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Investors are wondering what is driving the stock market sell-off that has caused heightened stock market volatility in recent days with steep falls for major indices.
There is no simple answer as several factors combined to send stock markets lower.
The MSCI All-Country World Index (ACWI) was down -6.4% in three days and there have been signs of recovery since last Tuesday, with Japanese markets rebounding. But what was behind the sell-off and how worried should investors be?
“Firstly, it is important to remember that sharp falls are not especially unusual in equity markets,” Simon Webber, head of global equities at Schroders, says.
“There has been a violent sell-off in equities in recent days, punishing consensus and crowded trades. However, this must be seen in the context of exceptionally strong equity markets since October 2023 (by mid-July, the MSCI All-Country World Index was up c.32% from its October lows) and a correction is perfectly healthy and normal.”
Webber says several factors have combined to send stock markets lower, including weaker US economic data raising fears of a recession in the US and an expectation of rapid rate cuts, combined with a surprise interest rate increase from the Bank of Japan and worries over corporate earnings.
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George Brown, senior US economist at Schroders, says the increase in the unemployment rate triggered the ‘Sahm rule’ which signals the start of a recession when the three-month moving average of the unemployment rate rises by 0.5% or more relative to its low during the previous 12 months.
“This rule has been a reliable indicator of recession in the past but has also given some false positives.”
Brown says the worry for investors is whether the Fed has left it too late to cut interest rates and if its inaction risks causing a recession. “The problem is that in June the Fed signalled only one rate cut this year. That was too hawkish and left it unable to pivot swiftly in July. The Fed may 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, he points out, the recent weaker labour market data shows that higher interest rates are working as intended: if rates are restrictive you would expect the labour market to soften. “Also, much of the rise in the unemployment rate is due to new labour supply as a result of immigration across the southern US border.”
He says it is important not to read too much into one month’s jobs report. “We must wait at least another couple of months to see if it is a trend. The economic growth figures from the US for the second quarter were solid, with GDP up by an annualised 2.8%. We do not think the recent softness in US data warrants a sell-off on the scale that we have seen in the past few days.”
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What is the impact of the Bank of Japan’s rate increase to 0.25% from the previous 0-0.1% range? Taku Arai, deputy head of Japanese equities at Schroders, says while this was an unexpected move, the Bank of Japan’s rate hike reflects their confidence in Japan’s macroeconomic development, including wage growth. “It also mitigates the risk of further yen weakness, which could have driven higher inflation in Japan.”
When combined with the weaker US data (suggesting that the Fed will need to cut interest rates), this caused a sharp strengthening of the Japanese yen. In turn, this sparked further market volatility.
Webber explains that the Japanese yen carry trades (where investors borrow in yen and invest in higher-yielding foreign assets) are being rapidly unwound, causing high volatility and a rapid appreciation in the yen. “The yen had become very undervalued. It is hard to say yet that markets have overreacted or that all positioning has been unwound.”
These sharp moves in the yen caused turbulence in markets but as always there are winners and losers from any change in trend, Arai says. “We believe that these market trends will support our bullish view on Japanese small-cap stocks, given their more domestic focus. The financial sector is another beneficiary. However, Japanese exporters will likely see a negative impact”.
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Japan has borne the brunt of the selling pressure in recent days but the BoJ’s move is not all bad news for equities.
Taku Arai says: “A reversal in yen weakness, coupled with wage growth, is expected to support consumption going forward. Based on these economic trends, we maintain a positive outlook on the earnings strength of Japanese companies as a whole.”
Nick Kissack, fund manager for European and UK equities at Schroders, says investors elsewhere are considering whether this might lead to better relative performance for regional markets that have underperformed.
“We are asking if the correction seen over the last few days is the start of something more substantial and whether it is a new phase of technology and growth leading US markets lower. If so, we note that the UK was a strong outperformer over the six to seven years which followed the TMT (technology, media, telecoms) peak in 1999. Meanwhile, from the perspective of fundamentals, the UK is showing good resilience versus the much more mixed picture globally.”
According to Webber a soft landing for the economy remains their central scenario. “We still expect equity markets to be well-supported in the medium term by modest growth in corporate earnings. The bottom line is that equity markets were vulnerable to a correction but company fundamentals are decent and heightened volatility is an opportunity for repositioning where dislocations occur.”
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