Recent market moves: what happened, why it happened and what it portends

What happened

For the year to end July, global equity markets had enjoyed a propitious run with the MSCI World index of developed market equities up 13.7% (in USD, net dividends reinvested). All major regional markets were firmly in positive territory with the US leading the way, bolstered by strong performance from technology, media and consumer discretionary stocks. Markets were pricing in a Goldilocks environment of positive – but not excessive - growth, slowing inflation and expectations of easier monetary policy.

Chart 1. S&P 500 and 10-year Treasury yield

Source: Bloomberg, EFG calculations. Data as at 05 August 2024. Past performance is not indicative of future results.

Then at the end of last week equity markets experienced two consecutive days of sharp declines. The catalyst was weaker-than-expected US macro data, notably a step down in the ISM Manufacturing Purchasing Managers’ Index (PMI) followed the next day by a sharp rise in the unemployment rate. This was accompanied by a spike in the VIX index of implied volatility, a sharp rally in government bonds and a weaker US dollar as investors suddenly became much more concerned about the possibility of a US recession. Markets have begun the week in a similarly nervous mood.

It is perhaps ironic that the increase in risk aversion has occurred as rate expectations have become more dovish. Whereas in early July futures were pricing at most two Fed rate cuts by year end, that had shifted to three by end July and at the time of writing is currently at five; the market now believes the fed funds rate will finish the year in the range 4.00% to 4.25%.

Why it happened

There are no doubt multiple ways of explaining recent market moves. We have found it helpful to frame the narrative in terms of positioning. It is notable, for example, that many Wall Street analysts began the year with a relatively pessimistic view of the outlook for global and US equities; at the end of 2023 the median analyst thought the S&P 500 would finish the year at around 4,850. The analyst community has upgraded its views on the outlook as the year has progressed and markets have continued to power ahead. By end March the median analyst forecast the year-end S&P 500 level at 5,100, rising to 5,450 by end June and 5,570 by end July. As analysts upgraded their forecasts, investors rushed to put cash to work, especially those who missed out on strong year-to-date returns. This then created an environment priced for perfection in which the slightest bit of perceived bad news caused many investors to unwind their positions.

Chart 2. S&P 500: Actual level and median year-end forecast

Source: Bloomberg, EFG calculations. Data as at 02 August 2024. Past performance is not indicative of future results.

This dynamic is evident in many markets. Japanese equities had been one of the best performing regional markets for the year-to-date in local currency terms to end July, up nearly 20%. Conversely, Japanese equities suffered one of the sharpest pullbacks of all equity markets in the recent sell off. That move is also associated with extreme volatility in the yen, which has rallied by about 5% against the US dollar over the past few days and has gained more than 10% relative to the levels seen in early July. The speed with which this has happened has likely caused some deleveraging and unwinding of carry trades, further exacerbating the downside.

Outlook

It is natural for investors to feel uncomfortable when faced with such extreme moves. However, recent market action also needs to be taken in context. As at the close on Monday, world equities were down a little more than 8% from the top, representing more of a market correction than a collapse. Of course, bear markets always start out with smaller corrections and we remain highly vigilant to signs of deterioration but at present we do not see any reason to panic.

Recent indications of slowing US and global growth have been consistent with our expectations and are not yet pointing to a full-blown recession. For example, Friday’s US jobs report fed into negative investor sentiment yet there was an expansion in total employment, albeit a relatively modest one.

Nonetheless, the probability of a recession has increased and it is certainly true that when the turn comes, it often happens very quickly. There is no single data release or signal that reliably informs us recession is here but it is helpful to triangulate across multiple data points as a means of cross-checking the state of the economy. Signs that momentum is increasing further to the downside would include: 

• Sequential sharp increases in weekly US initial jobless claims (probably the best high quality, high frequency indicator of the health of the US economy)
• Widespread company announcements that layoffs are increasing
• Signs of constrained corporate cash flows and reduced capex
• Rising corporate and household defaults and delinquencies 
• Further sharp declines in PMIs

Against this background, our expectation is that markets will likely remain volatile in the weeks ahead and struggle for direction. It is quite possible that equity markets will suffer further declines as momentum takes hold and some investors are panicked into liquidating positions. Our expectation is that as and when evidence begins to emerge that the macro data is stabilising at the same time as Fed rate cuts come into sharper focus so that will help to calm investor nerves. If we were to experience a pull back in equity markets of 10% to 15% in the meantime that would be consistent with the normal ebb and flow of markets, particularly given the strong performance since the lows in late 2022.

It is possible for investors to use market volatility as an aid to help position portfolios, particularly for those who are underexposed to risky assets. Japanese equities now look notably cheap given recent sharp market declines. Some Asian markets that performed less well last year and this year look to have more defensive qualities.

With regards to fixed income, much already looks to be priced into the curve from five years out. There may be further modest declines in yields but we see these as trading rallies rather than anything else. The greatest potential for yields to fall is at the shorter end of the curve (three years and less) which will rally as and when rate cuts are implemented.

In summary: 

• Recent market moves have been alarming.
• However, thus far they are consistent with the normal ebb and flow of markets and sentiment.
• It is helpful to view recent market action in the context of investor repositioning and the unwinding of carry trades.
• For investors who are underexposed and who are happy stomach some ongoing volatility, such an environment can be helpful as a means to reposition portfolios.
• Whilst recession is not our core view, the risks have increased and we remain highly alert to the possibility of downside momentum building.
• We prefer to wait until there are signs of stabilisation before looking to increase exposure to risk assets.