It’s always different this time, but the reactions can be the same as last time

Think back to the spring of 2023. Central banks were walking the tightrope of beating inflation, whilst avoiding recession using the fairly blunt instrument of interest rate policy, along with some other monetary policy measures.

Then, out of the blue, we had Silicon Valley bank default and the Swiss National Bank conducted takeover of Credit Suisse by UBS, in order to avoid Credit Suisse folding. There were other US regional banking problems that had us all using the phrase “banking crisis” as a matter of course.

Over the weekend when the problems at Credit Suisse came to a head, we saw, what can be described as, an extraordinary change in central bank interest rate policy expectations, as it was assumed there was a risk of a full-blown financial crisis, akin to 2008, albeit for different reasons. All of a sudden, the Federal Reserve (Fed) et al had to put financial crisis to the top of the agenda, above inflation, as it would almost certainly lead to recession.
Had you forgotten about the “2023 banking crisis”? Probably, as it never transpired, it was a localised, short term event.

Now, let’s think all the way back to the week beginning 29 July 2024. We went into the week looking forward to policy announcements from the Fed, the Bank of England and the Bank of Japan (BoJ). We always have lots of economic data, but US employment numbers attract a lot of attention as they are a good barometer of US economic health and they were due as well.

Putting Japan to one side for now, the overall back drop was that inflation was slowing, but remained a concern, economic growth was slowing nicely and, as a result, interest rates were heading lower, BUT, we were worried that if rates didn’t fall fast enough, growth would slow too much. All pretty normal stuff.

A confluence of events

A couple of months ago I sat in an asset allocation meeting and we discussed how a range of sentiment and positioning indicators we looked at were suggesting that markets were benign and complacent over the many risks around – Magnificent 7 valuations, inflationary risks, growth risks, geo-political risks – and that a negative surprise could be painful.

Event 1

How long have we been talking about the Magnificent 7 rolling over and the risk to equity markets as a result? Many months is the answer, years for some people. The 7 was becoming 6, 5, 4, 3 …. as share prices weakened with the investment case. We should not underestimate the impact that the falling share prices of such large companies could have on investor positioning. We should also not have assumed that as they fell, the money coming out of them would move directly into other equities, particularly small caps. I know I have talked about the opportunities that small caps provide, and I still believe that, but it was never going to be a direct switch from one to the other and it was never going to be a linear sell-off and move up.

But share prices suggested it was happening, although there was volatility all the way through.

Event 2

The Fed didn’t cut rates on 31 July, as expected. However, many thought they should. They pointed to a robust economy and inflation still being a bit sticky and guided us to a cut in September.

Event 3

On the other side of the world, the BoJ lifted their short term policy rate to 0.25% and guided us to further tightening measures. Japan has been one of the best performing equity markets through 2023 and 2024. Bear in mind rates have been 0.5% or below since 1995 and below 0% since 2016. That’s a big move!

Event 4

Friday’s non-farm payrolls report was keenly anticipated for clues as to the robustness of the US economy. The data showed that the economy added ‘only’ 114,000 net new jobs in July but paradoxically the unemployment rate still increased to 4.3%, the highest level since October 2021, as workers joined or re-joined the labour force. The problem was that expectations were higher than 114,000. US recession is round the corner!!

What happened next?

Investors got spooked, all of a sudden everything was going wrong.

By the time of the US employment data, Japanese equities had collapsed on the BoJ policy measures. Everyone had got very excited about a return to a strong economy and then all of a sudden the door was shut.

But then the wave turned into a tsunami as views shifted to the Fed leaving it too late to cut rates and a US recession became a real concern; if the US sneezes, the rest of the world catches a cold. The expectations for Fed policy moved almost as aggressively as they did at the time of the “banking crisis” and that had a knock-on effect on other major regional expectations; markets rapidly discounted “emergency” decisions by the Fed and their peers.

Equity markets collapsed and bond markets rose; this was unsurprising, they had been riding high and a real threat to profits had arrived, but the scale and speed was extraordinary. There was volatility in gold, industrial metals and even crypto-currencies. We had entered a period of stress. Volatility spiked as seen by the VIX index, a measure of the expectation of volatility based on S&P 500 index options, or, in other words, how investors view the current levels of risk. As you can see below, the last time it got to these levels was during the heights of COVID.

Source: Bloomberg 18.07.19 – 05.08.24.

A rotation in market leadership (Event 1) had been expected but the additional problems created a market rout. Bonds benefitted as rate cuts got priced in and the yield curve changed shape dramatically, with the short end falling, causing it to steepen. Credit spreads had been tight and widened as the recession fears built, as would be expected.

Other than the scale of the moves (more on that below) the direction was appropriate and we even saw some other investments that should do better in this environment do well. For example property, in the form of REITs, whose businesses benefit from falling rates, held and some even went up. Alternatives, in the form of investment trusts did the same, until the stress set in and investors just sold, as cash and Treasuries became the investment of choice. As ever, in these situations, correlations increase.

We must not forget that as we are now in ‘holiday season’, market trading levels naturally reduce as liquidity becomes a bit thinner across markets. We suspect that this is exacerbating the moves we are seeing.

What happens next?

That will depend on what the central banks, particularly the Fed, say or do. Markets are pricing in early and swift, even emergency, action. In my view that would only spook investors more. Afterall, we have only had one “not so good” data release and these falls in equity markets and rises in bond markets have taken a lot of bad news into account.

Very large and fast moves are now a feature of markets. We saw that in spring 2023, at the time of the mini-budget, through COVID, the taper tantrums of the mid 2010’s, the Euro crisis earlier in the decade and the 2008 global financial crisis. But they have got more regular. Some of that can be put down to the speed of information flows, but also computer-driven systematic momentum trading employed by many investors. These feed the frenzy and cause greater volatility, down and up, meaning markets tend to overly discount too fast these days.

I think we are likely to see a period of elevated volatility across asset classes, this will include big moves up and down, and also quiet days. But the volatility should reduce. We will all analyse every economic data point in detail and look for guidance from central bankers when they speak. There will be more left field things to consider; the increase in the US unemployment rate triggered the ‘Sahm rule’, a measure which has accurately predicted forthcoming recessions in the past albeit that its creator, the economist Claudia Sahm, has suggested that it may not be accurate this time. Who knows? Claudia Sahm should!

Within all that I think the rotation out of technology companies will continue, smaller companies would be a natural beneficiary, but that might require an improvement in confidence in global growth.

But what of the economy? Let’s not get carried away. The data across regions and different periods was contradictory, but they were slowing, which was, let’s not forget, expected and hoped for. It would result in lower inflation and lower rates. One data point seems to have wrecked that.

Let’s look at other data. The PMIs (Purchasing Managers Indices) are considered good pointers as how economies will perform. A measure of above 50 is taken to mean economic expansion or growth and below 50 means contraction. The global manufacturing PMI has averaged below 50 through 2023 and over 50 so far in 2024. In July it slipped back to 49.7, hardly disastrous. The global services PMI nudged up to 53.3, still signalling decent expansion, although they have softened a bit. Overall, the global composite PMI has come back to 52.5 from the recent May peak of 53.7, comfortably in expansionary territory and certainly not predicting recession. Why not focus on those?

Finally

Volatility does wane, investors should look long term but do react to the short term, markets tend to overly discount too fast these days. Yes, there is a concern that the Fed and other central banks have not cut rates fast enough, they have a tightrope to walk, but that has yet to be proven and they do have plenty of room for action if needed.