Breathe … and Put Recent Swings in Proper Perspective

Shuddering sentiment sent stocks reeling again on Monday, extending declines across Europe, Asia and North America.^[i] America’s S&P 500 index measured in US dollars is down nearly -8.0% since its 16 July high, as we type, which is within striking distance of the -10% mark that would officially make this move a correction (normally a sharp, sentiment-fuelled decline of -10% to -20%).^[ii] Global markets measured from their respective highs in pounds and dollars are down a bit less, though they could yet reach the threshold.^[iii]

However, that is a distinction without much meaning, in our view. We think the key approach is the same: Stay calm. Market history demonstrates reacting to volatility, especially such sharp swings, is usually a mistake—a potentially costly one at that. We see little here to suggest this is a bear market (deeper, typically longer-lasting decline of -20% or worse with a fundamental cause) in the offing, and our research finds corrections come and go so swiftly that timing them is a folly.

We often counsel readers that volatility erupts without warning—cutting both ways, up and down—because sentiment can shift instantly. Markets appear to be living this now, with moods on the US economy and monetary policy changes seemingly shifting wildly as stocks flipped late last week from a big up day Wednesday to sizable drops Thursday, Friday and Monday.^[iv] Such swings are uncomfortable, maybe even unsettling. But when they strike, we think it is vital to step back, take a deep breath, and survey whether anything really, fundamentally changed.

We are always wary of ascribing daily moves to any one cause. Sometimes we think there is an obvious culprit. But sometimes it seems headlines find a post-hoc reason to justify whatever shook out from the millions of trades moving markets daily. But in general, commentary we follow pinned the sharp slide first on the Bank of Japan’s 31 July rate hike, then on Friday’s US jobs report and the Federal Reserve’s (Fed’s) decision not to cut rates Wednesday. Oddly, we saw several headlines Wednesday calling the Fed’s decision a big positive, cheering Fed head Jerome Powell’s strong hints of a September rate cut in remarks to reporters after the decision was announced. Many commentators we follow credited it for US stocks’ nice returns on Wednesday, even though the S&P 500’s rise that day preceded his comments.^[v] But with US hiring slowing and the unemployment rate up—and Thursday’s manufacturing purchasing managers’ indexes negative again—US economic sentiment shifted rapidly to worries the Fed is moving too slowly.^[vi]

Sentiment toward Japan’s move appeared to shift similarly fast. On Wednesday, the day of the rate hike, most commentary we read was pretty sanguine about it, noting Japanese stocks’ big rise that day and theorising that the strengthening yen would help ease Japan’s economic headwinds.^[vii] But Japanese stocks have tumbled, falling more than -10% on Monday alone and breaching -20% (in yen) cumulatively since the MSCI Japan’s 11 July peak.^[viii]

Most commentary we read pinned it on markets rapidly adjusting to a stronger currency, arguing this is a big headwind for Japan’s exporters, tourism-reliant companies and property firms. When stocks outside Japan fell, too, several analysts we follow also blamed the yen. Japanese investors were yanking overseas investments, they claimed, to reduce their currency risk. And international investors were allegedly unwinding the so-called carry trade—where they borrow in yen to invest outside Japan, profiting off currency movement as well as market returns—sparking a vicious circle of forced selling as currency moves and market volatility fuelled each other.

This is probably happening, to a degree. There is no clear way to see it with data, but logic and experience suggest traders are probably adjusting positioning to an extent. But we wouldn’t overstate the prevalence or long-term effect. For one, whilst the yen has strengthened, it still trades at levels seen in January—which we recall many analysts bemoaning as 40-year lows.^[ix] Little has actually shifted, if you take a longer view than most commentary we read does. Carry trades and overseas investments placed a few weeks ago might be out of the money and sparking panic, but longer-term ones likely aren’t in anywhere near as much jeopardy, so we question how much forced selling is really in the offing. Then, too, basic economic theory holds that money flows to the highest-yielding asset. Even with the rate moves, that isn’t Japan—its short- and long-term interest rates remain well behind the US, UK and eurozone nations.^[x] So to us, this looks primarily like a sharp sentiment reset.

As for commentary we read claiming US stocks are rapidly pricing in a mounting risk of recession (deep or prolonged economic contraction) as the labour market deteriorates and the Fed delays, we are sensing a bit of a chicken/egg thing. That is: Would headlines be sounding such loud warnings over one jobs report if stocks weren’t already taking a hit? We can see a strong case for the volatility colouring commentators’ view, especially when we dig into the report.

