Are we adjusting our current positioning?
As of the time of this writing (August 5, 2024), the S&P 500 Index has lost over 8% since July 16, with a steep selloff since August 1, 2024.1 While we are monitoring these events, and believe in being nimble (and humble), we are maintaining our neutral positioning from a cross-asset perspective (equities versus fixed income).
The US stock market hit record highs this year. What preceded this selloff?
Enthusiasm for artificial intelligence (AI)-related stocks drove the stock market rally in the first half of this year. This very narrow leadership was less than healthy, as corporate fundamentals remained supportive, but not evenly spread across the market. As a result, we were not surprised to see some rotation into assets that had lagged the rally. Over the month of July, this was most prominent in smaller companies, which might benefit from lower interest rates.
How do you assess the current market situation and what is driving this volatility?
Softer US labor market data released on Friday, August 2, 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 realized market volatility and implied volatility in the price of hedging through options has been extreme. With the VIX index briefly trading above 65%,3 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 labor-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 labor market momentum should remain crucial.
However, the moves in financial markets, and the dent in accumulated net wealth, may create a similar loss of confidence. We do not see a high probability of recession in the United States over the next year, but the odds have probably risen slightly in recent weeks.
We’ve written before about disconnects between the macro economy and stock markets. Let’s first talk about the economy. What indicators are you monitoring and what odds do we place on a US recession?
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.”
Regarding labor market news, which partially spurred this downturn, we are not just monitoring nonfarm payroll growth but a myriad of indicators, such as hours worked and jobless claims. These indicators have weakened but remain near pre-COVID levels.
We view corporate fundamentals as a potential leading indicator of the labor market. Therefore, we are closely watching earnings breadth. It’s important to realize that most US workers are not employed at its biggest public companies (by market capitalization). For instance, even though the Magnificent Seven4 stocks have driven over 50% of earnings and 70% of returns since January 2022,5 they only employ a fraction of the US labor force. As economic growth remains near trend and we get some relief from interest rates, we expect earnings breadth to broaden out.
Lastly, inflation readings in the United States have been extremely positive these last two months; positive inflation surprises would alter the macro backdrop. We continue to expect inflation normalization but acknowledge this is usually a bumpy process. A positive inflation surprise would be particularly untimely.
The size of an equity market drawdown can provide an estimate of recession probability. As of August 5, 2024, we calculate the recession probability signal from equity markets is roughly 25%-30%.6 This seems in line with our fundamental view that recession probability has risen but remains relatively low.
And let’s talk about markets. What are some frameworks we are using to navigate the equity drawdown?
There are several indicators that suggest we are in “oversold” territory. For example, as noted prior, the level of the VIX7 index briefly eclipsed 60% and the forward volatility curve shows expectations of a decline in volatility levels.8 For most equity indexes, relative strength index (RSI) levels are below 30; this is usually an indication of oversold levels.
Does this mean we are at a buying opportunity? Not necessarily. Some longer-term indicators still suggest stretched valuations and positioning. For instance, equity risk premium in the United States is well-below long-term averages9 and the percentage of household equity allocations remain elevated as a percentage of financial assets.10
What could cause us to become more bullish? Market breadth and momentum signals, especially combined with oversold conditions, are among the key guideposts we are looking for to re-enter long positions. A few examples of breadth indicators we are monitoring are advance/decline breadth and volume, along with the proportion of stocks above select moving averages.
Which sectors or regions do you think are particularly vulnerable to a potential downturn and why?
The sectors that led the rally earlier in the year had already started to correct but may have further to fall. Most notably US large-cap growth companies had outperformed their value factor counterparts by more than 56 percentage points from the start of 2023 until the recent peak in July.11 Although they have since fallen sharply, they have given back less than one third of the gains and remain ahead year to date. This might be justified by strong earnings growth, but expectations were elevated, and even from here, most of the good news is priced in (at what we consider still-elevated valuation levels).
Which asset classes or specific investment strategies do you consider particularly resilient to potential recession risks?
Government bond yields have fallen in recent weeks and the price of high-quality bonds have appreciated sharply. Fixed income markets are reflecting a more benign inflationary environment and the prospect of a developing rate-cutting cycle. This was true even before the recent days’ price moves and raises the risk that these safe-haven assets are themselves overvalued today. However, if the market chaos that we are currently experiencing were to continue, it is likely that bonds could potentially offer one of the few assets that would be resilient to this environment.
What role do you think geopolitical tensions and trade conflicts play in current market concerns?
Interestingly, the volatility in markets seems to have offset the normal response to geopolitical risks. Take oil, for example, as a measure of this uncertainty. Investors may have expected that events in the Middle East would lead to rising prices, yet oil has fallen along with equities. This tells us that it is linked more to the concern of falling demand.
The appreciation of the Japanese yen, which has historically behaved as a “safe-haven” asset, seems this time to be driven more by domestic interest-rate increases and a narrowing of the differential to US yields. While this could be a result of the impact of geopolitics, it feels more to us like it is linked to the change of heart on US economic prospects noted above.
How do you assess the role of central banks, particularly the US Federal Reserve (Fed), in potentially mitigating or exacerbating these recession risks?
If the Fed were to respond to market calls for emergency rate cuts, it is not clear that this would ease tensions. It might even be viewed by many investors as a reason for additional panic! However, accelerating the pace of normalization of currently very tight monetary policy should ease the headwinds on growth, in our opinion.
Where this could become more complicated is if the dislocation in financial markets starts to drain liquidity from the highest quality assets. In recent years, attention has focused on fears over the size of the Fed’s balance sheet and efforts to reduce the level of holdings of US Treasury bonds. This, together with concerns over potential losses in the financial system due to asset price moves, may force the central bank to act in ways that are about preserving broad financial stability, rather than just about managing the growth of the economy. Commentators may risk making incorrect assumptions about the risk of recession if they simply look at market assumptions for the future path of interest rates.
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1. Source: Bloomberg.
2. Source: Bloomberg. The Nikkei 225, or the Nikkei Stock Average, more commonly called the Nikkei or the Nikkei index, is a stock market index for the Tokyo Stock Exchange. It is a price-weighted index, operating in the Japanese Yen, and its components are reviewed twice a year. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
3. Source: Chicago Board of Exchange (CBOE). The VIX index is the popular name of the CBOE Volatility Index, a popular measure of the stock market’s expectation of volatility based on S&P 500 Index options. Often called the “fear gauge”, lower readings suggest a perceived low-risk environment, while higher readings suggest a period of higher volatility.
4. Alphabet (parent company of Google), Amazon, Apple, Meta (formerly Facebook), Microsoft, Nvidia and Tesla. These stocks were dubbed the Magnificent Seven in 2023 for their strong performance and resulting increased index concentration in recent years.
5. Sources: Bloomberg and Macrobond, based on S&P 500 earnings and performance.
6. Source: Analysis by Franklin Templeton Investment Solutions. There is no assurance that any estimate, forecast or projection will be realized.
7. Sources: Bloomberg, CBOE Volatility Index.
8. The volatility curve prices volatility across time, similar to a commodities curve or fixed income curve.
9. Source: “Excess CAPE Ratio.” Robert Shiller.
10. Source: “Percent of household equity allocations, Flow of Funds.” Federal Reserve.
11. Sources: Bloomberg, Russell. US large-cap growth represented by the Russell 1000 Growth Index. US large-cap value represented by the Russell 1000 Value Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
