Inside the market sell-off, why & what's next?

US equities experienced a period of volatility, triggered by the fear of an economic recession, before stabilising toward the end of the week. However, uncertainty persists as market observers closely monitor whether the Federal Reserve will make a policy decision and if that decision will be deemed a policy mistake if implemented too late.

Japanese equities, which had gained popularity among investors in the past two years due to improved shareholder value and the end of a deflationary era, suffered a sharp decline due to forced margin selling.

In the midst of these market conditions, a pressing question looms large: do these unsettling bouts of volatility serve as harbingers of an impending economic recession? How should we navigate the volatility? 

Here are several excerpts we have taken from our fund manager partners.

Recession risks overdone

This is an excerpt taken from a commentary by Blackrock published on 5 August 2024.

We think the July U.S. jobs report is more in line with a slowdown than a recession. 

The unemployment rate is rising, but unlike ahead of past recessions, the main driver is not layoffs – it is an immigration-driven increase in labour supply. Job creation is slowing, but averaged a robust 170,000 over the past three months. 

Consumer spending, while cooling, remains relatively healthy and Q2 corporate earnings have so far topped expectations, with S&P 500 earnings growth projected at about 13%, above the 9% expected at the start of the season, LSEG Datastream data show. =

We think risk assets can recover as recession fears ease and the rapid unwinding of carry trades stabilises. We keep our overweight to U.S. equities, driven by the AI mega force, and see the selloff presenting buying opportunities. We think growth will be supportive of risk assets and believe markets are pricing in too many Fed rate cuts.

Markets have reacted strongly to recent data that suggests further weakening in the US labour market. Global stocks have had a volatile start to August, while ten-year treasury yields rose above those on two-year treasuries for the first time since July 2022 before normalising on Monday.

These price moves reflect growing fears that the jobs data signals imminent recession in the US. We think those fears are misguided. 

The uptick in unemployment over July can be largely explained by the supply of labour, reflected in the higher participation rate (i.e. more people of working age either in employment or looking for work). Moreover, the report showed a large number of temporary layoffs, which has the potential to reverse in the coming months. Consequently, the employment-to-population ratio, particularly for prime-age workers, remains steady.

Given we don’t believe today’s volatility is a harbinger of recession, we still expect the US Federal Reserve to cut interest rates by 25 basis points in September and December.

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Recession fears rise, but fundamentals remain resilient

This is an excerpt taken from a commentary by Fidelity International published on 7 August 2024.

Markets have reacted strongly to recent data that suggests further weakening in the US labour market. Global stocks have had a volatile start to August, while ten-year treasury yields rose above those on two-year treasuries for the first time since July 2022 before normalising on Monday.

These price moves reflect growing fears that the jobs data signals imminent recession in the US. We think those fears are misguided. The uptick in unemployment over July can be largely explained by the supply of labour, reflected in the higher participation rate (i.e. more people of working age either in employment or looking for work). Moreover, the report showed a large number of temporary layoffs, which has the potential to reverse in the coming months. Consequently, the employment-to-population ratio, particularly for prime-age workers, remains steady.

But market concern is understandable, especially after a slowing in the pace of economic growth and a broad-based easing in price pressures. We expect this trend to continue, with momentum moderating through the rest of the year. 

That means recession risk is rising, but not to levels we are uncomfortable with. Growth is unlikely to fall off a cliff and economic fundamentals remain fairly resilient. Consumer and corporate balance sheets look healthy. Our base case remains a soft landing, with a probability of 55%, and a 30% probability of recession.

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Accessing equity volatility and recession risk

This is an excerpt taken from a commentary by Franklin Templeton published on 5 August 2024.

Softer US labour market data released on Friday, 2 August, following growing signs of macroeconomic deceleration more broadly, have partially prompted a significant equity market correction. Ultimately, though, our view of global economic prospects has not changed significantly.

On August 5, 2024, Japan’s equity market, as measured by the Nikkei 225 Index, dropped over 12%, its largest one-day percentage drop since 1987. This followed a 5.8% decline on Friday, August 2, which combined mark the largest two-day drop in its history.2 In our analysis, the rise in both realised market volatility and implied volatility in the price of hedging through options has been extreme. 

