4% 1.6% 1.8% 2.0% 2.2% 2.4% $30 $60 $90 $120 Ja n-14 Fe b-14 A pr -1 4 M ay -1 4 Ju n-14 A ug -1 4 Se p-14 N ov -1 4 D ec -1 4 Fe b-15 M ar -1 5 Ju n-15

Outlook/asset allocation implications

Deflationary fears in the financial markets have ebbed in recent weeks, as evidenced by the modest rise both in oil prices and in inflation expectations, followed by an upturn in global bond yields. While the market gyrations are more violent than the underlying fundamentals might suggest, they do reflect the continued modest improvement in the global business cycle. Along with low inflation and heavy monetary accommodation, this improvement provides a relatively favorable backdrop for global equities, particularly in developed economies such as Europe that have better cyclical dynamics.

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).

Business Cycle Framework

Japan enjoys an early-cycle recovery, while the U.S. and Germany remain in mid-cycle, and China experiences a growth recession

Risks to our benign outlook include one on each side of the low-inflation trend. Tighter U.S. labor markets have the potential to stoke greater wage inflation and push the economy toward the late-cycle phase. On the other hand, China’s struggles with rising debt, overcapacity, and slower growth represent a deflationary risk. In the near term, we expect markets to become choppier as we approach the first rate hike by the Federal Reserve. In light of the more mature phase of the current U.S. mid-cycle expansion and our expectations for higher volatility, smaller asset-allocation bets appear warranted.

Inflationary Pressures Red = High

LATE RECESSION

EARLY MID

• Activity rebounds (GDP, IP, employment, incomes) • Credit begins to grow • Profits grow rapidly • Policy still stimulative • Inventories low; sales improve

• Growth peaking • Credit growth strong • Profit growth peaks • Policy neutral • Inventories, sales grow;

equilibrium reached

• Growth moderating • Credit tightens • Earnings under pressure • Policy contractionary • Inventories grow; sales

growth falls

• Falling activity • Credit dries up • Profits decline • Policy eases • Inventories, sales fall

CONTRACTION U.S. Germany Cycle Phases China# RECOVERY EXPANSION Relative Performance of Economically Sensitive Assets

Green = Strong + Economic Growth

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 Jacob 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 Senior Research Analyst Irina Tytell, PhD, Senior Analyst Austin Litvak, and Research Analysts Ilan Kolet and Caitlin Dourney also contributed to this article. Fidelity Thought Leadership Vice President Kevin Lavelle and Thought Leadership Director Christie Myers provided editorial direction.

AUTHORS

For Canadian Investors

For Canadian prospects only. Offered in each province of Canada by Fidelity Investments Canada ULC in accordance with applicable securities laws. 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.

Views expressed are as of the date indicated, based on the informa-tion 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 in-vestment-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 develop-ments, 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.

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.

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. Clearing and custody services are provided through National Financial Services LLC, Member NYSE, SIPC.

© 2015 FMR LLC. All rights reserved. 729501.1.0