Market volatility has spiked over the past two weeks, with equity markets seeing significant falls (before bouncing). Bond yields fell sharply and currency markets (most notably the Yen) experienced heightened volatility.
In the space of three trading days, US equities fell just over 6%. Australian equities also fell almost 6% in only two sessions, while Japanese equities fell more than 20%. Over the same period, US ten-year bond yields fell over 40 basis points, while market expectations for Fed rate cuts for this year jumped from two to over four cuts.
Markets have been impacted by two main concerns: 1) growing fears that the US Federal Reserve is behind the curve with its monetary policy, amidst signs of more significant economic weakness than expected and 2) a rate rise accompanied by more hawkish than expected rhetoric from the Bank of Japan, prompting an unwind of the Japanese yen carry trade which contributed to market volatility.
We think risk assets can stabilise and ultimately recover, as US recession fears ease and the rapid unwinding of carry trades stabilises. Encouragingly, we have seen evidence of stabilisation/recovery in recent days, prompted by some easing in concerns around both these issues.
US Recession Concerns Look Overdone
A weaker-than-expected US employment report, alongside a further significant drop in the ISM Manufacturing Index from 48.5 to 46.8, rapidly undermined the prevailing optimism toward the US economy over the last week or so. This softer-than-expected data quickly fuelled investor fears that the Fed may have waited too long to ease monetary policy, significantly increasing the odds of recession.
The US manufacturing ISM released on August 1 initially sent a weak signal on the economy. It fell from 48.5 to 46.8, versus expectations of 48.8. While the headline number was weak, the composition was also poor, with new orders and production down significantly. The employment component was the weakest since 2009.
This weak data print prompted a fresh selloff in US equities and a sharp drop in bond yields.
The following day, US employment data cemented the negative shift in sentiment, as July non-farm payrolls rose only 114k versus the 175k forecast, while the prior month was revised 29k lower. It is worth noting that the three-month trend rose from 168k to 170k, which is still very much consistent with a soft landing.
Despite this, the 20 basis point rise (bp) in the unemployment rate – from 4.1% to 4.3% (versus the 4.1% expected) – caused concern. It is now 60bp higher than its low point, just enough to trigger the so called “Sahm rule,” which suggests that a recession has started (or is imminent) when the three-month average unemployment rate rises 50bp off its three-month average low in the prior 12 months.
We would, however, note that this increase was driven by a continued rise in the participation rate from 62.6% to 62.7%, with a hefty 420k workers added to the labour force in July.
Importantly then, the rise in the unemployment rate has been driven more by the increase in the labour force, rather than an acceleration of layoffs. This means employment is still rising, just more slowly than workforce expansion. This is a different profile to the rise in unemployment seen in previous cycles. Indeed, since the low point of the US unemployment rate (3.7%) in February, to the current unemployment rate of 4.3%, the US labour market has averaged 194k in monthly jobs growth. This is an above average rate of jobs growth, with the rise in the unemployment being driven by a surge in the available labour force, not a by a slump in labour demand.
In summary, we don’t believe we are seeing a dramatic shift down in the economy. The most recent data does suggest that the US economy is slowing, but not collapsing. While the economy is likely decelerating, that doesn’t mean a recession is imminent. Looking at some broader indicators underlines that the US economy does not appear to be sliding into recession. On August 5th the ISM Services Survey lifted to 51.4, beating expectations. This is not a reading consistent with an economy slipping into recession. We note that services account for around 90% of the US economy, while manufacturing accounts for only around 10%. While the core of the US economy – the US consumer – is cooling, consumption nonetheless remains relatively healthy. Q2 corporate earnings have also beaten expectations, with S&P 500 earnings growth now projected at about 13%, above the 9% forecast at the start of the season. In addition, company commentary for the US reporting season indicates that there has been no broad-based deterioration in corporate attitudes to employment and no sign of a step-change in the need to cut costs. Finally, the Fed has significant room to cut interest rates to cushion any slowdown if required. As a result, we believe that a soft landing is still the most likely scenario for the US economy. This should provide support to the equity market and risk assets more generally.
Japanese Rate Hike Prompts Seismic Market Moves
At the same time that weak US data fuelled recession fears, a hawkish policy shift from the Bank of Japan (BOJ) fuelled the unwinding of the yen carry trade and triggered de-leveraging of widely owned market trades. Japanese rates were raised from a range of 0.0-0.1% to 0.25%. The BOJ also announced a plan to gradually reduce JGB holdings over the next two years (QE tapering), and its statement pointed to further rate hikes. The market’s reaction was severe, with the yen surging and the equity market falling over 20% in just three sessions.
The broader pressure point was that the yen was funding a range of other market trades across the globe, and this unwinding and subsequent volatility spike have forced investors to shut down other trades, extending the de-risking sell-off.
While the importance of yen carry trades to the funding of global risk assets means a more persistent selloff cannot be ruled out, the pressures of carry trade unwinding, while dramatic, appear to have subsided relatively quickly. Importantly, the initial source of the volatility, the Yen, has reversed its appreciation, and the Japanese equity market has bounced. Recent comments from the BOJ deputy governor that the bank will not tighten further into heightened volatility appear to have calmed investor nerves.
There is still the risk that crowded trades could be unwound further, although we don’t expect the extreme volatility of the past week or two to re-emerge, based on what we expect to be a relatively benign macro and monetary policy backdrop over the next few months.
Extreme Volatility Should Subside but Expect Choppy Condition for a While
In summary, we retain a measured but constructive view on risk assets despite the recent lift in volatility. Our equity allocations remain relatively neutral. This is primarily based on a view of a soft landing for the US and domestic economy. Valuations have improved a little since the equity selloff, although US equity valuations in particular still look relatively full. We would expect choppy US equity market conditions in the run-in to the US election. Government bond yield valuations look closer to fair value after the rally in yields, although high-quality bonds still appeal as a portfolio hedge. Credit (listed and private) continues to offer attractive risk-adjusted returns in our view.
We also continue to see good opportunities in a range of semi-liquid and unlisted alternative investment opportunities, to round out diversified portfolios.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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