Market correction: managers react
6 AUG, 2024
By Jose Luis Palmer from RankiaPro Europe
What is going on in the markets? US employment data has alerted the market, as well as the Bank of Japan's rate hike, the earnings season… The market has corrected and an emergency Fed rate cut cannot be ruled out, but what do the managers think?
An emergency cut by the Fed cannot be ruled out
Jean-Louis Nakamura, Head of Conviction Equities (boutique Vontobel)
Global equity markets - already extremely volatile since mid-July - have experienced a dramatic sell-off following the release of the US jobs report, which reawakened fears of a possible recession in the United States.
Although not very surprising, the correction has turned out to be more brutal and concentrated in time than expected. It took the form of a rapid discount in the pricing of Fed funds rate cuts (both in number and magnitude), a drastic fall in US long-term bond yields and a jump in the yen/USD exchange rate of more than 13% in the last three weeks. This has been reinforced by the dramatic divergence in (expected) monetary policies between the Federal Reserve and the Bank of Japan, especially after the latter unexpectedly tightened its policy rate again last week. In return, the sharp appreciation of the Japanese currency unwound much of the carry trades that supported technology and growth-sensitive markets (Nasdaq, Taiwan), while overly penalising Japanese domestic equities. In contrast, value stocks, defensive sectors or markets driven by their own monetary cycle (China) have held up somewhat better.
Some of this price movement is legitimate. Earnings growth forecasts were probably excessive for 2025 and beyond and have had to be adjusted from a more realistic basis. The fact that the employment data was released after the Fed meeting also leaves markets with the additional fear that there will be no real policy rescue before September.
However, taking a somewhat longer-term view, these developments will force the Fed to abandon its long-standing paralysis, while the evolution of long-term interest rates already provides a floor to the magnitude of a US economic meltdown. If the collapse in risk asset prices is significantly prolonged, an emergency cut by the Fed cannot be excluded. In that case, the rebound in equities could be as brutal as the recent bout of massive selling, and the sectors and markets most supported by secular drivers and/or interest rate sensitivity (technology, artificial intelligence, US, Taiwan, India) would make the most rapid progress.
A week can be a long time in the markets….
Damian McIntyre, Portfolio Manager, Federated Hermes
The sell-off was triggered by the latest US jobs data, but there were other factors.
Last week was a crazy one. The S&P 500 index initially posted a 158 basis point rally on Wednesday after the FOMC meeting, before falling more than 1% on both Thursday and Friday. It closed the week at 5,346 points, down 206 basis points, its third consecutive week in the red. The Nasdaq 100 fell further, 306 basis points, and is now almost 11% below its peak, while small caps were crushed, falling 3% on both Thursday and Friday to close the week down 667 basis points. Yields fell sharply, with the 10-year bond down 40 basis points to 3.79% and the two-year bond down 50 basis points to 3.88%.
What has happened? While markets have lately seen bad data as a sign that rate cuts were coming soon, Thursday's data was perhaps so bad that it was no longer "good". The culprit was the ISM manufacturing which disappointed at 46.8 points versus expectations of 48.8 points. As a reminder, the ISM is an index where a reading above 50 indicates expansion, while below 50 is contraction. In addition, the employment component came in at 43.4, its lowest level since 2020, having reached that figure during the global financial crisis. All this spooked markets about the possibility of a hard landing. As a result, yields fell, as did equities. Fears were reinforced by Friday's jobs report, in which only 114,000 jobs were created, against estimates of 175,000. More importantly, the unemployment rate came in at 4.3%, triggering the so-called "Sahm rule", which is supposed to predict recessions. However, the employment report may not have been as awful as initially perceived. According to the household survey, 436,000 people reported being unable to work due to bad weather, the highest figure ever for a month of July. We will have to wait and see if next month picks up. In any case, the Fed's futures market now forecasts a whopping 4.6 rate cuts between now and the end of the year, including a significant probability of a 50 basis point cut to start the cycle in September.
