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.