Central bank meetings and jobs data sparked selloffs across two of the world’s most popular equity markets this week disrupting many a CIO's summer holidays.
Japan’s TOPIX and Nikkei 225 benchmarks both collapsed more than 12% apiece on Monday alone, triggering trade-halting ‘circuit breakers’ amid the worst session for Nipponese equities in 37 years.
Elsewhere, US equities also felt the pain, with the S&P 500 and Nasdaq-100 both falling at least 3% apiece to mark their worst sessions since September 2022. Meanwhile, the VIX volatility index briefly spiked above 60 on Monday, its highest level since the COVID-19 crash of March 2020.
Drivers of the sell-off
As with most incidents of equity volatility in recent years, central bank balancing acts were centre stage, as the Bank of Japan (BoJ) hiked rates to 0.25% and the Federal Reserve kept its policy rate unchanged ahead of US jobs data last week.
On Japan, Nathan Sweeney, CIO at Marlborough, noted a turn to hawkishness by the BoJ has seen the Japanese yen strengthen more than 10% against the US dollar over the past month.
“A stronger yen makes Japanese goods more expensive and consequently less attractive for potential overseas buyers.
“Unlike other central banks, the Bank of Japan lifted interest rates last week. As a result, international investors have become cautious about Japanese corporate earnings, especially those of exporters such as automakers.”
Allan Lane, CEO of Algo-Chain, added: “The recent historic rates hike in Japan has been a very long time in the making, whereas the unwinding of the carry trade has seemingly happened overnight.
“Not surprisingly, the mismatch in those two timescales mostly explains the 12% single day drop in the Nikkei 225 Index.”
Turning to the US, Sweeney said the market reaction to a disappointing jobs print last Friday suggests investors believe the Fed “may have made a mistake” keeping rates steady at its meeting last week, despite most recent data showing the US economy expanding at an annual rate of 2.8%.
“The jobs data for July raised concerns that a long-running jobs boom in the US might be coming to an end. It stoked speculation about when - and by how much - the Fed will cut interest rates,” he said.
He also noted investors are becoming more pensive about the impact of high borrowing costs, especially in the context of high spending on AI capabilities and questions about the longevity of the tech sector rally.
Lane added: “The selloff in US equities is a by product of a large-cap equities market dominated by a handful of stocks, accounting for a significant part of the strong performance of the Nasdaq and S&P 500.”
Core assumptions for H2
As for where recent events leave investors’ H2 outlook, Wayne Nutland, multi-asset investment manager at Skerritts, said US jobs data points towards an economic slowdown, rather than recession.
“Although the data led to a notable reaction in bond markets, in our view, recent market turbulence has been significantly exacerbated by concerns over AI as well as technical factors, especially in Japan,” Nutland said.
Yves Bonzon, CIO at Julius Baer, agreed: “The current market action is driven more by technical factors, which have become increasingly stretched in recent weeks and months, rather than by a meaningful deterioration in underlying fundamentals.
“From a market technical point of view, the current consolidation phase is not only healthy but also absolutely necessary to sustain the primary uptrend for developed market equities.”
Markets have priced in as many as five Fed rate cuts by the end of year – totalling 1.25 percentage points - to counteract economic slowdown, however, some fund selectors are yet to be convinced this pace of dovish pivot will materialise.
“We respectfully disagree,” Bonzon said. “Overall, US private sector balance sheets are healthy and an aggressive Fed easing might trigger an asset bubble similar to what happened after 1998 when the Fed was forced to ease in the wake of the LTCM hedge fund collapse.”
Lane concluded the sustainability of large tech name rallies was already under close examination and markets were looking for a reason to correct, at least in the short term.
“Given the retreat of Nvidia has been in many investors’ mind, last week’s weak non-farm payrolls numbers was the straw that broke the camel’s back. Come the end of the year, I suspect this will be all behind us,” he said.
Implications for asset allocation
Taking a similarly steady approach, others are not rushing to make major changes to their allocations in light of recent events.
Nutland said: “At this stage we are not making material changes to our allocations, but are reducing underweight positions in high-yield credit given spread widening over recent days.”
While corporate reforms buoyed Japanese equities last year, economic contraction in Q1 and softening earnings momentum prompted some fund selectors to trim relatively long-standing overweights.
Sweeney added: “We had already cut our Japan holding significantly from between 6-10% of equity content for most portfolios, down to around 2%. As a result, the sharp down move in Japanese equities has had limited impact on the portfolios.”
Elsewhere, Marlborough has reduced its US tech exposure in the short-term and favours government bonds and a broader opportunity set in US equities in light of Fed rate cut expectations.
“We expect broader market participation from areas that will benefit from falling interest rates in 2024,” Sweeney said.
“This paves the way for government bonds to take the spotlight from cash, while we also expect to see equities delivering a more broad-based recovery as opposed to being dominated by profitable technology companies, on balance, we are neutrally positioned in portfolios.”