Back to this week, Japanese markets are in turmoil. On Tuesday, the Bank of Japan raised its target rate from 0.10% to 0.25%. This move, coupled with growing speculation of a cut in domestic interest rates, has caused the yen's exchange rate to plunge from 154 on Tuesday to 145 on Sunday evening, down from a high of 161 on 3 July. Japanese equities also plunged, with the Nikkei falling 2% on Thursday, almost 4% on Friday, opening down 6% on Sunday night and falling as much as 12% early on Monday. Many experts speculate that this could be due to the unwinding of a large carry trade. In a carry trade, an investor takes a long position in Japan, converts the money into dollars and then buys US Treasuries. Given the difference in interest rates, this trade has been very popular and would work as long as the yen did not strengthen against the dollar (as we have seen recently). Unfortunately, unwinding this operation would require selling dollars to buy yen, which would create more demand for yen and, in turn, make the yen stronger. Internationally, the recent attacks in Beirut and Tehran have increased tensions in the Middle East. Iran has vowed to retaliate against Israel for what it sees as a violation of its sovereignty.
Volatility in the earnings season
Earnings continue to beat estimates but stock reactions have been volatile. The S&P 500 is reporting aggregate earnings above 5.2% and revenues above 0.9%. However, this has not necessarily translated into stock returns. Amazon, for example, beat earnings per share estimates by 20% ($1.23 versus $1.02 expected). However, concerns about the health of the consumer, who "bargains down on prices" and does not buy big-ticket items at a pace consistent with a robust economy, caused the stock to fall almost 9% on Friday. This week will be slower in terms of the number of names, but we will get an important read on the consumer with Dollar Tree, CVS, Wynn and Papa Johns. With all this in mind, fortunately, it will be a quiet week as far as economic data is concerned.
Market sentiment is once again getting out of hand: this time, it seems too pessimistic
Jack Janasiewicz, Lead Portfolio Strategist, Natixis IM Solutions
Global equity markets are reeling as a massive risk-unwind grips global risk assets. A confluence events seems to have reached a head, forcing a brutal shift in risk appetite. The Wall of Worry certainly has a broad enough foundation currently. Weakening US economic data driven by a softer than expected ISM manufacturing print, rising jobless claims and a jobs report that underwhelmed have caused growth worries to flare up. And the growth scare is not limited to the US either. Weaker global data is adding to the concerns with weak PMIs out of Asia coupled with China stimulus hopes that are repeatedly dashed. Against this softening growth backdrop, investors were expecting a more dovish take from Federal Reserve Chair Powell last week and “wanting to have greater confidence” that inflation was moving towards the 2% target perversely sparked fears that the US Federal Reserve was now behind the curve. Mix in some geopolitical concerns – rising war tensions between Iran and Israel – and a tightening race for the White House in the US and we now have a proper equity market correction afoot. The resulting spike in near term volatility has exacerbated the issue, with a slew of technical factors amplifying the velocity and magnitude of the sell-off.
More fundamentals. Less emotion. If we take a step back and survey the landscape, a few things are worth noting. While the US Federal Reserve carries a dual mandate – price stability and full employment - the risks associated with these have shifted. The risk to the inflation side has skewed towards inflation slowing rather than accelerating while the labor side of the equation risks seeing a rising unemployment rate. Against this backdrop, a gap has been widening between what investors want the US Federal Reserve to do and what the FOMC has been communicating. But while the risks have shifted from inflation worries to labor market softness, sentiment may very well be overshooting once again. But this time, overshooting to being too pessimistic. Evidence certainly points to a slowing economy. But slowing and slow are two very different points. Keep in mind that starting points matter. The most recent advanced GDP print for the US economy came in at +2.8% QoQ annualized, well above expectations. Slowing from such a level is very different than slowing from the longer term trend growth level that sits around 1.8% QoQ annualized. Stall speed worries would certainly be appropriate there.
