No brake for investors
Following the market movements from Friday and over the weekend, Monday was not offering any relief. In the early hours Japan’s equity markets experienced their largest losses since 1987, with the spiking yen being one of the main reasons . The benchmark volatilityindex VIX is experiencing high volatility itself by jumping from the mid-twenties to above 60 in a few hours, the highest reading since the outbreak of the Covid pandemic in early 2020. The popular "Trump trade," which has dominated market sentiment in recent weeks, has reversed course. This shift has contributed to sending U.S. small-cap stocks, the U.S. dollar and cryptocurrencies deeply into the red.
Speaking more broadly, the market came to the realization that the "bad-news-is-good-news" mantra might better be turned into the new reality: bad news is, well, bad news. In addition to the bad macro news flow from Friday, the seasonally low liquidity also played its part in the market downturn.
Starting with the S&P 500 in the U.S., we see a market that was priced for perfection, with investors exhibiting a high degree of complacency reflected, for instance, in the low levels of the VIX over the past months. A narrow margin for error in the major stock index was reflected in a forward price-to-earnings (P/E) ratio of 21.5, which is significantly higher than its long-term average. While the earnings season has been solid, concerns are mounting about the ability to recoup the extensive capital expenditure (capex) spending related to Artificial Intelligence.
On the macro front, last week’s jobs data is finally confirming the impact of the Federal Reserve's (Fed’s) interest-rate hikes. While the market is reacting to the news as if it were a revelation, it is not entirely surprising to us – the laws of economic gravity apply to the U.S. just as they do to any other nation. This shift is further driven by the realization that the fiscal stimulus that has propped up the economy is fading, and the full impact of the Fed's (i.e., monetary) tightening is being felt.
Adding to that were several other factors, like the mentioned summer slump in liquidity, the Bank of Japan's (BoJ’s) surprising rate hike (pushing up the yen), and escalating tensions in the Middle East. Recent events there are heightening the risk of a major military conflict. The release of Monday’s U.S. service sector PMI numbers, coming in slightly higher than anticipated, was the first good news of the day.
“Abnormally good or abnormally bad conditions do not last forever.”
So, what is the path going forward? We expect the Federal Reserve to continue on its expected path, with a panic-driven response being unlikely. A 50 basis points (bps) cut or an inter-meeting cut would signal a significant shift in policy, which we believe the Fed will try to avoid. Instead, our baseline scenario remains that the Fed will stick to a more gradual approach of cutting rates three times by 25bps over the coming months, likely to be starting in September.
While a U.S. recession is not our base-case scenario, it cannot entirely be ruled out. The bond market, with 10-year Treasury yields at 3.70%, is already reflecting a very high recession probability. However, even if a recession were to materialize, it is likely to be a mild one given the overall strength of the economy and solid private-sector balance sheets.
At the time of writing, the S&P 500 has experienced a pullback of around 7% from its recent high. On the back of our baseline economic scenario as well as our earnings forecasts, we still don’t expect an outright bear market, defined as a decline of 20% or more, which would be taking the index below 4,500. Quoting Benjamin Graham[1]: “Abnormally good or abnormally bad conditions do not last forever.” However, we are keeping a close eye on the risks inherent in the recent aggressive market moves, including highly leveraged players being forced to cut positions. Therefore, we are also closely monitoring indicators that capture systemic risks.
