Dissecting the market correction – the carry trade unravelling

Economic data out of the US suggest that the economy might be going through a rough patch, as manufacturing is slowing down and unemployment is rising (even as inflation is falling). At first sight, stocks falling and bonds gaining on bad economic news is a textbook case of recession fears rising.

However, while a US recession narrative fits the bill, we are not convinced that it is indeed driving equity markets. If anything, experience suggests that bad macroeconomic data and consequently higher rate cut expectations are more often fuel for market rallies, not pullbacks.

Instead, we are probably looking at two separate events. The first is a re-rating of the tech sector and a partial unwinding of the AI trade, not a wider market sell-off after valuations remained extended for a period of time. This started two weeks before bonds began to gain. This morning’s action in Japan suggests a spillover into wider markets, but we’d wait for the rest of the week before calling a generalised correction. The second, is that worse-than-expected growth data out of the US have led to a significant repricing of rate cuts, with bond markets positioning for five US rate cuts by December.

We should note that the move is taking place during July and August, months when trading activity is traditionally thin as many – human – investors are usually on holiday.

Let’s take it from the top

The equity sell-off was sparked mostly by two factors, none of which is macroeconomic: a more aggressive approach to tech during the US presidential campaign, and Japanese rates moving higher. The latter especially is a known technical factor that may drive corrections. Investors often use ‘carry trades’ to finance their operations. This means borrowing in the cheapest dependable currency they can find (for decades that has been the Japanese Yen where rates have been zero), and investing in higher-yielding assets, especially US Dollar assets. With the Bank of Japan announcing higher rates, a source of cheap financing for traders became more expensive, rolling back some leveraged trades.

The sell-off mainly focused on the Magnificent Seven, and especially Nvidia, Microsoft and Amazon. Nvidia in particular, has shed more than -20% of its market value since 10 July. Despite the drop, the stock is still double its value at 2023 year-end, and trading 40x its forward earnings. While US large caps are down -5%, ex-the Magnificent 7, they are only down -0.75%. Notably, UK stocks haven’t moved significantly. As of Monday 5 August, we are seeing evidence of spillover in the wider market (Japanese Stocks down -12.4%, US futures down -3%). However, this is precisely the point where we’d expect the Fed to affirm it’s ‘Put’, one way or another.

In terms of valuations, things are similar. It is only the Magnificent Seven and some European stocks that were re-rated.

Despite the Japanese ‘Black Monday’, the equity market downturn doesn’t have the classic elements of a broad sell-off and more resembles profit-taking after a long period of unfettered upside, high valuations and focus on one particular trade, prompted by a reduction in leverage due to higher costs of funding. So far, we don’t have evidence to call anything but the partial and concentrated unwinding of a very concentrated rally. Will it continue? Nvidia’s valuation is still expensive of course, at 40x earnings, and retracing some of the excesses should have been expected and could well persist. But we don’t see a fundamental shift in the positive factors that drove the AI rally so far. We still stand at the precipice of the fourth industrial revolution, with hundreds of operations borrowing immense amounts of cloud computing power to discover the next big AI application. Chip makers, who operate in an extremely oligopolistic market, are the direct beneficiaries of that demand. So while we do understand the reasons behind a re-rating, we don’t see a narrative that would justify a complete unravelling.

Turning our attention to the macroeconomy and the rally in the bond markets. In the past few days, there has been a string of worse-than-expected macroeconomic news out of the US. As a result, bonds rallied +3.5% and the US 2-year yield fell below the 4% threshold.

Firstly, US durable goods orders fell by 6.6% in June. While the drop is significantly bigger than expected, the numbers look a lot better if one takes out the aircraft orders component, which is very volatile.

Second, two separate manufacturing PMI indicators suggested a sharp slowdown in manufacturing orders.

Third, data suggested weakness in the employment markets, with non-farm payrolls rising slower than anticipated, unemployment unexpectedly climbing to 4.3% from 4.1% and worker earnings slowing down.

While durable goods are by and large a very volatile number, PMI and employment indicators suggest that overall economic activity is slowing down both in services and manufacturing.

We believe that the economic rough patch is probably legitimate and not just a blip in the data, which suggests that the economic slowdown will persist into H2.

Having said that, one of our key themes in the past couple of years has been the return of macroeconomic volatility. Thus we don’t expect things to develop in a linear fashion, nor inflation to come down smoothly. But we don’t think a recession is likely either. A poll of economists from all major banks and financial institutions believes that US economic activity will continue to slow in the last two quarters, but will remain positive, with growth near 0.4% in Q4. The US economy has already surpassed expectations, fuelled by generous fiscal expansion. Only 4 in 66 economists are forecasting a recession.

