Why to Expect More Volatility Ahead

Stocks rebounded last week, with the U.S. market taking the lead. However, investors should be aware that the good times may not last for long. As I write in my new weekly commentary, “Troubling Signs on the Horizon,” there are at least two signs pointing to higher volatility ahead for stocks.

Slowing global growth

Estimates for 2015 growth by the G8 countries have fallen from more than 2 percent last fall to barely 1.7 percent today, according to Bloomberg data. Meanwhile, recent U.S. economic news has been mixed. Second-quarter gross domestic product rebounded from the first quarter’s slowdown, which was not as bad as initially recorded. That said, overall growth over the past several years was weaker than previously thought. From 2011 through 2014, the U.S. economy grew at an annual rate of 2 percent, well below the previously estimated 2.3 percent.

In addition, there was another notable headwind for growth in last week’s economic news: Slower growth implies that productivity was a bit lower than the already anemic level that earlier reports suggested. This may have significant implications for the U.S. economy. To the extent productivity doesn’t pick up, this, coupled with an aging-related deceleration in the labor force, suggests a much slower norm for U.S. growth than the post-WWII average. Indeed, this possibility was reflected in the recent downgrade of U.S. growth estimates by Federal Reserve (Fed) staffers.

Less benign credit conditions

With global growth estimates coming down and commodities continuing to trade lower, it should come as no surprise that bond yields are once again falling. Investors are reacting to signs of slowing global growth, plunging commodity prices and more modest inflation expectations. In addition, last week’s Employment Cost Index (ECI) number, the weakest since 1982, called into question expectations of a September Fed rate hike.

Beyond lower rates, the other key trend in the bond markets is widening credit spreads, or the difference between the yields of U.S. Treasuries and credit instruments of comparable maturity. U.S high yield spreads have expanded by roughly 150 basis points over the past year, from around 360 last August to about 510 today, according to Bloomberg data.

Growth expectations and credit market conditions are both important determinants of equity market volatility. Last week the VIX Index, a measure of stock market volatility, traded back down to 12, roughly 40 percent below its long-term average, according to Bloomberg data. This implies equity investors may be too complacent.

Should volatility rise and equities correct, one area of the market is particularly at risk: the popular “momentum” trade (in other words, stocks or sectors exhibiting strong price gains recently). If volatility heats up, so-called momentums stocks, which have rallied strongly this year, could falter.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.

© BlackRock

© BlackRock

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