The past week has witnessed a surge in volatility across investment markets. Heavy declines occurred on Monday, 5th August, followed by subsequent recoveries. Japanese equity markets experienced the largest swings, with a 12% loss on Monday and then a 10% recovery on Tuesday. Smaller, yet still notable movements also occurred in US, European and UK markets throughout the week, each falling on Monday and then staging volatile recoveries. At the time of writing on Friday, 9th August, these markets have returned to approximately the same levels as last Friday.
The turbulence can be attributed to a combination of three factors: growing negativity surrounding high valuations in the US tech sector, a disappointing data release for the US labour market on August 2nd, and a flight of capital from Japanese markets due to differing interest rate policies.
The Shine is Coming Off
We are currently in the middle of earnings season, with listed US stocks releasing their quarterly financial results. Technology companies, and especially those which benefit from the AI revolution have experienced extremely strong profits and earnings growth over the past year. Investors have been rewarding these with high share prices. However, as highlighted in previous market updates, the sustainability of these valuations has been questionable in many cases and in this latest crop of results, more imperfections are starting to show. For instance, Amazon’s quarterly results indicate that their substantial capital expenditure on AI capabilities has not yet translated into enhanced revenues, leading to shrinking profit margins and a significant drop in Amazon’s share price.
Similar stories can also be told for many of the largest technology companies and it has contributed to the trend of underperformance for the sector which started in early July. This has therefore created an attitude of concern amongst investment markets which was further exacerbated over the past weekend.
A Disappointing Employment Number
During the previous week, the Bank of England cut interest rates for the first time in this cycle (from 5.25% to 5%). In contrast, the US Federal Reserve chose to keep interest rates steady. Initially, markets accepted this decision, understanding that the strong US economy justified waiting until September for the first rate cut. However, this acceptance gave way to a feeling that the Fed was mistaken in its cautious approach. The monthly non-farm payrolls employment results released on that Friday showed a significant slowdown in job creation relative to the previous month’s data. Although still positive, the data fell far below expectations, raising concerns that the US economy may be slowing more than anticipated.
Interest Rates Diverging
Meanwhile, across the Pacific, the Bank of Japan raised interest rates during the same week, continuing its trend of tighter monetary policy following success in achieving much-wanted inflation in the economy. Higher interest rates in Japan and the expectation of lower rates in the US led to the appreciation of the yen against the dollar, which then resulted in falls in Japanese stocks.
Each of these three stories would have created notable market movements in their own right, but given they all occurred simultaneously, they started to feed off each other, resulting in panic over the weekend and delivering large losses.
As mentioned, nerves eased on Tuesday, 6th August, and recoveries have been mostly experienced. Concerns are valid over a slowing US economy, but the wild movements appear an overreaction from which investors have since calmed.
A Lack of Liquidity
The direction markets go from here in the short term is uncertain. Further economic data releases from the US over the coming weeks will shed more light on the state of the US economy, but volatility is likely to stay high. This is especially the case during the summer holiday period when fewer market participants are active, resulting in fewer trades being placed. Lower trading volume means liquidity is thinner than at other times of the year, which can lead to higher-than-usual swings in performance. This factor likely contributed to the large market swings of recent days.
Bonds, Doing Their Job
What was encouraging during this episode was the performance of bond markets. In general, bonds are typically considered as a ‘defensive’ asset class, often rallying at times when equities are falling. While, over the long term this is usually accurate, over recent years it hasn’t always been the case. Following years of strong performance, bond prices were very high in 2020 and 2021 and correspondingly, yields were low. Therefore, when in 2022 equity markets fell heavily due to inflation becoming problematic, bonds also sold off, with few defensive qualities on show.
Now, however, with bond prices back at more sustainable levels, and yields more attractive, bonds are better positioned to provide appropriate diversification. During the recent heavy equity market falls, bonds grew in value, helping clients with multi-asset portfolios offset some of the losses stemming from equity allocations. While this is a side note to the main story of recent days, it serves as a positive reminder of the benefits of diversification in investment portfolios.