— George Aiken
“I’m not very keen for doves or hawks. I think we need more owls.”
Thin trading volumes and the unwinding of Yen carry trades rocked markets in early August.
The rotation out of Big Tech and into small cap and ‘value’ stocks in late July, transformed into a steep, undifferentiated sell-off at the start of August as investors fretted about the possibility of a US recession following weak US jobs data and disappointing results from several large firms (such as Intel and Amazon). Deep summer is often a tough period for markets as low trading volumes increase the chance of a dislocation if investors get spooked by some event – or dodgy data point. But the recent market moves were abnormally large even by summer’s standards.
“Deep summer is often a tough period for markets but the recent market moves were abnormally large even by summer’s standards.”
By the close of play on the 5th of August (just three trading days into the month), the S&P 500 was down -6.1%, the NASDAQ Composite Index had fallen -7.9%, and (in a reversal of recent fortunes for US small-caps) the Russell 2000 Index had sunk -9.5%. At the same time, the CBOE Volatility Index (or ‘VIX’), which provides one measure of S&P 500 Index volatility and is often used as a proxy for investor fear, leapt from c.16 to c.61 – the highest level since the depths of the pandemic in 2020! Meanwhile, markets outside the US fared no better from the sudden change in mood. The Euro Stoxx 600 Index had fallen -6.0% by the close on the 5th of August; and, not wanting to be outdone, the MSCI Emerging Market Index managed a similarly large -6.3% drop in that time.
Nevertheless, it was Japanese equity markets that saw the largest declines globally: the NIKKEI 225 Index fell a staggering -19.6% (in JPY) in those first three trading days. The reason was that, at the same time investors were dumping stocks globally, FX speculators began to unwind massive and long-standing USD/JPY carry trades following the hawkish Bank of Japan (‘BoJ’) meeting on the 31st of July. At that meeting, officials decided to hike Japanese policy rates from 0.0-0.1% to 0.25% and suggested that further tightening might be necessary to control inflation. This caused the Yen to soar and Yen-denominated returns from Japanese stocks to fall; the unwinding of such large FX positions undoubtedly also exacerbated the broader risk-off move.
Of course, investors ignored the fact that BoJ policymakers only felt able to hike rates because of their growing confidence in Japan’s economy; and, in particular, in the economy’s escape from a multi-year deflationary trap that had forced them to adopt quantitative easing (‘QE’) as far back as 2001 – well before it was cool. The sell-off thus created an interesting entry point for anyone brave enough to take the plunge, buy the dip, and benefit from improving long-term fundamentals.
But the return of the ‘soft landing’ narrative has pushed many markets back to all-time highs. Can these levels be sustained?
Despite the ferocity and depth of the sell-off in early August, equity markets were quick to recover. Indeed, many indices are back at their all-time highs as the month comes to a close. The reason for this market about-turn was the release of positive (i.e., declining) jobless claims data on the 8th of August, followed shortly thereafter by a soft July US inflation print, which came in at +0.2% MoM or +2.9% YoY (i.e., <3% for the first time in >3 years). Together this mix of good fundamental data and falling inflation reinforced the ‘soft landing’ narrative, which, whenever ascendant, has helped to support risk appetite this year.
“Despite the ferocity and depth of the sell-off in early August, equity markets were quick to recover. Indeed, many indices are back at their all-time highs as the month comes to a close.”
But with most markets already having chalked up big gains for the year, can current levels (and in some cases stretched valuations) be sustained through the notoriously tough autumn months? US election uncertainty is likely to loom large through September and October, while the risk of a wider war in the Middle East hangs over markets like a sword of Damocles…
We are cautious and remain underweight equities (particularly Big Tech) in favour of alternatives and gold in this environment. Gold, in particular, has served us well this year – and we continue to see upside for the yellow metal through year-end. Geopolitical, macroeconomic, and technical factors all seem to point in one direction: up; and if tail risks materialise then an allocation to Gold may be crucial to offset losses in traditional markets.
All eyes are on the next Fed meeting – how low can rates go?
But perhaps the most important factor influencing all markets – and forecasts – is the trajectory of rates in the US. The Fed is trying to shepherd the economy away from the distorted conditions that prevailed during and immediately after the pandemic to a new ‘normality’ characterised by low rates, low/target inflation, strong growth, high productivity, and low unemployment. This is no easy feat. But, so far, the Fed has achieved better results than many expected… particularly after the abject failure of its inflation forecasting in 2021-22.
“The most important factor influencing all markets – and forecasts – is the trajectory of rates in the US.”
Today, with inflation finally falling below 3% YoY – at the same time that unemployment is starting to rise – we are at a critical policy juncture. Will the real economy keel over before the Fed is able to cut rates to support it? Will the Fed cut rates too early, causing inflation to boil over once more? Is it already too late for the Fed to cut rates to avoid a US recession? Will inflation return whatever the Fed does – perhaps following a fresh supply shock caused by an expanded Middle East war?
These and other critical questions will have been discussed at length among bank officials and economists when they gathered at the annual Jackson Hole Symposium in the rocky mountains last week. But markets only cared about what one man had to say: the Fed Chair, Jerome Powell. And in his conference speech he was decidedly dovish, leaving little doubt that the Fed would cut rates when the Federal Open Market Committee (‘FOMC’) met in September. Indeed, following his speech, rates futures markets began to price in a 50bps rate cut with a 35% probability (this has since fallen back to 32%).
For our part we do not think that Powell will go for a 50bps cut just yet. The US economy does not appear to be on the brink of recession, and dovish comments can ease financial conditions on their own. Falling rates and strong equity performance in recent days attests to that. Meanwhile, above-target inflation remains a significant risk and there are pockets (like shelter inflation) where there has been minimal progress so far. That said, bond yields are high, the trajectory for rates is almost certainly downwards, and long-end bonds are attractive as a hedge against any possible economic deterioration from here. Thus we continue to favour a market-neutral duration posture with significant short-end and long-end allocations (for yield and hedging purposes, respectively).
If you have any questions about the themes discussed in this article, please do not hesitate to get in contact with us: info@bedrockgroup.ch
The frequency of severe natural catastrophes appears to be picking up and yields on catastrophe bonds are near all-time highs. In this article, Ben Hancock from Bedrock's Research team explores some of the dynamics driving catastrophe bond markets, sharing key insights from a Q&A session with Etienne Schwarz, Head of Investment Management and Insurance-Linked Securities at Twelve Capital.
This month, we discuss the rotation out of Big Tech and into other sectors, the outlook for US rates, and the fast-moving US election.
Resilient global growth data mask divergent fortunes among major economies: the US and some emerging markets are growing strongly while most other developed markets are at a crawl. Still, global inflation is falling and multiple policy rate cuts are expected in the coming months. Upside inflation surprises cannot be ruled out, notably given the wars in Ukraine and Gaza. But there is a clear, if narrow, path to a global economic soft landing. That markets have fully priced in this optimistic outcome nonetheless suggests that risks are skewed to the downside. Bonds and gold are obvious places to take shelter, while pockets of value in equities can also be found.