With consumption driving almost 70% of US growth, the US consumer remains key. And while the most recent payrolls print came in softer than expected, the data wasn’t screaming recession by any means. To provide some perspective, the US economy is still adding jobs. Yes, the pace of hirings is slowing. But the economy is hiring workers. Not laying them off. The 3 month moving average for job adds stands at 170,000, far from being recessionary. And simply taking the product of those who are employed, their weekly average hourly pay and their average weekly hours worked shows that aggregate income is still rising at a pace of 4.86%. This growth in the household paycheck is on par with the average seen throughout the entire post GFC period. An imminent recession should see a marked deceleration in this number. And we just aren’t. Yes, the labor market is slowing. Hiring is slowing. Firings are not increasing. If consumers have a job with a real wage that is rising, they will spend. That spending might ease. But it’s still robust enough right now to keep the economy chugging along. And that’s all on top of household balance sheets still hovering near the strongest levels on record.
It's easy to point the finger at the Fed. One can make the case that Chair Powell and company have plenty of cover to begin easing. The case for a July cut was there quite honestly. The easy fix for the Fed is to embark on a cutting cycle, possibly even front loading some cuts to “make up” for lost time. Expect the Fed to begin resorting to forward guidance, with members out on the speaking circuit talking up the flexibility for them to cut should they see the need. Keep in mind that August seasonality remains a historically weak time for markets. And right on cue, we get a correction. One that we haven’t had for quite some time. Markets drop 3% on average 7 times a year. 5% corrections happen on average 3 times a year. And 10% pullbacks? Once a year on average. The leveraged de-grossing that we are seeing makes this weakness feel a lot worse than it probably is. The economy is slowing. Not slow. A soft patch. Not a recession. The Fed can course correct. They have plenty of fire power to do so. But a few data points that come in on the soft side doesn’t make for a recession. The data still doesn’t support that from our perch.
Weak labour market, consumer fatigue and echoes of past inflation
Ariel Bezalel and Harry Richards, managers of the Jupiter Dynamic Bond fund at Jupiter AM
The US has exhibited strong economic growth over the past two years. We believe that a slowdown might be warranted at this point and there are signs of weakness in the two pillars of the post-pandemic cycle: the labour market and consumption.
In particular, labour force survey data (which calculates the unemployment rate) show negative growth in new hires since the beginning of the year and a much slower pace of job creation since 2021. The US labour market looks much less tight today than it did two years ago. This should also contribute to a further normalisation of wage growth. Indeed, with productivity fluctuating between 1.5% and 2%, current rates of wage growth are in our view supportive of the Fed's 2% target.
A second overriding issue remains US consumer fatigue. Consumers and their relentless spending have acted as drivers of the post-pandemic recovery, but over the past year we have been noting the decline in excess savings accumulated during the pandemic and the deterioration in consumers' financial health. Rising consumer credit delinquency rates are a clear symptom of fatigue and the recent general retail index has remained virtually stagnant in nominal terms. In addition, large retail chains have been much less optimistic in recent earnings presentations, which is reflected in the recent weakness in retail sales data.
In addition to the above, after a pick-up in inflation in the first quarter, we note that the disinflationary trend continues in the US figures for the second quarter (especially in May and June). The strong seasonality of month-on-month inflation and the unreliability of seasonal adjustments have made it very difficult to assess the real progress towards the 2% target. However, if we go back to more basic parameters and look only at the non-seasonally adjusted month-on-month figures for the US core consumer price index, it is worth noting that since October 2022 monthly inflation has been below the figure recorded a year earlier in 19 out of 21 months.
This is not surprising, as most of the usual drivers of inflation have been absent. Over the last two years:
- Money supply growth has been non-existent in major developed markets
- Commodity prices (Bloomberg Commodity Spot index) are down -15% through June
- Food prices (UN FAO food price index) are down -23%, also through June
- Supply chain tensions have eased
The sluggish labour market outlook also eliminates a possible wage-price spiral. What remains are the last echoes of past inflation, coming from items such as housing and car insurance, which are likely to fall (housing's drop in June's CPI was large).
In such an environment, we think that there could be scope for developed central banks to cut rates further in the coming years than currently discounted by the market.
Reality check? Why markets are reassessing risk
Gregor M. A. Hirt, Global Chief Investment Officer Multi Asset at Allianz GI
Global markets were looking for weaker US data to justify rate cuts by the Federal Reserve. But when faced with the reality of weaker numbers – in the form of Friday’s US jobs report – they took fright. It comes amid overall tech sector weakness that the Bank of Japan’s rate tightening did nothing to alleviate. While the sell-off may be overdone in the medium term, investors will want to adjust for the fall-out.
