Market Ructions

What has happened?

Equity markets, and risk assets more broadly, sold off sharply resulting in some of the biggest one-day falls seen in thirty-plus years. The VIX index, a measure of US stock volatility, saw its second biggest rise since 1990. The Japanese equity market fell the most in 37 years. US 10-year government bond yields fell 0.60%, equating to a roughly 6% capital gain. Investor expectations of the US central bank cash rate changed rapidly, from a 0.25% cut at the September meeting, to a 0.50% cut at the same meeting, to an emergency 0.50% as soon as this week!

Why did it happen?

Markets appear to have “short-circuited” last week following an unexpected rate increase from the Bank of Japan and weaker than expected US jobs report.

The Bank of Japan surprisingly tightened monetary policy for the first time in 17 years, with a rate increase whilst also flagging they would soon begin reducing the amount of money printing they had been undertaking. Important to note, the rate rise brought about the unwind of a unique market dynamic, known as the “carry trade”, which sees investors borrow huge amounts in Japanese Yen (given 0% interest rates there) to invest in higher yield currencies / investments in other markets. This also resulted in big falls in the Japanese equity market which had been a favoured trade by many investors calendar year to date.

The US unemployment rate jumped to a 3-year high of 4.3% in July, amid a significant slowdown in the pace of hiring, and not helped by an expanding labour force. This weaker data culminated in sudden fears of an impending US recession. The increase in the unemployment rate in July marked the fourth straight monthly increase. The US economy saw payrolls increase by 114,000 jobs in July, well below the 215,000 jobs per month added over the last 12 months and the 200,000 jobs needed to maintain a steady rate of unemployment. Expectations were for 175,000 new jobs in July, whilst May and June jobs numbers were revised down by 29,000.

Equity markets had been a little weaker since the middle of July as economic realities began to kick-in with investors questioning the “soft landing” narrative which had been bandied around for most of the year. That narrative had resulted in a very strong rally in equity markets, a continuation of the rally that began in November 2023, led by US technology and A.I. beneficiary stocks.

We had previously noted our concerns with the narrowness of the rally, what we thought was a disconnect between assumed “soft-landing” characteristics and reality, and an increasing disconnect between equity earnings expectations and the weakening economic backdrop.

Other things of note

Crowded trades, another one of our warnings of late, usually get punished more than others in market selloffs. The technology-heavy NASDAQ is now “only” up 6% so far this year, which has seen it fall behind the broader S&P 500 which is now up less than 9% this year. Worth noting that these are still very healthy returns over a seven-month period!

Warren Buffett’s Berkshire Hathaway also disclosed that it had slashed its position in Apple in the June quarter, selling nearly half of its huge stake and sitting on large piles of cash, sending a strong message to investors looking for signs of shifting market sentiment.

Rising political and geopolitical tensions have also not helped.

European Union, French, and UK elections saw large changes in parliamentary make-up. In the US, we had the failed assassination of former president and 2024 presidential Republican nominee Donald Trump, whilst President Biden announced he was pulling out of the contest, and endorsing Kamala Harris, for the Democrat nominee. We saw significant and ongoing social unrest in the UK and social unrest in Venezuela following Nicholas Maduro’s apparent win in their elections. We saw Middle East tensions rise with a bombing in Israeli-controlled Golan Heights, which then culminated in Israeli retaliation on key targets in both Lebanon and Iran with the death of a key Hamas leader, and overnight, a reported attack by the Iranians on a US base in Iraq.

Taking stock

US second quarter reporting season had brought mostly good news with 78% of the largest 500 listed firms that had reported so far beating analysts’ expectations. Though there were some reports of very lofty expectations being missed.

Extremely low volatility has persisted for much of the year, against a backdrop of weakening economic conditions, rising Middle East tensions, and rising political and geopolitical risks. This had been unusual.

Sudden market selloffs are usually a sign of too much speculative trading or trading disconnected from the realities of fundamentals and economic backdrops.

Two senior US central bank officials spoke separately overnight with both saying they stand ready to fix any deterioration in the US economy in meeting the bank’s inflation and employment goals. They reaffirmed their stance that the US didn’t appear to be in recession and that all information will be assessed before acting.

What should I do?

The short answer is nothing for now.

Portfolios remain very well diversified with a cautionary stance. They include reasonable exposure to uncrowded trades (i.e. underweight crowded trades) with a strong bias to high quality investments that can and will withstand market ructions and/or a weakening economic backdrop.

We remain very watchful of the prevailing market dynamics, the changing and likely economic backdrop, rising geopolitical tensions, and are monitoring underlying investments very closely.

Our forward view, i.e. one of caution, hasn’t fundamentally changed given the events of the past week. But it might mean that market participants have reset some of the lofty expectations they had for the forward period. This would be a welcome change grounded in the ever-fleeting premise of rationality, one we look forward to seeing more of. Finally, it is also important to note that equity weakness often provides a normal reset, especially for a market that had stormed ahead for months with little to no pause.