Caught Between Slow Growth and the End of Easy Money

As I expected, volatility is picking up. The VIX or CBOE Volatility Index (otherwise known as the fear gauge), which measures implied volatility in S&P 500 options, recently climbed to its highest level since late April. Meanwhile, bond volatility, particularly for US Treasuries, has spiked in recent weeks.

Two contradictory investor concerns are to blame. As I write in my latest weekly commentary piece, investors are worried about slowing global economic growth at the same time that they are also anxious about an imminent end to easy money in the United States and Japan. In my opinion, however, investors should be more concerned now about slower growth. Here’s why:

  • Most recent economic data has come in below expectations, including higher jobless claims and weaker manufacturing surveys.
  • Most leading economic indicators are suggesting that growth will likely decelerate in the second and third quarters. The Chicago Fed National Activity Index, for instance, fell sharply in April. As I pointed out in a post last week, this metric has a particularly strong relationship with economic growth over the next one to two quarters.
  • The slowdown is not just a US phenomenon. With the exception of Japan, most economies around the world are slowing. For example, in Europe, unemployment is lingering at a record of more than 12%. Elsewhere, India last week announced a second straight quarter of sub 5% growth, a big slowdown for an economy that up until recently was expected to grow at closer to 10%.
  • US inflation is falling. The Fed’s preferred measure of inflation, the personal consumption expenditure (PCE), is bouncing around close to 1% and is at barely half of the Fed’s target inflation level.

The upside of slower growth and falling inflation: A change in monetary policy isn’t likely until the fourth quarter or early 2014. To be sure, concerns about an end to easy money in the intermediate term are completely rational. However, worrying about a monetary policy change now is a bit premature.

So what does this all mean for investors?

1.) Maintain an overweight to stocks over bonds. A continuation of easy money should help mitigate the downside for stocks.

2.) Prepare your portfolio for more market volatility. All else equal, slower growth suggests higher volatility ahead.

Source: Bloomberg

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