In addition, some of the leading economic indicators have been trending downward. We would point to the Chicago Fed National Activity Index (which fell sharply in April) as a prime example. Although this is not the most widely followed economic index, it is an important one since it tends to do a solid job of predicting the future direction of economic growth.
Additionally, it is worth noting that the growth slowdown is not just a US phenomenon. With the notable exception of Japan, most economies in the world are slowing as well. Europe is in recession and with unemployment lingering at over 12%, that region’s outlook remains troubled.
Emerging markets are also showing signs of relative weakness, highlighted by last week’s announcement that India experienced a second consecutive quarter of sub-5% growth—a significant slowdown for an economy that until recently was expected to be growing at closer to 10%.
Fed Tightening Fears Appear Premature
While investor concerns over the pace of economic growth appear well founded, the other factor that is driving volatility higher—a fear that the Fed is on the verge of enacting tighter policy—appears to us to be premature. While it is understandable to be concerned that at some point the Fed is going to have to reduce some of its accommodative policies, we do not believe any such action is imminent.
Not only are most economic indicators signalling slower growth, but as we have highlighted previously, inflation is also falling. Last week data showed that the Personal Consumption Expenditure (PCE) Index (the Fed’s favourite measure of inflation) continues to hover around 1%, half of the Fed’s target level of 2% for inflation. With inflation low and economic data lacklustre, it is hard to imagine why the Fed would be in a rush to remove monetary accommodation.
Stick with Stocks Through Increased Volatility
In our view, investors should be more concerned about slower economic growth than a near-term tightening of monetary policy. We are not expecting the United States to enter into another recession, but we do expect growth will deteriorate in the second quarter and probably the third quarter as well. All else being equal, slower growth suggests that market volatility will rise.
The upside to slower growth, however, is that it will likely push back any change in monetary policy to the end of this year or early 2014. From an investing perspective, continued easy policy will help mitigate the downside for stocks that comes with slower growth. So for the near term, even with increased volatility, we would continue to recommend an overweight position to stocks over bonds.