Several factors conspired to spark a major sell-off in Japan. While these factors may not be wholly related, any market reaction can become self-fulfilling following a strong recent run in markets and amid a low-liquidity environment during a vacation month. In addition, sudden spikes in volatility from ultra-low levels will force certain risk-based investors to retreat.
We think these are the factors to watch:
- The US jobs report released on 2 August showed an unexpected uptick in unemployment – but we don’t think the data makes a US recession inevitable. In our view, the report further reduces the probability of a so-called no landing – where the economy continues to expand despite the central bank’s best efforts to dampen inflation – and increases the chances of either a soft landing or recession. Our base case scenario for now remains a soft landing, but we remain cognisant of the risk of recession. Some investors were not positioned for the probability of recession (as evidenced by recent ultra-low volatility) and recent market activity signals a healthy reassessment of the outlook. The reassessment of risk helps explain why the VIX index, known as Wall Street’s “fear gauge”, reached its highest level since 2022.
- The lack of supportive news from China’s recent Third Plenum – a five-yearly deep dive on social and economic policy – also reinforced a less certain outlook. While the declaration alluded to measures to support consumption, there were few details.
- On the face of it, the latest US data supports rate cuts by the US Federal Reserve (Fed) – all things considered, a positive for markets. In this environment, however, bad news is now bad news. Markets are ignoring – at least for the moment – the potential for good news in the form of impending rate cuts and lower inflation risk. Even so, we will be watching any US data for confirmation that our soft-landing scenario remains in place and the probability of a recession is under control. While “micro” data on the US consumer is not especially good (travel, restaurants, etc), it is not dramatically poor. In fact, it fits rather well with a controlled slowdown of the US economy. Even with Friday’s data, US unemployment remains at a very low level. If we see further negative data, a larger reallocation from equities to bonds might take place, but after a recent yield rally the potential seems limited.
- Reported earnings by the Magnificent Seven tech stocks were not that bad – the problem is that expectations were high. Indeed, a Bank of America survey pointed to very long tech exposure by market participants, and so short-term profit taking is normal. We think the long-term investment case for tech remains in place, amid an AI revolution and digital Darwinism.
- In our view, the most critical – and potentially overlooked – factor impacting global financial stability is the Bank of Japan's decision last week to raise its key interest rate. Many investors were using JPY for financing/carry due to the currency’s predictable volatility. The bank’s unexpected intervention effectively “broke” these trades and the result is large reallocations by investors closing them out. Beyond the Japanese equity market, this shift will also likely impact emerging markets such as the Mexican peso and could also partly explain Nasdaq weakness.
Growth fears trigger another painful summer market drawdown
Paolo Zanghieri, Senior Economist at Generali AM, part of Generali Investments ecosystem
- Souring manufacturing sentiment and worse than expected employment data have raised fears of the Fed falling behind the curve in providing accommodation to an economy running out of steam. Moreover, disappointing sentiment data (e.g., PMIs) and further evidence of a struggling German economy raised concerns about the sustainability of the EA recovery.
- The weakening in activity and the labour market is undeniable and the odds of a mild recession in early 2025 have risen to around 1/3, but looking beyond payroll data, we do not see large scale job destruction in the short term, as the drivers of domestic demand (chiefly disposable income) are not tanking. Indeed, the non-manufacturing ISM today came out slightly above expectations, signalling ongoing expansion.
- The Fed will emphasise its easing bias more strongly, helped by benign inflation prints. Another batch of poor activity data over the summer will very likely lead to three 25bp cuts this year (vs. between 100 and 125bp of cuts currently priced by the market, including 50bp by the Sep. meeting). The repricing of the ECB rate policy looks slightly excessive: we stick to our year-end 2025 expectation at 2.5% (vs. market priced near 2%, from currently 3.75%).
The panic reaction of the last few days may be exaggerated
Enguerrand Artaz, fund manager at La Financière de l’Echiquier (LFDE)
Yesterday's sharp decline in markets is due to four catalysts occurring almost simultaneously: growing concerns about US growth - most notably the latest jobs report; the Bank of Japan's abrupt surprise rate hike; doubts about US tech giants; and intensifying geopolitical tensions in the Middle East - the prospect of a possible large-scale military conflict in the Middle East increases the risk premium in an already particularly feverish environment.