See for yourself: Nonfarm payrolls rose by 114,000 in July, slowing from June’s 179,000 and missing economists’ consensus estimates for 175,000.^[xi] More troubling, according to most commentary we read, was the unemployment rate’s uptick from 4.1% to 4.3%.^[xii] With more people out of work, the story went, it is clear higher interest rates are taking a toll and the Fed is moving too slowly to reduce interest rates. Given monetary policy moves hit the real economy at a lag, some coverage claimed it may already be too late and recession inevitable.

But the unemployment rate is open to interpretation. It can rise for bad reasons, yes, if it is up because more people are out of work. But that isn’t what happened in July. America’s Employment Situation report comprises two surveys—one of US businesses and one of households. The Household Survey, whose data underpin the unemployment rate, showed a 67,000-person increase in total employment.^[xiii] The unemployment rate rose because the civilian labour force rose even more, by 420,000 people.^[xiv] That outstripped the 206,000-person growth in the general civilian population, inching the labour force participation rate back up to 62.7% from June’s 62.6%.^[xv] So it looks to us like a strong economy continued attracting more workers.

At the same time, whilst the Fed focusses on the labour market as part of its dual mandate to foster maximum employment alongside stable prices, our research finds jobs data aren’t predictive. In general, businesses’ hiring (and firing) decisions result from the economic trends in the months preceding them. They hire when they have reached the limit of boosting output with their current headcount and have to add in order to keep up with demand. They shed workers, usually very reluctantly, when trouble is deep enough and entrenched enough that they have to reduce overhead. Hence, we find labour market moves are a late-lagging economic indicator. They confirm the trends other data (e.g., quarterly output, retail sales, industrial production, etc.) showed in the months preceding them. Stocks, meanwhile, pre-price anticipated events 3 – 30 months out, including economic developments, according to our research. So whatever July’s jobs report shows, we think stocks already lived through and priced it.

Therefore, setting aside the jobs report: Have US economic drivers changed meaningfully in recent weeks? We don’t think so. Gross domestic product (GDP) accelerated in Q2.^[xvi] Business investment accelerated, which we think shows a more offensive Corporate America—not companies withering in the face of high rates.^[xvii] New factory orders for durable goods (those designed to last three years or more) notably fell -6.7% m/m in June, but we don’t think this is a convincing counterpoint. The drop stems primarily from the always-volatile commercial aircraft industry.^[xviii] The metric economists consider more meaningful, nondefense capital goods orders excluding aircraft, rose 0.9%.^[xix] The contractionary manufacturing purchasing managers’ indexes (PMIs, surveys measuring the breadth of growth) aren’t great but also aren’t new. The Institute for Supply Management’s (ISM’s) has been in contraction since April … and for much of the past two and a half years.^[xx] If that didn’t cause a recession before, we aren’t sure why it would suddenly do so now. Especially when services, according to S&P Global’s and ISM’s July PMIs, are growing at a very nice clip.^[xxi] Manufacturing may get the headlines and be more relatable, but services is nearly three-fourths of US GDP.^[xxii]

We aren’t dismissing the risk of the Fed being too slow on the uptake. Historically, we find that is typical. Rate cut cycles are usually a delayed response to a deteriorating economy.^[xxiii] So from our standpoint, rate cut hopes were always a matter of be careful what you wish for. But for now at least, we don’t see convincing evidence this is the case.

To us, this all just looks like a big sentiment shakeout: sharp, short-term and stunning, classic correction traits. It appears to be resetting investors’ expectations lower in a hurry. This is the opposite of how our research finds bear markets usually begin. Bull markets (broadly rising equity markets) generally die with a whimper, not a bang. Bear markets typically lull investors to sleep with long, rolling tops, packing big volatility into the late stages. Using US stocks for their higher volatility at the moment, we are talking about an -8% slide from a high in 14 trading days.^[xxiv] That is a bang out of the gate. It isn’t escaping many investors’ notice, based on professional reaction and newsflow. Such moves usually reverse fast.

In the moment, it is jarring. But we think there is a silver lining: Sudden negativity helps reset sentiment and expectations, rebuilding some of the bull market’s proverbial wall of worry. We find this is a normal, even healthy development in a bull market.

Trying to time the start and end of such swift sentiment swings is a folly, in our view. Before you react to the swings you see, take a breath. Step away. Take the time to remember investing decisions tend to be wisest when they are forward-looking, planful, business decisions. In other words, remember what you likely already know: Selling on fear is not a strategy.