“The Cboe Volatility Index, or VIX, briefly broke above 65 on Monday morning, up from about 23 on Friday and roughly 17 a week ago. It had cooled to around 38.6 by about 4 p.m. ET in New York, which would still be its highest closing level since 2020.” ̶ www.cnbc.com
For more than twelve months, sharemarket volatility has been unusually low and US equities have delivered strong returns, fuelled by an AI-led boom in mega tech. Narrow leadership and expansive PE multiples have been a consistent feature over this period, resulting in increased market concentration and weaker internals, such as market breadth. In the eyes of some, investors were complacent and ignoring what appeared to be growing risks.
Conversely, bond markets have experienced relatively high levels of volatility, as traders’ position and reposition around changing inflation and interest rate expectations. In May, economic data surprises started to turn negative and by early July, a soft patch of economic data (including better-than-expected CPI figures) triggered excitement among investors that the US Federal Reserve (the Fed) would commence its rate-cutting cycle in September.
While risks of a recession had risen, investors initially welcomed the data and were broadly anticipating a ‘soft landing’. Bond markets were playing host to bull steepening (where shorter-term yields decline by more than longer maturities) This kicked off a fierce rotation out of mega tech names trading on stretched PE multiples into the unloved SMID-cap space where corporate borrowers are more exposed to variable interest rates.
The ‘great rotation’, as it has come to be known, continued throughout July and reached fever pitch at month’s end when Fed chief Jerome Powell gave the strongest indication yet that a September interest rate cut was indeed on the cards.
Exhibit 2: US quarterly core CPI – annualised rate (www.fred.stlouisfed.org)
However, weak manufacturing and jobs market reports in early August sparked fear that the US economy might be heading for a ‘hard landing’. The now famous Sahm Rule had been triggered and the protracted yield curve inversion in US Treasurys was beginning to quickly dissipate. Historically, such moves have been fairly reliable indicators that a recession was in the offing or had already commenced. If the US were to enter a deep recession, corporate earnings would surely miss lofty expectations and high market PE multiples would need to be unwound.
Contemporaneously, geopolitical risks heightened in the Middle East when Israel responded to the killing of twelve youths by assassinating the Tehran-based political leader of Hamas and a senior Hezbollah commander with an airstrike on Beirut. The rising potential for a co-ordinated attack on Israel by Iran, Lebanon and Yemen worsened investor sentiment as this would surely draw the US directly into the conflict.
Meanwhile, a tectonic shift had just taken place in Japan. In late July, against expectations, the Bank of Japan (BoJ) raised interest rates to 0.25% from 0.10% and unveiled plans to halve its bond purchases. However, in the preceding months, global investors had been borrowing heavily in yen to buy US tech stocks (at the same time as huge flows into Japanese equities). The unexpected narrowing of the interest rate differential between the US and Japan saw to a dramatic appreciation in the yen against the US dollar. This triggered margin calls for foreign hedge funds and speculators as the yen carry trade unwound. Japanese equities slumped by 20% across a few trading sessions and falls in global sharemarkets, including Australia, were magnified.
Overall, the above factors led to an extraordinary spike in volatility and a sharp drawdown in equity markets. As can be seen in Exhibit 1, the VIX (often referred to as Wall Street’s ‘fear gauge’), experienced a significant and dramatic surge. Investor anxiety resulted in the largest ever intraday jump on Monday 5th August, with the VIX closing at its highest since October 2020, as panicked traders hedged against market volatility during the selloff. The benchmark S&P 500 was down as much as 4.3% on Monday and closed down 3%. (The ASX 200 slumped 3.7%.)
Prior to the August drawdown event, volatility had mostly been relatively low for more than a year, highlighting positive risk appetite among equity investors. A combination of calm trading and strong returns created conditions where “short-volatility” strategies could thrive (e.g., ETFs that profit from calm markets). Indeed, up until late July (when Alphabet and Tesla missed earnings expectations), the S&P 500 had gone 356 trading days without a 2% fall ̶ its strongest run since 2017. But the initial sell-off on July 25th placed a spotlight over the remaining Magnificent 7 stocks. More concerns were raised around their high multiples and still-high index weightings, despite the ‘great rotation’.