With the VIX index briefly trading above 65%, we believe this is indicative of a crisis moment that is currently more pronounced in markets than in the real economy. This kind of situation is very tricky to interpret and often it is a signal of capitulation from leveraged investors, such as hedge funds.

Therefore, it’s important to distinguish between what is happening economically and the stock markets’ reactions. The US economy is slowing but still seems to be growing near trend. Even though the rise in reported unemployment is large enough to lead to comparison with the early stage of previous recessions, we do not see the current labor market as being so negative. Many labour-market indicators have merely reversed their post-COVID gains and now sit at levels closer to pre-COVID equilibrium. We think many of these indicators remain at healthy levels, although monitoring labour market momentum should remain crucial.

We pay particular attention to a broad set of leading economic indicators and try to focus our attention on patterns of changes in the direction, level and rate of change of these measures. These global leading indicators have moderated, and the rate of change is slowing, but they continue to suggest reasonable growth. However, when we incorporate risks on top of this, we retain a more measured view—that “growth is constructive but slowing.”

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Implications of recent market volatility for equity investors

This is an excerpt taken from a commentary by Schroders published on 6 August 2024.

Japan has borne the brunt of the selling pressure in recent days but the BoJ’s move is not all bad news for equities. Taku Arai says “A reversal in yen weakness, coupled with wage growth, is expected to support consumption going forward. Based on these economic trends, we maintain a positive outlook on the earnings strength of Japanese companies as a whole.”

Simon Webber, Head of Global Equities at Schroders, says “We have been anticipating increased equity market volatility given the disconnect between buoyant consensus expectations, mixed economic data and an apparent mispricing of risk. As a consequence, we remain intentionally well-diversified, with a balanced exposure to cyclical and defensive segments of the market.

“A soft landing for the economy remains our central scenario and we still expect equity markets to be well-supported in the medium term by modest growth in corporate earnings.

“The bottom line is that equity markets were vulnerable to a correction but company fundamentals are decent and heightened volatility is an opportunity for repositioning where dislocations occur.”

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Why we’re not hitting the panic button

This is an excerpt taken from a commentary by T. Rowe Price published on 6 August 2024.

Recent developments in the U.S. suggested that recession probabilities may be higher than the market had priced in a couple of weeks ago.

[Signs] of weakness in the U.S. economy forced the market to consider the possibility that the Fed could be behind the curve and would need to ease monetary policy potentially faster than expected. And this possibility, combined with the Bank of Japan raising rates, raised questions about the popular yen/dollar carry trade.

Technical factors, such as excess optimism in positioning that built up before the sell‑off, seem to be behind a lot of the market volatility.

And let’s remember that not all the economic data have been concerning.

U.S. gross domestic product surprised to the upside in the second quarter, while the latest reading of ISM’s measure of activity in the services side of the economy remained at levels that indicate expansion.

It feels to me like the market is saying “crisis,” but I’m not sure there’s an actual crisis. The risk, as always, is that this kind of market action can be self‑fulfilling.

However, the dislocations that occur during periods of indiscriminate selling can create compelling investment opportunities for thoughtful asset allocators.

The same goes for bottom‑up stock pickers who are willing to take a longer view and are guided by a deep understanding of individual companies and industries.

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Stay invested with global diversification

To many, the most important question is: what does this all mean to you and your portfolios? We believe this is not the time to change portfolios or move everything into cash. Time and time again, we have seen how easy it is to miss out on the next rally by staying on the sidelines.

Seven of the ten best days took place in bear markets – and just by missing 10 of the best days, it would automatically shave 50% off your returns. 

As long-term investors, we will inevitably see more volatility in our investing journey, which typically transcends multiple market cycles. And, it is the price that we pay to earn ‘market’ returns. Looking at the annual returns for the S&P 500 Index for almost a century, just six of the 97 years ended the period with a return that’s within two percentage points of the long-term average of 10%. 

Global diversification and staying invested have consistently proven to be key factors in achieving long-term investment success. To maintain investing discipline, consider leveraging the dollar-cost averaging strategy.

To start your core allocation of wealth, we recommend exploring the Endowus Flagship Portfolios. These portfolios are built upon an evidence-based investment approach to portfolio construction that has stood the test of time.