Amid heightened stock market volatility, Schroders asked its investment experts for their views on what’s driving the falls, the outlook for the US economy, and what it all means for equity investors looking ahead.
Global stock markets have seen extreme volatility in recent days with steep falls for major indices. The MSCI All-Country World Index (ACWI) was down -6.4% in three days (source FactSet as at 5 August 2024, net return in US dollars). As of 6 August there are some signs of recovery, with Japanese markets rebounding. But what has driven the sell-off and how worried should investors be?
Firstly, it’s 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.”
Several factors have combined to send stock markets lower. These include weaker US economic data, raising fears of recession and an expectation of rapid rate cuts; a surprise interest rate rise from the Bank of Japan; and some worries over corporate earnings. Our experts consider these factors below.
How worried should investors be about weaker US economic data?
The US Federal Reserve (Fed) left interest rates on hold at a 23-year high at its 30-31 July meeting, despite some signs of softening inflation. This decision was followed in early August by weaker US jobs data. The non-farm payrolls report showed that 114,000 jobs were added in July, well below the consensus expectation of 175,000, while the unemployment rate rose to 4.3%.
George Brown, Senior US Economist at Schroders, says “The rise in the unemployment rate has 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 percentage points 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.”
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.
George Brown adds “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, the recent weaker labour market data shows that higher interest rates are working as intended: if rates are restrictive then 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.
“It’s important not to read too much into one month’s jobs report. We need to wait at least another couple of months to see if it’s a trend. The Q2 economic growth figures from the US were solid, with GDP up by an annualised 2.8%. We don’t think the recent softness in US data warrants a sell-off on the scale that we’ve seen in the past few days.”
What is the impact of the Bank of Japan’s rate rise?
On Wednesday 31 July, the Bank of Japan raised interest rates to 0.25% from the previous 0-0.1% range. While this was an unexpected move, Taku Arai, Deputy Head of Japanese Equities at Schroders, explains the rationale: “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.
Simon Webber explains “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 have caused turbulence in markets but, as ever, there are winners and losers from any change in trend. Taku 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”.
Are corporate earnings giving cause for concern?
The sell-off has coincided with the corporate earnings season for Q2, but these have given little cause for alarm. “Q2 earnings have been fairly robust across major equity markets, though with pockets of consumer weakness apparent”, according to Simon Webber. “Recent market moves largely represent a de-rating in equities to reflect a more uncertain outlook for the US economy, bringing US equity valuations down from elevated levels that we have been flagging for some time.”
Indeed, with the earnings season for the US S&P 500 now around 75% complete, there have been more earnings beats than misses. Tina Fong, Strategist at Schroders, points out that “Earnings growth has been good at 14%, which is above what consensus was expecting going into this earnings season. It seems the market has been disappointed that the scale of positive earnings surprises has been more muted compared to previous quarters”.
The current market sell-off has been led by some previously popular areas, such as technology stocks. Several large US technology companies highlighted spending on AI during their earnings calls. Tina Fong adds “For investors, the ability of these tech companies to monetise their AI spending will remain an important theme over the coming quarters”.
What are the implications for equity investors?
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.”
Investors elsewhere are considering whether this might lead to better relative performance for regional markets that have underperformed. Nick Kissack, Fund Manager, European and UK equities, adds “We’re 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.”
Simon Webber says “We have been anticipating increased equity market volatility given the disconnect between buoyant consensus expectations, mixed economic data and an apparent mispricing of risk. As a consequence, we remain intentionally well-diversified, with balanced exposure to cyclical and defensive segments of the market.
“A soft landing for the economy remains our central scenario and 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.”
Further reading : click here.