Can the situation deteriorate further?
The reasons for this sharp fall in equities are therefore well-founded and relate to two major issues for the future trajectory of markets: the dynamics of the US economy - and the growing risk of recession - and the prospects of the technology giants, which have buoyed markets over the last year and a half.
However, the panic reaction of the last few days may be overdone, and there are several factors that put it into perspective:
- This correction occurred against a background of very bullish markets and large accumulations of speculative positions (including short positions on the yen). The sudden unwinding of these positions, combined with the traditionally more limited liquidity of the summer months, probably amplified market movements.
- It is undeniable that the US economy is on a downward trend that could become worrisome. However, last week's dismal employment report, which served as a catalyst for the acceleration of the market decline, is possibly biased by one-off effects. In particular, the number of workers laid off for weather-related reasons reached an exceptional level in July (461,000 compared to an average of 41,000 for that month of the year). There is no doubt that the US labour market has entered a phase of deterioration, but the situation at any given time may not be as bad as the latest figures suggest.
- According to The Information, citing unnamed sources at Nvidia and Microsoft, Nvidia's new processor, called Blackwell B200 and dedicated to artificial intelligence tasks, would see its launch, scheduled for the coming months, delayed until early 2025. This prospect is already causing investors to fear further bad news when the company releases its quarterly results on 28 August. For the moment, the information about Nvidia remains in the realm of rumours - although these have not been refuted by the company - and there is no indication that the potential delay is sufficient to jeopardise Nvidia's growth trajectory and cause significant harm to its customers.
What to do in this context?
The market capitulation of the last few days seems particularly exacerbated, although, as we have already explained, some of the triggers must be taken seriously. We therefore feel it is important at this time to adopt a cautious approach, without overreacting to short-term movements.
Are we entering a bear market?
Björn Jesch, CIO at DWS
Trading continued on Monday where it left off on Friday. Where will it stop?
After Friday's market moves and over the weekend, Monday's session offered no relief. Earlier in the day, Japanese equity markets experienced their biggest losses since 1987, with the rally in the yen being one of the main reasons. The benchmark VIX volatility index itself is experiencing high volatility, rising from just over 20 to over 60 in a few hours. The highest levels since the outbreak of the Covid pandemic in early 2020. The popular "Trump trade", which has dominated market sentiment in recent weeks, has reversed course. This shift has helped small-cap US equities, the US dollar and cryptocurrencies to plummet.
More broadly, the market realised that the mantra "bad news is good news" could become a new reality: bad news is indeed bad news. In addition to Friday's macroeconomic bad news flow, seasonally low liquidity also played its part in the market decline.
Starting with the S&P 500 in the US, we see a market that was perfectly priced, with investors showing a high degree of complacency, reflected, for example, in the low levels of the VIX in recent months. The narrow margin of error of the major stock indices was reflected in a price to earnings ratio (P/E) of 21.5, significantly above their long term average. Although the earnings season has been solid, concerns are growing about the ability to recover the large capital expenditure (capex) related to Artificial Intelligence.
On the macroeconomic front, last week's employment data finally confirms the impact of the Federal Reserve's (Fed) interest rate hikes. While the market is reacting to the news as if it were a revelation, we are not entirely surprised: the laws of economic gravity apply to the US as to any other nation. This shift is driven by the realisation that the fiscal stimulus that has underpinned the economy is fading and the full impact of the Fed's (monetary) tightening is being felt.
This was compounded by other factors, such as the aforementioned summer slump in liquidity, the Bank of Japan's (BoJ) surprise rate hike, which pushed up the yen, and escalating tensions in the Middle East. Recent developments in the region are raising the risk of a major military conflict. Monday's release of slightly better than expected US services PMI figures was the first good news of the day.
