The Calm After The Storm!
Author:Tom McGrath – Chief Investment Officer, 8AM Global
Market Review
After the initial rout at the beginning of last week, a degree of calm returned to financial markets by the end. Japan, which had fallen 12% overnight on Monday, clawed its way back to only a modest 5-day loss of -2.46% for the Nikkei. The US, Emerging Markets, and the UK ended up flat, and Europe and China made small gains.
The USD/JPY ‘carry trade’ stabilised, gold pushed higher still, and oil staged a comeback as investors tempered their fear of a US recession. Bond yields held at sub 4% for the UK and US 10-year notes.
The VIX (volatility index) went on a wild ride that saw some of the largest moves this century. It spiked at over 60 at one point on Monday as Japan tumbled before reversing much of that on Tuesday and then drifting lower to around 20 on Friday. Are we through the worst?
Famous last words – but it feels like it!
Calm Reflection
The rapid and significant decline in equity markets and the bond rally caught most investors off guard. As usual, shifts in share prices are driving the narrative, with explanations ranging from a looming US recession triggered by a weak July employment report, excessive spending on AI limiting ‘big tech’ earnings and the unwinding of the Japanese Yen/USD carry trade.
Carry Trade: Here, investors leveraged by borrowing cheaply in Yen to invest in risk assets such as US Big Tech stocks. Carry trades are great until they’re not. This one started to unravel in the past few weeks after Japan’s Ministry of Finance defended the currency, and the BoJ subsequently tightened monetary policy. The rising Yen forced carry traders to cover their shorts in the Yen rapidly and liquidate their assets financed by their carry trades. Many had piled into momentum stocks, including the Magnificent-7 and those in the Nasdaq 100.
Regardless of the reasons, investors are now facing share prices that are, in some cases, substantially lower than they were just days ago. Is it a buying opportunity now, or will prices get cheaper still? We all know that the equity markets are short-term voting machines whipped around by sentiment, but over the long term, they are driven by the fundamentals.
For positive equity growth, investors ask themselves: Is economic growth sufficiently robust to provide an environment where companies can grow their earnings?
If the answer to this question is ‘yes,’ the second question is: Is the price appropriate given what is on offer from cash and fixed income?
The fundamentals remain favourable, and the ‘Goldilocks soft landing’ scenario is still the most likely. With the froth blown off market valuations, my biggest fear of the ‘Melt-up’ or ‘crash’ scenario is now much less likely. Throw in the fact that Fed rate cuts are now much more likely and that the recent earnings season points to a healthy corporate sector, I therefore conclude that we could still see new highs from the equity markets this year.
There has been a lot of negative market commentary over the last two weeks as the Bears finally had something to shout about, and some of their arguments are compelling. The fact that there are still a lot of them around is a good sign, and I am sticking with the fundamental assertion that the ingredients of the bull market are still very much intact. The Bull/Bear ratio has now moved back in line, which is a good sign.
The Fundamentals (part 1) – is the US heading into recession?
The biggest cloud on the horizon for equity investors is the threat of an economic recession in the US, and that would probably not be good news. The July unemployment number brought recession fears front and centre, which came out at 4.3% and triggered the ‘Sahm rule’. This rule (in principle) signals a recession when the three-month moving average of the unemployment rate rises by 0.5 percentage points or more from its lowest point in the previous 12 months. The rule has a strong track record, accurately predicting recessions in nearly all instances since the 1950s.
However, Claudia Sahm has noted that while this indicator is concerning, it doesn’t guarantee an immediate or severe recession. She pointed out that unique factors, such as increased labour force participation and immigration trends, might influence the current data, suggesting that the situation could be less dire than the indicator alone might suggest.
Investors also seem to have forgotten that it was only two weeks ago that we got an upgrade to economic growth, with Q2 real GDP jumping 2.8% q/q and 3.1% y/y. Business investment, in the same report, appeared to be booming at 8.4% q/q, up from 4.4%, driven by spending on capital equipment and intellectual property, which doesn’t square with a brewing recession.
It is just possible that inclement weather was responsible for July’s labour market weakness. If you dig into that employment report, announced layoffs actually fell sharply in July to 25,900 (chart). During employment-led recessions, this series should spike up, not down, as it did.
