At the beginning of August Global financial markets have experienced severe turbulence. Despite the initial panic, they have since recovered, raising questions about the underlying causes and consequences of such volatility. Stephen Dover, Chief Market Strategist and Head of Franklin Templeton Institute, wonders if this phase of turmoil on market was it just a passing episode or can it provide valuable insights to investors in navigating the complexities of the current economic environment.
Much ado about nothing?
A few weeks ago the markets andfrog in turmoilGlobal stocks fell, led by a 12% decline in Japan’s Nikkei index on August 5, 2024, its second-worst one-day decline ever. Bond yields plunged, while the yen, which tends to benefit from bouts of market turmoil, surged.
Now the markets areThey seem to have forgotten about this episode. The major stock indices have fully recovered, bond yields have rebounded from their August lows, and the US dollar has gained ground again in the currency markets.
The turbulence of early August was “much ado about nothing”? Or could recent volatility provide valuable insights into what lies ahead?
Here are our main conclusions:
- Investors must always find a balance between risk and return. When it comes to global equity markets, the maxim that the market is “climbing a wall of worry” is always true. Investors must be willing to accept short-term volatility as the price of positive returns over longer time horizons. Volatility should not be intimidated, but rather, it should be understood and used to adjust market exposures up or down.
- The recent worrying movements in the markets reflect a certain change in fundamentals, but according to our analyses Among the main catalysts behind the turbulence were factors related to positioning and leverage. Just as clearing away deadwood in a forest reduces the risk of catastrophic fires, we believe the turbulence of early August may have allowed the market to shed the fruits of excessive investor behavior, making it less vulnerable to similar episodes.
- The recent volatility reflects a shift in what matters most to investors. For much of the past 18 months, investors’ attention has rightly been focused on inflation and its excruciatingly slow decline as the main obstacle to a rally in global stock markets or a gradual reduction in interest rates. But today the focus has shifted to concerns about the sustainability of the global economic expansion and, by extension, the path of corporate earnings.
A question of fundamentals?
Contributing to the speed and magnitude of the wave of volatility at the beginning of August, the technical factors were the main ones, as happened on various occasions since the 90s with the spread of “carry trade” operations on the yen4. Such leverage, however, is a double-edged sword. If the value of assets fluctuates, investors can liquidate their long positions and use the proceeds to repay their loans (in yen). The result is usually a sharp decline in what are perceived as “risky assets” (primarily stocks), accompanied by a strong appreciation of the Japanese currency. While in phases of yen strengthening, the Nikkei often suffers a collapse due to fears about the reduction in competitiveness of Japanese companies. And that is exactly what happened in the first week of August.
But a second technical factor has also contributed to the volatility: the concentration of equity exposures. The script, in recent years, has been that of a massive outperformance of US equities driven by mega-cap growth stocks such as those of the Magnificent Seven5. Narrow market leadership, exacerbated by the practice of index investing (which tends to heavily favor mega-caps since major indexes assign their weightings by market capitalization), has meant that selling pressure on a handful of stocks has contributed to the speed and depth of market declines. Shares of several major U.S. technology companies, for example, fell more than 20% between late July and early August, more than double the decline of the S&P 500 as a whole.6.
Have the fundamentals changed?
As we have seen the sell-off dThe market has been fueled by technical factors. But equally important has been a series of changes in fundamental perceptions of risks to earnings.
The main driver of the sell-off was a weaker-than-expected US employment report (with lower-than-expected growth in jobs, hours worked, and wages, as well as a jump in the unemployment rate). The bad news came on the heels of a plunge in the ISM index for US manufacturing, falling below the 50 threshold that marks the boundary between contraction and expansion. This is a sign that the goods-producing sectors of the US have already entered a recession.
These worrying developments have added to other concerns about risks to global expansion. Throughout 2024, there has been a dangerous escalation in the conflict in the Middle East and between Russia and Ukraine. And despite the risk that the war in the Middle East will expand and jeopardize energy supplies, oil prices are falling, a potential sign of weak global demand. Chinese authorities have also done little to reassure investors about the uncertain growth of the country’s economy. At the same time, the Bank of Japan has revised interest rates upwards, moving to a tighter monetary policy and hinting at the possibility of further tightening.
Another fundamental factor that changed was US politics. President Biden’s decision to withdraw from the presidential race changed the cards on the table, moving from a probable victory for Donald Trump to a more uncertain outcome. The so-called “Trump trade”, based on investors’ expectations of tax cuts and less regulation, has begun to unravel.
As mentioned, investors always have to “climb a wall of worry”. The reality, however, is that the sources of concern are not always the same, but come and go and, at times, can shift abruptly. No sooner had investors had time to worry less about inflation, which has fallen behind in the United States, Europe and elsewhere, than worries about global economic activity and its implications for corporate profits began to mount. One sign that earnings fears are becoming more pronounced is the extent of the sell-off experienced by companies that have reported earnings that were below expectations. In the last earnings season, the number of such companies was double the five-year average, according to FactSet7.
Conclusions and perspectives
In short, we believe it would be wrong to dismiss the market turbulence of early August as a child’s tantrum, or “much ado about nothing.” Like almost all aspects of markets, price movements convey important information. Our key takeaway from this episode is that “excessive market positioning created vulnerabilities that were exposed as perceptions of global growth changed.”
For this reason, we believe that, from now on, “investors will have to be aware of the fact that in the next phase, the perceptions on economic activity will drive the performance of stock, bond, currency and commodity markets, not on inflation. The pace of growth will determine how soon and rapidly the US Federal Reserve, the European Central Bank and the Bank of England can cut interest rates and whether the Bank of Japan will continue to do so. in the tightening of monetary policies. It may also determine whether China finds ways to stimulate its weak economy.”
But perceptions about growth, above all, “could determine what they can expect the investors from the perspective of future corporate profits, which could impact the valuations they will be willing to pay in exchange for those profits.”
