Macro: Sandcastle economics
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The perfect storm hits market and what comes next
Peter Garnry
Chief Investment Strategist
Key points
- Historic selloff in Japanese equities. Japanese equities are down 12% today as financial markets have been hit by a perfect storm. Bank of Japan’s surprise rate hike last week together with a weak US jobs report have kickstarted risk reduction across many markets.
- Long-term investors should stay calm. While the last couple of trading sessions have been volatile and seen big declines it is important to stay calm. Long-term investors should not overreact to recent volatility but instead assess whether the portfolio has the right level of diversification. If anything, the recent selloff will create a lot of interesting opportunities in equities.
- Recession and AI demand are key concerns. Recession fears are coming back after Friday’s US jobs report and investors are taking profit in momentum stocks such as US technology stocks including AI related stocks. Tomorrow’s earnings release from Super Micro Computer is going to be key for sentiment in AI stocks.
Japanese equities fall the most in a single day since 1959
Financial markets were already shaky on Friday with the weak US jobs report triggering discussions about that the Fed had made a mistake by keeping interest rates too high for too long. Today the worries that surfaced on Friday exploded into significant risk reduction and a historic move in Japanese equities down 12%. This is the biggest single day decline in Japanese equities going back as far as 1959. Equity futures are also pointing to a significant down day in US technology stocks indicated down 3.9% in pre-market trading. What are the factors behind this sudden sharp selloff?
- Recession fear as the “Sahm Rule” is triggered. The “Sahm Rule” is triggered when the 3-month average US unemployment rate is up more than 0.5% from its low over the previous 12 months. This indicator has correctly identified every recession since WWII, so its triggering on Friday planted the seeds of recession fear that led to declines in equities.
- AI profit taking after massive bull market. The AI and semiconductor theme had been one of the strongest themes over the past year. When there is a turnaround in sentiment the pockets with the most momentum are always hit the most.
- Surprise JPY rate hike upsetting funding markets. The Japanese central bank has kept its policy rate much lower than any other central bank throughout this entire cycle causing the JPY to consistently decline. As a result JPY has been a key funding current for leverage in financial markets. The central bank’s surprise decision to hike the policy rate last week while making hawkish comments have caused turmoil in JPY and funding markets.
- 1-day options and the “dispersion trade”. The US options market has become enormous and especially the 1-day options market has become a dominant force. In addition, Wall Street has been playing an options game called “dispersion trade” which involved selling VIX futures and buying call options on technology stocks. When the VIX Index explodes higher this trade has to be unwound quickly. It adds to the volatility and increases market moves.
- Historical equity market concentration. We have written a lot about this topic. In late June the US equity market reached its highest market concentration since the 1930s meaning that the equity market weighting is dominated by a small group of stocks. This increases the risk in the equity market because the diversification is lower and thus more fragile to a change in sentiment as we have seen today.
What is the outlook now given today’s event?
When the VIX Index (the fear index) goes to 38 from 18 in just two trading days it kickstarts reduction of risk, and when everyone wants out of the door at the same time things move fast. That is what we have seen today in Japanese equities. Markets will in the short term be very volatile and more technically driven than based on fundamentals. This is exactly why long-term investors should avoid reacting too much today. As Warren Buffett has famously said “The stock market is a device which transfers money from the impatient to the patient”. The worst mistake any investor can make today is drastically selling positions.
The correction in US equities is set to reach around 7% today from the peak in July based on equity futures in pre-market. This is what is called a mild drawdown and something that is seen rather often inside a longer bull market and a positive economic cycle. If the next round of macro indicators worsen then the decline could extend to around 15% which would take the S&P 500 Index down to around the 4,800 level. The 5,000 level in S&P 500 was where the market bottomed back in April and where the 200-day moving average is currently sitting. A 15% correction is more rare but typically an important inflection point because either the recession is not coming and equities rebound, or the recession is coming and the correction extend further.
The key questions on every investor’s mind
Looking into the future the two key fundamental drivers will be whether the AI boom can continue and whether the economy slips into a recession.
- Is the economy headed into a recession? There is not a simple answer to this question because the economy is complex. We are always talking probabilities for a recession until it is there. The most optimistic economists have increased their US recession probability to 25% while the more bearish economists are at 50% and some even sure it is already here. Our view is that there is a 33% probability of a recession. There are still too many economic indicators that are not aligned with an incoming recession. The US economy is still growing around the 2% real GDP growth rate and Europe’s economic activity has recently improved a lot. If we are right the setback in equities will prove to be an opportunity for long-term investors.
- Is the AI hype real or fake? AI related stocks have been weak throughout July and the weakness has accelerated as the big US technology companies have reported significant increases in AI investment. This has made investors questioning whether technology companies can recoup their AI investments. News has also surfaced that Nvidia is delaying its next-generation AI chip called Blackwill B200 until early next year in another blow to sentiment around AI. Nvidia’s stock price was already down 23% on Friday from the peak in June as the industry has likely already got caught of the news of the delay. Super Micro Computer, which is an important company in the AI ecosystem, will report earnings tomorrow and this earnings release could be critical for AI sentiment. Our view is that AI faces some significant challenges ahead and that investors reduce their exposure to this theme.
Previous notes on asset allocation and macro
- Everyone on Wall Street is talking about these key risks (9 July 2024)
- French election: Is this a new Meloni moment for Europe? (24 June 2024)
- US rate cut seems distant as inflation report looms (10 June 2024)
- Commodities setback, investment drought in mining, and EM elections (3 June 2024)
- The inflation conundrum and private equity party (27 May 2024)
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