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Equity markets sold off heavily on a combination of economic factors that seem to have erupted all at once. On top of these economic concerns, both an uncertain U.S. political election season and escalating geopolitical risk add to the feeling that suddenly everything looks turbulent. Over the past three weeks, the S&P 500 is down nearly 10% from its peak and the Nasdaq is down even more. Below we lay out the major factors behind this recent selloff, our expectation of how these will play out going forward, and finally considerations of portfolio positioning.
What’s driving the markets?
The first factor behind recent market concern is softening economic data, which was punctuated this past Friday with uninspiring data on job creation. The unemployment rate increased to 4.3%, which is 0.8% above the low in July 2023. That increase in the unemployment rate, although driven by additional people seeking work rather than by job losses, led the market to fixate on what is termed the “Sahm Rule” recession indicator and raised fears that the economy is on the cusp of rapid deterioration.
An additional concern permeating markets is that impacts from AI spending and companies’ ability to improve productivity are over-hyped. This quarter’s earnings results from megacap technology companies were heavily tilted toward spending on AI rather than details of tangible benefits.
The abrupt market selloff has also been exacerbated by what is referred to as the unwinding of the Yen carry trade. Large investors, such as hedge funds, have borrowed heavily in Japanese Yen and used those proceeds to invest in risky assets, including in U.S. technology companies. Recent and sharp strengthening of the Yen along with the stock market pullback has led to severe losses on both sides of that trade for these large investors, leading to forced selling.
A final major concern is, of course, the Fed. Just last week, the Fed met and held short-term interest rates steady at 5.25% to 5.5% - a level which it considers very restrictive. The market is acutely concerned that the Fed has fallen behind the curve and should cut interest rates promptly to stave off economic weakness.
Outlook
Our first and most important response to the above concerns is that we believe recession dynamics are not strongly in play, or, if they are, they could be reversed by quick Fed action in cutting interest rates. The rise in the unemployment rate that has led to recession fears is entirely driven by an increase in labor force participation rather than driven by job losses. Furthermore, the ratio of job openings to unemployed persons remains at high levels. The labor market is indeed cooling but is not a source of downward momentum as is currently feared. Other economic data has been soft-to-stable, such as a weak ISM Manufacturing survey juxtaposed against a stable and healthy ISM Services survey. Overall, we believe the indicators are more consistent with a soft landing rather than an impending recession.
As for the fading AI enthusiasm, it is unsurprising that an environment of macroeconomic and political uncertainty lends to a correlated doubt of AI being able to deliver on its promises. Technology-driven productivity cycles take a long time to play out. This was true in the early-to-mid 1990s and it is true today. We remain optimists on the medium and long-term potential of economic benefits from AI, but acknowledge that it may take a few quarters before “proof” is forthcoming.
The degree to which the unwinding of the Yen carry trade will continue to pressure markets is unclear, but we believe the Yen is now in a fair value range, which implies that the worst of this forced selling pressure is likely behind us.
The largest problem in the economy today is the high level of Fed-controlled short-term interest rates. Unfortunately, the Fed’s next scheduled meeting is still six weeks (and then meetings again in November and December), but there is precedent for between-meeting rate cuts as happened in 1998. It is unclear whether the Fed’s mindset would shift in this direction, and it certainly does not want to be seen as being at the market’s behest. That said, we believe that the recent jobs data along with signals from the stock and bond markets are telling the Fed that short-term interest rates are simply too high. Given inflation’s downward trajectory, the Fed has ample room to cut rates aggressively.
Portfolio considerations
Our portfolio recommendations prior to this selloff remained relatively balanced even as equity markets ran up earlier in the year. It is almost never advisable to sell into a panic such as was seen in the markets on Monday morning. Both the stock market and the economy await Fed action. We expect that the Fed will not just be cutting rates on a one-off basis but will begin a rate cutting campaign that will last well into 2025, which should eventually serve as a tailwind to markets.
The recent stock market correction and period of heightened uncertainty does imply a presently elevated level of near-term risk. Even though we believe that Fed tools and current flexibility to cut interest rates (given low inflation) can stave off downward economic momentum, it is certainly possible that the stock market correction has more room to run. We believe the current pullback and volatility represent a possible extended bumpy stretch along the existing longer-term path rather than a fundamental shift in direction. We continue to assess the outlook but do not presently recommend portfolio changes in response to these near-term factors. It is also possible that pullbacks could lead to opportunities in the coming weeks or months for uninvested cash to be deployed favorably.
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