A Roller Coaster Week After a Surprise Move by China
Signs of a Struggling Global Economy?
Last week, China was back in the limelight, although this time for its currency rather than its stock market. On Tuesday, the People’s Bank of China (PBoC) announced a one-off devaluation of the yuan versus the dollar and said it will change the mechanism by which it fixes the currency rate daily. Following the devaluation, the Chinese currency continued to fall, experiencing its largest two-day drop since 1994, before stabilizing by week’s end.
For many investors, the move reinforced fears about the growth prospects of the world’s second-largest economy. U.S. equities remained resilient, but 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 inflation expectations. Too little inflation can be just as perilous as too much, as a decline in inflation expectations can indicate slower growth ahead. As a result, the recent drop in bond yields has been mostly due to falling expectations for future inflation. Last week, 10-year inflation expectations (taken from the Treasury Inflation Protected Securities, or TIPS, market) fell to 1.60%, the lowest level since January. And we see a similar trend in other countries, particularly in Europe.
While Not the Nightmare Scenario, Volatility Still Likely to Rise
As we’ve been discussing in recent weeks, it does seem likely that the global economy will once again disappoint. That said, there is a difference between slow growth and no growth. Consider, for example, some context for last week’s events:
First, while China’s devaluation was a surprise, 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, the move should provide some modest stimulus to the Chinese economy.
Second, despite the slump in inflation expectations and other signs that U.S. growth remains below trend, we 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 is 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, but this had more to do with supply than demand. Last week’s drop in crude 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. While U.S. production has slipped since peaking in April, daily production remains over 9.5 million barrels, roughly 700,000 higher than a year ago.
While the U.S. is not slipping toward deflation, there is at least one key takeaway from last week’s action: The ingredients are in place for more financial market volatility.
Indeed, volatility is on the rise. At its peak last week, the VIX Index, which measures volatility of the S&P 500 Index, was up 50% from the previous week’s low. There are bigger moves beneath the surface. During the recent earnings season, more than 5% of stocks in the S&P 500 had a move of three standard deviations or more, roughly double the percentage from a few years ago.
That said, volatility is still below its long-term average. But a world marked by slow growth, unstable inflation expectations and U.S. monetary tightening (yes, we still believe the Federal Reserve will raise interest rates before year’s end) is incompatible with the low-volatility climate of the past few years.
Russ Koesterich, BlackRock