Unemployment might have ticked up, but at 4.3% it remains significantly below the 5.7% long-term average. And inflation continues to come down. Core consumer expenditure, the Fed’s preferred gauge of inflation, is now at 2.6%, which is good news for real growth.

Most importantly, the Fed now seems ready to begin cutting interest rates, which should further alleviate economic pressures.

What it all means for investors

So, to recap, we feel that the equity markets have corrected initially on the same limited tech-focused basis they had rallied in the past few months and then more broadly, due to technical factors and during a period which traditionally features low trading activity, at least from humans. While they may well continue to correct in the next few days or weeks, we don’t see a fundamental case for a broader equity re-rating. If anything, we believe fundamentals are still sound and trust that the Fed will re-affirm its Put. Assuming that the Fed acts quickly enough so that a risk asset correction doesn’t threaten an actual recession, we wouldn’t be too surprised if a further correction is seen as an opportunity by traders and investors to position at more attractive valuations.

Bond markets gaining due to bad economic news is an expected reaction and good news for defensive portfolios. However, presently they are pricing in five rate cuts in the US (two in September, two in November and one in December). We think that, much like last December, expectations for rate cuts might be disengaged from the Fed’s signalled intentions. Affirmation of a Fed Put could see cuts beginning earlier, to be sure. Our view remains that we are likely to see 2 rate cuts in the US this year, significantly below present market expectations. Assuming that view is correct, and markets don’t spiral into a crisis, it means that bond yields may have fallen too steeply and could tick up in the next few weeks.

George Lagarias – Chief Economist

Market update

Global stocks fell by -1.8% in Sterling terms last week in a tumultuous week for markets. Investors contended with a string of data surprises that spanned across three themes at once: tech earnings, central banks, and US growth.

The ‘Magnificent 7’ of top US tech companies broadly missed their sky-high expectations over this earnings season, as investors appeared to demand more evidence that record spending by companies on AI research and infrastructure was leading to tangible earnings. Technology stocks led a -1.5% fall in US stocks over the week, as investors rotated to the more defensive sectors of the market, such as utilities and consumer staples.

The meetings of the Fed and the Bank of England brought relatively few surprises. However, the Bank of Japan unexpectedly raised interest rates from a range of 0-0.1% to a level of 0.25%. The Japanese Yen surged relative to the USD and GBP over the week (USD/JPY fell -4.7% while GBP/JPY fell -5.2%), affecting a -6.0% rout in Japanese stocks in local terms. UK investors were spared the worst of this, as this translated to a smaller -1.3% decline in Sterling terms.

Weaker manufacturing PMI and employment data triggered a broad sell-off late in the week. The US non-farm payrolls number came in at 114,000 jobs added, far below consensus estimates of 175,000, causing traders to ramp up their bets for interest rate cuts by the Federal Reserve, and raising fresh fears over the possibility of a recession.

‘Safe haven’ assets rallied. Global bonds rose by +3.3% as bond yields declined across the board. Gold prices also increased by +3.0%.

Macro news

The Bank of England cut interest rates by 0.25% at its meeting on 1st August; the first rate cut in more than four years. The policy rate now stands at 5.0%. Headline inflation in the UK is already at the 2% target, but services inflation remains stubbornly high at 5.7% in June. This was reflected in the MPC voting, which was split, with a 5-4 majority in favour of the rate cut and four members preferring to keep the rate at 5.25%. In its communiqué, the MPC stated that “underlying [GDP growth] momentum appears weaker.”

In a similar vein, on Wednesday the Bank of Japan increased its policy rate to 0.25% from 0.1% and the US Federal Reserve signalled it could cut rates in September.

Euro area annual inflation stood at 2.6% in July 2024, up from 2.5% in June according to a flash estimate from Eurostat, the statistical office of the European Union. Looking at the main components of euro area inflation, services had the highest annual rate in July (4.0%, compared with 4.1% in June), followed by food, alcohol & tobacco (2.3%, compared with 2.4% in June), energy (1.3%, compared with 0.2% in June) and non-energy industrial goods (0.8%, compared with 0.7% in June).

The week ahead

After a big week for macroeconomic data releases last week, the first full week of August will see some important data releases. China’s Services PMI data on Monday will be closely watched after the manufacturing PMIs surprisingly fell into contraction territory.

UK construction, house price and retail sales data will also be released over the week, which could provide some sector-moving news.