However, as I write in my new weekly commentary, “As Markets Plunge, Some Value Surfaces,” and in my new paper, “After the Rout,” I don’t think the selloff is a prelude to another 2008-style cataclysm. Indeed, here’s the key takeaway for long-term investors: The selling has restored some value to most areas of the market.
There was no single catalyst for the brutal selloff. Rather, it appears to have been a delayed reaction to several developments. Further weakness in Chinese data added to concerns over the health of the global economy. Falling inflation expectations and the lingering potential for a monetary tightening by the Federal Reserve (or Fed) also contributed to the anxiety. Meanwhile, it could be argued that the spike in volatility is a somewhat overdue response to slower economic growth and deteriorating credit market conditions.
Market Realist – A fall in inflation expectations was one of the catalysts of the recent market selloff. The ten-year breakeven inflation rate measures the spread between ten-year Treasury yields and ten-year Treasury inflation-protected securities. It’s broadly considered to be the gauge for inflation expectations. As Bloomberg reported, the ten-year breakeven inflation rate fell below 1.5% on Monday, August 24, 2015, for the first time in almost five years. You can see this change in the graph above. The drop in inflation expectations was triggered by a slump in crude oil prices (USO)(BNO) and a drop in Treasury yields (TLT). Energy prices (XLE) are crucial for inflation expectations since energy is priced into almost every consumable in the market.
China has quickly become a significant concern for global markets (ACWI). Given that China is one of the largest consumers of global resources, a slowdown in China (FXI) is likely to transmit its effects across the world. In the seven months leading up to July 2015, China’s imports from Australia (EWA) were $15 billion lower (~1% of Australia’s GDP) than they had been in the same period last year. China’s imports have declined by almost 14.6% so far in 2015. The recent Chinese currency devaluation has raised new concerns about the state of the economy, triggering a selloff around the world. The previous graph shows how a bunch of macroeconomic indicators in China are trending below their four-year average.
The other source of volatility has been the will-they-won’t-they saga of the Federal Reserve. The current US economic indicators look strong enough for the Fed to start hiking rates in September. However, the recent selloff and the fall in inflation expectations has again left the Fed dithering.
Read on to the next part of this series to see why, despite slowing global growth, a recession may not be in the cards.