By Erik Sherman
Sound investment always considers risk. But risk gets harder to measure and integrate into strategy when conditions become more uncertain, and at this point in 2024, there is plenty to go around.
“The fundamental challenge we have going into the second half of the year is there’s more uncertainty than usual across a variety of things, but the economic climate has strong benign elements as well,” Ian Toner, chief investment officer at institutional investment consultancy Verus.
The economic and financial worlds look bifurcated at the moment, with some factors looking positive, some negative, and some — unable to make up their minds.
Positive Factors
Traditional investments like equities — specifically the S&P 500 — have seen volatility fall since the COVID-19 pandemic. The below graph is of the Chicago Board Options Exchange volatility index, or CBOE VIX, a popular “calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500 Index (SPX) call and put options,” the firm writes. The source is the Chicago Board Options Exchange, CBOE Volatility Index: VIX [VIXCLS], retrieved from FRED, Federal Reserve Bank of St. Louis; June 24, 2024.
The CBOE VIX is higher when price swings increase in size. typically moves inversely to the direction of the S&P 500, which has been gaining strength since the fall of 2022. When the equity index consistently grows, investors are more confident about the future and invest more capital, meaning less up and down in pricing and, as a result, less volatility.
Another positive factor is inflation. “Markets and economies of the world have largely dealt with inflation quite well,” Toner says. “It’s come down but not as much as people would have liked it to come down.”
Year-over-year personal consumption expenditures (PCE) — the preferred metric for the Federal Reserve — was 2.8% in April for the core version excluding food and energy. That’s been a steady number since February. In April 2023, the year-over-year core figure was 4.7%.
Inflation has come down far enough to see rate cuts at both the European Central Bank and the Bank of Canada. “Prices increased a lot, especially for energy and food,” wrote the ECB, which pointed to Russia’s invasion of Ukraine and pandemic damage to supply chains as factors. Conditions have changed. “Prices are no longer rising so fast, and inflation is on track to return to our 2% target, As a result, our Governing Council recently cut interest rates, after keeping them at high levels for nine months.”
Inflation slowed in April to 2.7% year-over-year, according to the Canadian government. June saw the Bank of Canada cut baseline interest rates by 25 basis points.
Negative Factors
But not all seems clear. The so-called dot plot at the Fed — which shows future projections of the central bank’s officials — now shows only one expected rate cut according to their estimates, presumably a 25-basis point one, which is a tiny amount unlikely to cause large changes in corporate and investor behavior.
Mexico’s inflation rate was up, not down, in June. “It was worse than expected because the reported increase in the fruits and vegetables component was much greater than anticipated,” Jessica Roldan, chief economist at Casa de Bolsa Finamex, told Bloomberg. “That can last for longer not only because of the prolonged period of dry weather that we’ve seen, but because in the future other factors — such as stronger rains in parts of the country — could also affect crops.” Experts expect Mexico’s central bank to keep their key rate at 11%.
Reuters just reported that the Bank of Japan considered an interest rate hike “without too much delay” and not a cut at all.
Then there are U.S. Treasury 10-year yields, elevated for some time, as the graph from the Federal Reserve Bank of St. Louis shows below.
Although down off the late-May 2024 high of 4.61%, the trend is still significantly higher than pre-pandemic. That supports ongoing elevated financing costs in multiple areas, including the shaky commercial real estate industry that faces big waves of loan maturities and few opportunities for many property owners to refinance their debts. And yet, one could argue this seems like reversion to the mean, especially if you can remember double-digit inflation and interest rates in the 1980s.
As Toner at Verus says, “It makes it a more nuanced problem. The end result is that inflation has come down partly because of supply chain normalization, partly because of monetary adjustments, and partly because of year-over-year effects.” Private credit, he offers, is “about who selects the credit.”
“Don’t take all your chips off the table,” he advises, adding not to “enthusiastically load up on risk.” Inflation seems like it will be sticky in places and interest rate decline “will be slower and less than what the markets would like, particularly in the United States.”
“Institutional investors should focus on their policy rather than deviating from the policy,” Toner adds. “The probability of a significant economic disruption in the next few months is relatively low.”