So, when volatility exploded in early August, potential systemic risks were highlighted because the dearth of short-volatility strategies quickly incurred substantial losses, requiring positions to be unwound and exacerbating market instability.
Returning to the economy for a moment, the risk of some kind of recession (mild or deep) has increased significantly in recent times. The Sahm Rules states that when the 3-month moving average national unemployment rate for the US rises by half a percentage point (0.5 pts) from its lowest 3-month average level in the preceding 12 months, the economy is in a recession or will enter one soon. The July labour market data triggered the Sahm Rule, with a reading of 0.53 pts.
Exhibit 3: Real-time Sahm Rule Recession Indicator (www.fred.stlouisfed.org)
But is this time different due to Covid-related labour market distortions? While jobs growth in the US has been weak in 2024, this has coincided with a rise in workforce participation. The latter appears to be due to the return of workers who left the labour force during the pandemic. Upward moves in the participation rate can result in a higher headline unemployment rate in the short term, as many workers do not find employment. But, the increased labour supply can drive growth over the longer term, especially if productivity rises. Furthermore, it is not unusual to see weak labour market data during the summer months. The pandemic may have exacerbated this seasonality, and it may not currently be accurately captured by the statisticians. As the US moves into autumn, we expect to get a clearer picture of the state of the jobs market. Given the above discussion, if ever there was going to be a false positive in the Sahm Rule, this is as likely as any scenario.
There are rising risks of a US recession, with some investors fearing a ‘hard landing’. Our view is that the data so far points to a softer landing (as opposed to a deep recession) and that the market moves in early August were overdone due to a multitude of factors.
The data could of course deteriorate, but the most recent service sector report showed that services had rebounded moderately, with stronger employment. Real time measures of logistics activity still point to modest expansion. Meanwhile, personal income growth remains positive. However, risks remain around high levels of consumer debt and a weaker savings rate. Earlier this year, analysis by the San Francisco Federal Reserve concluded that post-pandemic surplus savings had been exhausted. Hence, a step down in financial market returns would clearly be an unwelcome development at this time. In our view, if the middle classes begin to worry about their job security and dramatically cut spending in line with poor consumer confidence surveys, then job losses could well become a self-fulfilling prophecy.
And if a hard landing was imminent, the Fed could implement out-of-cycle emergency rate cuts. But, an emergency rate cut by the Fed would further reduce yield differentials between the US and Japan, again spooking markets and eventually lead to a rebound in inflation (could we see a repeat of the 1970s?). Such a scenario cannot be ruled out and would eat into the recent bond market gains, leaving investors scrambling for truly defensive exposures until confidence returned.
We expect further pockets of volatility over the coming period as economic data surprises in both directions. But overall, now does not seem the time to be rushing to the exits.
This economic and market update has been prepared by Evergreen Fund Managers Pty Ltd, trading as Evergreen Consultants, AFSL 486 275, ABN 75 602 703 202 and contains general advice only and has been distributed by Gild Wealth Pty Ltd, trading as Gild Wealth, AFSL 222154.
It is intended for Client use only and is not to be distributed to third parties without the consent of Gild Wealth. Information contained within this update has been prepared as general advice only as it does not take into account any person’s investment objectives, financial situation or particular needs. The update is not intended to represent or be a substitute for specific financial, taxation or investment advice and should not be relied upon as such.
All assumptions and examples are based on current laws (as at August 2024) and the continuance of these laws and Evergreen Consultants’ interpretation of them. Evergreen Consultants does not undertake to notify its recipients of changes in the law or its interpretation. All examples are for illustration purposes only and may not apply to your circumstances.
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