A Tumultuous Week
It appears the period of unusually low volatility that began a couple of years ago has finally come to an end. In a tumultuous week, the Dow Jones Industrial Average fell 0.99% to close at 16,380, the S&P 500 Index declined 1.05% to 1,886 and the Nasdaq Composite Index dropped 0.42% to 4,258. Meanwhile, the yield on the 10-year Treasury dipped below 2% intraday Wednesday, but ultimately ended the week at 2.20%, down from 2.28% the Friday before. Of course, as Treasury yields fell, their prices rose. All of last week’s action points to a classic flight-to-safety scenario.
While investor sentiment has clearly shifted, economic fundamentals remain relatively stable, in our estimation. This suggests the recent sell-off in stocks could present opportunities for long-term investors.
Concerns Over Low Growth and Even Lower Inflation
Stocks recouped some of their losses on Friday, but last week was another difficult one for equity markets. Volatility — as measured by the VIX Index — traded at its highest level since December 2011 and equity markets experienced their worst three-day stretch in years.
As was the case in prior weeks, the selling derived largely from fears over economic growth (or lack thereof). Consistent with the past few months, much of the worry remains centered on Europe. Last week brought more evidence of the slowdown in the eurozone when the German Economic Ministry cut its 2014 and 2015 growth estimates.
Though Europe is the focus, the growth scare does not stop there. Investors continue to worry about the scope and consequences of the Ebola outbreak. Even the U.S. is not immune to the threat of slower growth. Last week brought September’s retail sales data, which showed sales unexpectedly dropped 0.6%. The decline was fairly widespread across many categories (although it should be noted that other data, specifically industrial production and initial jobless claims, were strong).
Beyond the pace of growth, investors are also justifiably nervous over inflation, or more accurately, the lack of any. While low inflation is typically a good thing, when it crosses the line into deflation, companies lose pricing power, debt becomes a bigger burden and, as Japan has demonstrated over the past 20 years, central banks have a difficult time getting prices to rise.
While most deflationary concerns are focused on Europe, where inflation is running at a scant 0.3%, recent readings suggest that unusually low inflation is a global phenomenon. Last week witnessed a drop in U.K. inflation to the lowest level in five years and a soft reading for Chinese consumer prices. Even U.S. inflation remains tepid, with producer prices unexpectedly falling in September for the first time in a year.
The drop in inflation has led to a corresponding decrease in inflation expectations. The “breakeven” on U.S. Treasury Inflation Protected Securities (TIPS) now suggests investors expect inflation of roughly 1.90% over the next decade, down from expectations of 2.30% in early August. This drop explains the entire decline in U.S. Treasury yields over the same period.