After a good first half of the year, equity markets hit the buffers last Monday. Global markets fell, volatility surged, and investors stampeded into safe assets, including US treasuries. At one-point, global equities were down 8% from their July peak. The sell-off was most acute in Japan, where the main index suffered the sharpest one-day decline for 37 years last Monday. Investors also focused on the US, with the S&P 500 having its worst day since 2022.
Since then, markets have regained most of those losses and volatility has fallen back. Most major stock markets are still up comfortably year-to-date. As the dust settles the big question is whether last week’s market ructions were a harbinger of weaker growth. Several reasons have been given for the sell-off.
Firstly, tech stocks, and semiconductor makers more specifically, have fallen in recent weeks as investors reassess prospects for gen-AI. Chipmakers ASML and Nvidia are down more than 20% from their July peaks (though are still up 618% and 58% respectively since the start of 2023). Intel, a US chipmaker, has suffered a collapse in its stock at the start of the month after announcing a turnaround plan including 15,000 job cuts. Its equity valuation is now just over half of its July peak.
Second, the Bank of Japan surprised markets by raising interest rates for only the second in 17 years, taking Japanese rates to highest level since 2008. The yen rallied in response, creating a new headwind for Japanese exporters. These companies have powered the revival in the Japanese equity values in the last two years. Fears that a strong yen would hamper exports contributed to last week’s sell-off in Japanese stocks.
The BoJ’s action also triggered selling pressure in other countries’ equity markets, driving stock prices lower, as investors partially unwound so-called carry trades, where money is borrowed in currencies where rates are relatively low (in this case Japanese yen) and invested in higher yielding assets in countries with higher rates.
Third, compounding these technical issues, weak economic data in the US stoked investor fears about a possible recession in the world’s largest economy. There have been signs the US economy is slowing and markets appeared to take exception to the weaker-than-expected jobs numbers released at the start of this month and survey data showing a softening in US manufacturing activity.
The rise in US unemployment triggered the so-called ‘Sahm rule’. Research by US economist Claudia Sahm shows that, in the past, when the three-month average unemployment rate exceeds the lowest rate of the last 12 months, a recession had begun. The ‘rule’ is not an exact science, and the recent rise in US unemployment has been slower than ahead of previous recessions. Dr. Sahm herself said that her rule may be giving a false positive due to the unusual conditions that have followed the pandemic.
An additional concern is that consumption, which has driven America’s recovery, is weakening. Rising unemployment, the depletion of pandemic-era savings and a rise in delinquencies on credit card payments for poorer households suggest higher interest rates are squeezing demand. The University of Michigan’s consumer sentiment index fell to an eight-month low in July and many consumer-facing businesses have reported disappointing earnings, including fast food giant McDonald’s, delivery firm UPS and domestic appliance maker Whirlpool.
However, these developments seem consistent with a widely expected slowdown in US growth rather than an imminent recession. Investment bank Goldman Sachs has increased the probability it assigns to the US going into recession in the next 12 months, but only to a one-in-four chance. The economy is still adding jobs, albeit at a slower pace, and although the unemployment rate has ticked up, it remains at low levels. Other macro data are more positive. Last week a separate labour market release showed claims for unemployment insurance declined. Though backward-looking, GDP growth accelerated to an above-trend 2.8% on an annualised basis in the second quarter, and last week PMI data indicated continued robust expansion of the services sector in July.
Prior to the weak jobs report the US Federal Reserve held rates unchanged at their highest level since before the financial crisis. The decision was expected by traders but the subsequent soft jobs data increased anxiety that the Fed should have cut rates. Markets are now pricing in four or five quarter-point reductions by the end of the year, a sharp increase in the pace of easing expected just a week ago.
If the Fed does cut rates as expected, it should have a supportive effect on markets and the real economy. On the other hand, if the Fed feels the need to keep rates higher for longer to quell inflation, market volatility may return, which could hit business confidence and tighten credit conditions, weighing further on growth.
Equity market moves are rarely an accurate predictor of changes in the economic outlook, but last week’s increase in volatility, which has been strangely absent so far in this tightening cycle, is a reminder about the risks to growth. For now, the data seem consistent with a slowdown in the US not a recession. Still, a soft landing is not in the bag. A Fed assessment of previous US economic cycles finds that, “soft landings, in which inflation is contained without inducing a recession, are rare but not unprecedented”. We must hope for just such a rare but not unprecedented outcome this time round.
A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK. To subscribe and/or view previous editions google Deloitte Monday Briefing.
Write to us with your comments to be considered for publication at letters@reaction.life
