The perfect storm hits market and what comes next

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?

1. 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.
   
   
2. 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.
   
   
3. 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.
   
   
4. 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.
   
   
5. 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.