Abnormally good or abnormally bad conditions don't last forever
So what is the way forward? We expect the Fed to continue on the expected path, with a panic-driven response unlikely. A 50 basis point (bp) cut or a cut between meetings would be a significant policy shift, which we believe the Fed will try to avoid. Instead, our baseline scenario remains that the Fed will maintain a more gradual approach of cutting rates three times by 25 basis points in the coming months, probably starting in September.
Although a recession in the US is not our baseline scenario, it cannot be completely ruled out. The bond market, with 10-year Treasury yields at 3.70%, already reflects a very high probability of recession. However, even if a recession were to materialise, it is likely to be mild, given the overall strength of the economy and the strength of private sector balance sheets.
At the time of writing, the S&P 500 has experienced a pullback of around 7% from its recent peak. Based on our scenario and our earnings forecasts, we do not yet expect a full-blown bear market, defined as a fall of 20% or more, which would take the index below 4,500 points. To quote Benjamin Graham: "Abnormally good or abnormally bad conditions do not last forever". However, we are very mindful of the risks inherent in recent aggressive market moves, including that highly leveraged traders may be forced to pare positions. We are therefore also keeping a close eye on indicators that capture systemic risks.
Are we entering a bear market?
Luke Bartholomew, Deputy Chief Economist, abrdn
Markets have been extremely volatile over the last few days, with a sharp fall in equity prices, significant appreciation in the Japanese yen, and a large fall in US interest rate expectations. Markets have stabilised somewhat today, consistent with our sense that the moves exaggerated the changes in the global economic outlook. In particular, beyond soft earnings reports, the volatility seems to have three main macroeconomic drivers.
First, weak US data reigniting recession fears. Last week’s labour market report was soft across the board, with unemployment now rising in a manner historically consistent with a recession. However, the services ISM rebounded to 51.4 in July from 48.8 previously and the PMI equivalent was even firmer at 55. And the Senior Loan Officers Survey pointed to stabilising credit conditions, although without any loosening from the sizeable tightening over the last few years. More broadly, relatively few economic data are consistent with a recession. Consumer spending and business investment were both solid through Q2, and the Atlanta Fed nowcast is tracking a 2.5% gain in Q3 GDP. Indeed, the NBER recession indictors are signalling few signs of alarm. On balance, then, while we take the deterioration in the US labour market very seriously, we don’t think the economy is in a recession.
The second, and related, driver is the sense that the Fed might be falling behind the curve in responding to weak US data. If the Fed had been meeting this week rather than last, it may well have cut rates. But this does not mean that an unscheduled meeting to announce a rate cut now is likely. In fact, such a move risks heightening volatility by creating a perception of panic. Instead, policymakers will probably try to use verbal interventions to reassure markets. For example, Chicago Fed President Austan Goolsbee was very much looking to calm nerves in comments yesterday, arguing that the employment data was just “one report”, and that the economy does not look to be in recession. We expect similar messages from other Fed speakers in due course. But what is important to stress is that the path to a soft-landing runs through rate cuts. There is a vital distinction between rate cuts that are delivered pre-emptively to stop a slowdown, and reactive rate cuts that come in response to a slowdown. The market needs reassurance the Fed is ready to deliver pre-emptive easing and will not wait until the economy is clearly in recession before cutting.
For now, we continue to forecast a 25bps cut in September, along with a clear path towards further easing this year and next. But another weak labour market report or little let-up in market stress could easily tip the Fed towards delivering a more rapid cutting cycle. We expect the Bank of England and European Central Bank to also extend their rate cutting cycles later this year, although most recent market pricing probably exaggerates the speed and scale of those cuts.
The third driver of volatility is the unwind of the yen carry trade. The Bank of Japan (BoJ) announced more monetary tightening than expected last week, causing a sharp appreciation in the yen. As the yen has been a preferred funding currency for the global carry trade, this appreciation caused a significant positioning unwind, begetting a positive feedback loop of yen appreciation. The BoJ will probably be somewhat chastened by the size of the moves in equity and currency markets. Given that the progress on underlying inflation in Japan is far from complete, it is not obvious that Japan needs a material tightening of financial conditions. So, while the unwind of the carry trade might have further to run, and we expect further tightening from the BoJ, policy rhetoric may now soften and the next hike could be delayed until much later into the year.