Much of the improvement in sentiment and the rally last week was driven by the weekly jobless numbers.This data point comes out every week, and while it’s important, it’s not a biggie in the sense that, say, the nonfarm payrolls or a Federal Reserve interest rate decision is a biggie.In yesterday’s report, the number of new people signing on/claiming welfare was slightly lower than forecast. Seeing the dramatic bounce in equity markets on that relatively minor positive shows how sensitive we have become to short-term economic news and how fragile sentiment is.
I don’t think we can say it is the start of a trend, but it didn’t suggest we are inexorably sliding toward recession. I remain convinced that a recession isn’t on the cards any time soon, and if anything, when you throw in a few rate cuts from the Fed, get the elections out of the way, and I see the US economy picking up growth in 2025.
The Fundamentals (part 2) – Earnings
As the latest quarterly earnings season from Corporate America approaches its conclusion, one thing has become evident: companies that had previously been overlooked during the (AI) boom are finally beginning to recover. This shift is unmistakable. For several quarters, profit growth in the seven largest technology companies had been the primary driver of gains for the S&P 500 Index. However, this trend is poised to change. According to data from Bloomberg Intelligence, the remaining stocks in the index, excluding the so-called “Magnificent Seven,” are on track to report their first profit growth since the fourth quarter of 2022.
Analyst research indicates that earnings for S&P 500 companies, excluding the “Magnificent Seven” tech giants, are expected to grow by 7.4% in the second quarter compared to the previous year, following five consecutive quarterly declines. Meanwhile, the major tech companies, including Apple, Microsoft, and Amazon, are projected to see profits rise by 35%, though this marks a slowdown from their previous gains. Remember that higher growth is probably already reflected in their share prices, making them vulnerable to a sell-off if they underdeliver, as many have discovered this season. Due at the end of August, Nvidia results will be crucial for a sentiment barometer.
This broader earnings growth across the market is encouraging, providing more opportunities for portfolio diversification beyond just a few dominant stocks. This trend has been partly driven by a shift in investor sentiment following a cooler-than-expected inflation report in July. Yet the broader picture remains sound. As of Friday, analysts put S&P 500 profit growth at just over 14% in 2025 and 11.8% in 2026. That’s a great backdrop and is another compelling argument for why this bull market can continue. However, we will see higher levels of volatility and more exaggerated reactions to data points for now, especially given the light trading volumes in August.
UK
Whilst almost all of the attention last week was on the big swings in the financial markets, I thought I would touch on a subject that I know is probably closer to the heart of most UK clients, namely UK house prices. Halifax’s latest data shows a 2.3% year-on-year increase in house prices for the past month, the highest growth rate since January. Annual growth could strengthen further if monthly figures remain steady due to favourable comparisons with last year. While individual monthly data can be volatile, the overall trend suggests a modest upward movement in prices underpinning the economic recovery underway in the UK.
The Royal Institution of Chartered Surveyors (RICS) also provided a cautiously optimistic outlook among property professionals. Although expectations are improving, there’s no overwhelming enthusiasm for a rapid market surge. Estate agents’ and surveyors’ broader expectations generally align with actual house price movements, reflecting a market that is gradually stabilising rather than booming.
From here, the direction of mortgage rates will play the most crucial role in shaping the housing market. Although the recent Bank of England rate cut was already anticipated and thus had minimal impact, the recent market volatility has led to expectations of more aggressive rate cuts, though this effect may be temporary. Currently, the best mortgage rates for remortgagers are around 4% for a five-year fix and under 3.9% for first-time buyers, which are close to the best rates since the rate hikes in late 2022. If mortgage rates continue to decrease and the job market remains strong, house prices will likely see a modest increase. I hope that house prices will grow at a pace similar to wage growth, improving affordability.
This Week…
In the US, the Consumer Price Index (CPI) will be released on August 13th, which will hopefully confirm that inflation trends are still downward, and the University of Michigan Consumer Sentiment Index will be released on August 16th, which gives us a gauge of consumer confidence.
In Europe, GDP figures for the Eurozone will be released on August 14th, along with the ZEW Economic Sentiment Index for Germany on August 13th.
China will release its industrial production and retail sales data in Asia on August 15th.
On the corporate front, we will get a real-world report on the health of the US consumer as both Walmart and Target report their numbers, and their forward guidance will be closely watched.
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