Quick Thoughts: Much ado about nothing?

Originally published in Stephen Dover’s LinkedIn Newsletter, Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Two weeks ago, markets were quivering. Global equity markets lurched downward, led lower by a 12% plunge in Japan’s Nikkei on August 5, 2024, recording its second-worst daily decline in history.¹ Bond yields slumped and the Japanese yen, a traditional beneficiary of market turbulence, soared.²

A fortnight later, the markets have seemingly forgotten this episode. Major equity indexes have fully recovered, bond yields have bounced off their August lows, and the US dollar has regained its footing in foreign exchange markets.³

Was all the early August turmoil much ado about nothing? Or is there valuable information for investors in the recent volatility that hints of what may yet come?

Our primary conclusions are as follows:

1) Investors must always balance risk versus reward. When it comes to global equity markets, the adage that the market “climbs a wall of worry” holds. Investors must be willing to accept short-term volatility as the price of enjoying positive returns over a longer timeframe. Volatility shouldn’t frighten off investors. Instead, they should try to understand the volatility’s sources and draw from that knowledge to dial up or down their market exposures.

2) While the recent unsettling moves in markets reflect some shifts in the fundamentals, factors related to positioning and leverage were important catalysts for the turbulence, in our analysis. Just as removing dead limbs in a forest reduces the chances of catastrophic wildfires, we believe the early August turbulence may have shaken out vestiges of excessive investor behavior that now make markets less prone to similar disturbances.

3) The recent volatility reflects a shift in investor attitudes about what matters most. Over most of the past 18 months, investors have rightly focused on inflation, and its stubbornly slow decline, as the primary risk to advances in global equities or to a gradual reduction of interest rates. The focus has now shifted to concerns about the durability of the global economic expansion and, by extension, the outlook for corporate profits.

Fundamentals or something else?

Technical factors contributed to the speed and size of the early August volatility. This is similar to what has happened on various occasions since the 1990s when Japanese yen “carry trades”⁴ had built up. However, such leverage is double-edged. If asset values wobble, investors may sell their long positions and use the proceeds to repay their (yen) borrowings. The usual result is sharp declines in perceived “risk assets” (chiefly stocks), accompanied by strong yen appreciation. And when the yen surges, the Nikkei often crumbles due to fears over diminished competitiveness of Japanese firms. That’s precisely what happened in the first week of August.

A second technical factor also contributed to the volatility: concentrated equity holdings. The tale of the tape in recent years has been the massive outperformance of US equities, led by mega-cap growth stocks like the Magnificent Seven.⁵ Narrow leadership, exacerbated by index investing—which leans heavily toward mega-cap positions given that major indexes assign weights according to market capitalization—meant that selling pressures in a few names contributed to the speed and magnitude of the market declines. For instance, shares of several of the biggest US technology firms fell over 20% from late July to early August, more than twice the size of the decline recorded by the broader S&P 500 Index.⁶

Did fundamentals change?

As noted earlier, technical factors supercharged the market selloff. But equally important were several shifts in fundamental perceptions of earnings risk.

The major catalyst for the selloff was a weaker-than-expected US jobs report (with below expected gains in jobs growth, working hours and wages, alongside a jump in the unemployment rate). That bad news came immediately on the heels of a slump in the US ISM Manufacturing Index, which was well below 50, the base level which marks expansion (above) or contraction (below). This is a sign that goods-producing industries in the United States have already entered a recession.

These worrisome developments came alongside other concerns about risks to the global expansion. Conflicts in the Middle East and between Russia and Ukraine have escalated in dangerous ways throughout 2024. And despite risks that the Mideast conflict could spread and imperil energy supplies, crude oil prices have been falling—a potential sign of flagging global demand. Additionally, China’s policymakers have done little to reassure investors about its economy’s stuttering growth. Meanwhile, the Bank of Japan raised interest rates and shifted to a tighter monetary policy, potentially heralding further tightening to come.

One other fundamental also shifted—US politics. President Joe Biden’s decision to withdraw from the presidential race shifted the odds from a likely Donald Trump victory to a more uncertain outcome. The “Trump trade,” based on investor expectations for lower taxes and less regulation, began to unravel.

As stated earlier, investors must always climb a wall of worry. The reality, however, is that the sources of worry are not constant. Concerns ebb and flow and sometimes abruptly shift. No sooner had investors begun to feel less anxious about inflation, as it receded in the United States, Europe and elsewhere, than concerns began to increase about global economic activity and the implications for corporate profits. One sign that earnings angst is becoming more pronounced is the size of selloffs for companies reporting earnings disappointments. FactSet reports that this number has doubled relative to its five-year average during the latest reporting season.⁷

Conclusions and outlook

In sum, we believe it would be wrong to dismiss the early August market turbulence as akin to a toddler throwing a tantrum—much ado about nothing. As in almost all aspects of markets, price moves convey important information.

The key insight we have gleaned from the turmoil is that excessive market positioning created vulnerabilities, which were exposed as perceptions about global growth shifted.

Accordingly, we believe investors must now be mindful that perceptions of economic activity, not inflation, will likely drive the coming phase of equity, fixed income, currency and commodity performance. The pace of growth should dictate how soon and how fast the US Federal Reserve, the European Central Bank and the Bank of England can cut interest rates, and whether the Bank of Japan will continue to tighten. It may also determine whether China finds the wherewithal to boost its flagging economy.

But mostly, perceptions about growth could direct what investors can expect in terms of future corporate profits, which would contribute to what valuations they are prepared to pay for those earnings.

The ground has shifted. Investors should take note and heed the messages markets are sending.