Global stock markets have been extremely volatile in recent days, with major indices posting sharp declines. The index MSCI All Country World (ACWI) fell -6.4% in three days (source FactSet as of August 5, 2024, net return in US dollars). Since August 6, there have been some signs of recovery, with Japanese markets on the rise. The picture of the situation is drawn by an analysis by experts at Schroders, one of the major global financial groups listed on the London Stock Exchange since 1959 and part of the FTSE 100 index.
What drove the sell-off and how worried should investors be?
First of all – we read in theSchroders analysis – it is important to remember that sharp declines are not particularly unusual in equity markets. “In recent days,” said Simon Webber, Head of Global Equities at Schroders, “there has been a violent sell-off in equities, which has hurt consensus and has led to intense trading. However, these moves need to be seen in the context of exceptionally strong stock markets since October 2023 (by mid-July, the MSCI All-Country World Index had risen about 32% from its October lows) and a correction is perfectly normal.”
How worried should investors be about weaker U.S. economic data?
At its meeting on July 30-31, the Federal Reserve kept interest rates unchanged at a 23-year high, despite some signs of weakening inflation. This decision was followed in early August by weaker US employment data. The nonfarm payrolls report showed that 114,000 jobs were added in July, well below consensus expectations of 175,000, while the unemployment rate rose to 4.3%. “The rise in the unemployment rate,” says George Brown, Senior US Economist at Schroders, “has triggered the ‘Sahm’s rule‘ that signals the start of a recession when the three-month moving average of the unemployment rate increases by 0.5 percentage points or more from its lowest point in the previous 12 months. This rule has been a reliable recession indicator in the past, but it has also yielded some false positives.” Investors are growing concerned that the Fed is waiting too long to cut interest rates and that its inaction could trigger a recession. “The problem,” Brown adds, “is that the Fed signaled only one rate cut this year in June. That was too aggressive and left it unable to quickly reverse course in July. The Fed could cut by 50 basis points in September to make up for lost time. But the market is now pricing in five cuts in 2024, which is an overreaction. In many ways, the recent weaker labor market data shows that higher interest rates are working as intended: if rates are tight, you expect the labor market to soften. Furthermore, much of the increase in the unemployment rate is due to new labor supply as a result of immigration across the southern border of the United States. It is important not to put too much weight on a single month’s jobs report. We need to wait at least another couple of months to see if this is a trend. The U.S. economic growth data in the second quarter was solid, with GDP up 2.8% year over year. We do not believe that the recent Weak US data justifies a sell-off of the magnitude we have seen in recent days.”
The impact of the Bank of Japan rate hike
On Wednesday, July 31, the Bank of Japan raised interest rates to 0.25% from the previous range of 0-0.1%. “The Bank of Japan’s rate hike,” said Taku Arai, Deputy Head of Japanese Equities, “reflects its confidence in the country’s macroeconomic development, including wage growth. It also mitigates the risk of further yen weakness, which could have led to higher inflation in Japan.” Combined with weaker U.S. data suggesting the Fed will have to cut interest rates, this caused the Japanese yen to strengthen sharply. This, in turn, triggered further market volatility.
“Japanese yen carry trades (where investors borrow in yen and invest in higher-yielding foreign assets) are currently being rapidly unwound, causing high volatility and rapid appreciation of the yen,” Webber said. “The yen had become very undervalued. It is difficult to say at this point whether markets have overreacted or whether all positioning has been unwound.”
These sharp movements of the yen have caused market turbulence, but as with any trend change, there are winners and losers. “We believe these market trends will support our bullish view on Japanese small-cap stocks, given their increased domestic focus,” Arai said. “The financial sector is another beneficiary. However, Japanese exporters will likely see a negative impact.”
Are Corporate Profits a Cause for Concern?
The sell-off coincided with second-quarter corporate earnings season, but those gave little cause for alarm. “Second-quarter earnings were fairly strong across major equity markets, albeit with pockets of consumer weakness evident,” Webber said. “Recent market moves largely represent a downgrade of stocks that reflect a more uncertain outlook for the U.S. economy, pulling U.S. equity valuations down from the lofty levels we’ve seen for some time.” Indeed, with the S&P 500’s earnings season now about 75% complete, there have been more wins than misses. “Earnings growth,” said Tina Fong, Strategist, “was good, at around 14%, above consensus expectations for this earnings season. However, it appears the market has been disappointed that the magnitude of positive earnings surprises has been smaller than in previous quarters.”
The current market sell-off has been driven by some previously popular areas, such as technology stocks. Several large U.S. technology companies have highlighted the impact of AI spending. “The ability of these technology companies to monetize AI spending will remain an important theme for investors in the coming quarters,” Fong added.
The implications for equity investors
Japan has endured the most sell-off pressure in recent days, but the BoJ’s move is not all bad news for equities. “A reversal of yen weakness, coupled with wage growth, is expected to support consumption going forward,” Arai said. “Based on these economic trends, we maintain a positive outlook on the strength of Japanese corporate earnings overall.” “A soft landing for the economy remains our central scenario,” Webber said, “and we still expect equity markets to be well supported over the medium term by modest corporate earnings growth. The bottom line is that equity markets were vulnerable to a correction, but corporate fundamentals are decent and rising volatility is an opportunity to reposition where dislocations occur.”
