Last week was another difficult one for stocks, marked by a bruising mid-week selloff triggered by China’s surprise devaluation of its currency. For many investors, the move reinforced fears about the growth prospects of the world’s second-largest economy. Though U.S. equities remained resilient, other markets came under pressure. European equities in particular struggled as the fall in China’s currency and the appreciation of the euro hit exporters especially hard.
It also did not help that the news came on the back of another worrisome trend: an accelerating decline in U.S. inflation expectations. Too little inflation can be just as perilous as too much, as a decline in inflation expectations can indicate slower growth ahead.
That said, as I write in my new weekly commentary, “The Scene Is Set for Higher Volatility,” there is a big difference between slow growth and no growth, so it’s important to put last week’s events in context.
China’s surprise devaluation
While I don’t believe China’s move has the dire repercussions some have suggested, it does fit within the broader narrative of a slowing global economy, with less support from emerging markets.
But it needs to be viewed in the context of the currency’s relative strength: The yuan was one of few currencies to have appreciated against the dollar over the past five years. In that light, the move can be viewed as part of a shift toward a market-determined exchange rate and broader financial liberalization. In addition, over the intermediate term, it should provide some modest stimulus to that economy.
Declining inflation expectations
Despite the slump in inflation expectations and other signs that U.S. growth remains below trend, I don’t view deflation as a real risk. Last week brought more evidence that U.S. economic growth should be modestly higher in the second half of the year, although it’s unlikely to surge. Reports on retail sales, industrial production and producer prices were all solid.
Finally, much of the recent drop in inflation expectations is being driven by lower commodity prices, particularly oil. Last week, headlines were focused on oil trading down to a six-and-a-half-year low. However, this had more to do with supply than demand and was mostly a U.S. phenomenon, driven by the recent stabilization in the U.S. rig count as well the fact that production has remained resilient, despite the pullback in drilling activity.
As for what this means for investors, there’s one key takeaway: the ingredients are in place for more financial market volatility.
At its peak last week, the VIX Index, which measures volatility of the S&P 500 Index, was up 50 percent from the previous week’s low, according to Bloomberg data. Yet volatility is still below its long-term average, and the low-volatility climate of the past few years is incompatible with a world marked by slow growth, unstable inflation expectations and a likely Federal Reserve rate hike before year’s end.