What happened?

After a highly volatile moment in global markets, it is important to take stock of what has been happening. It now seems very clear that markets got ahead of themselves. Sentiment indicators, valuations and surveys all showed significant complacency about the outlook for the global economy. Many different types of investors had become very bullish on the back of good earnings results and the expectation for interest rate cuts, creating a fragility to the market rally.

Valuations had priced in the softest of economic landings, in line with expectations (see chart), and a weak labour market report was the catalyst for many to come to the realisation that there is still a reasonable chance of recession. That said, it still seems too early to make a decisive call, with a lack of glaring financial weaknesses creating resilience in the US economy and a stronger Institute for Supply Management services release showing that it is not all doom and gloom. The magnitude of market moves is perhaps as much about the lower liquidity we see at this time of year as the scale of any reset in sentiment or economic outlook.

The equity rotation persists

It is notable that the worst volatility has been in the hottest parts of the global equity market, such as the so-called Magnificent 7, the NASDAQ 100 and certain Asia stock markets (eg, TOPIX). However, it is also important to note the areas that have held up better over the last couple of days and the last month, namely US value shares, US midcap stocks and the FTSE 100 Index in the UK. This suggests that there is an ongoing market rotation against the backdrop of a reset from over-enthusiasm. Lower interest rates, in the absence of a hard landing, have historically been good for risk assets overall, but some had already perhaps more than priced this in. A reset could create a more solid foundation for a push higher over the rest of the year, assuming the US labour market holds together.

A focus on Japan

The most significant volatility has been seen in Japan, where the export-sensitive stock market had previously benefited from continued weakening of the yen. The rapid strengthening of the currency in recent weeks likely pushed leveraged investors to unwind their positions. With interest rates having risen so much elsewhere and having barely moved in Japan, the yen has been an obvious candidate for funding foreign exchange carry trades.

However, the rapid currency unwind seems to have bled into equity market sentiment as a strengthening yen brought into question assumptions about Japanese export earnings. For those less committed holders, such a clear short-term headwind may have overpowered the longer-term argument of improving shareholder friendliness. The market may remain volatile in the short term as investors react to unprecedented market moves – Japan’s TOPIX rallied sharply on 6 August, a day after its second-worst single-day fall since 1950.

What’s next?

The silver lining is that, while the current volatility might be painful, a reset after a period of excessive optimism could lead to a healthier market. However, even if widely expected, a market reset of this speed and magnitude is unnerving for most any investor. It’s important to understand that a soft landing is being questioned but is not out of the question, meaning economic resilience and declining interest rates could ultimately help to lift risk assets again.

At the same time, these events are a critical warning that the market is relatively expensive and likely will remain extremely sensitive to any more negative economic news for the time being. Further, U.S. household stock ownership is at an all-time high, so stock market performance is likely to affect consumer confidence more than ever before.¹

While we continue to closely monitor the economic data, we see this as a favourable environment for active managers to benefit our asset allocations – the relative resilience of some areas of global markets shows that there are opportunities for those willing to look for them.

IMPORTANT INFORMATION

Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.