The market’s recent decline and spike in volatility appears to have been prompted by last Friday’s weaker-than-expected jobs report, which followed the FOMC holding the Fed Funds rate unchanged in a range of 5.25% to 5.50%. With unemployment climbing to 4.3%, a three-year high, and only 114,000 jobs being added in July, (compared to the 175,000 that economists estimated) investors seemingly view this as a clear sign that the Federal Reserve (the “Fed”) has waited too long to lower interest rates and that the U.S. economy could be heading for a recession.
In addition to weaker jobs data and a disappointing Manufacturing ISM (Institute for Supply Management) number on August 1, another catalyst to the recent volatility has been the technical unwind of the Japanese yen carry trade. This happened when the Bank of Japan (BoJ) raised interest rates, and thus prompted investors to unwind their borrowing in Japanese yen and reduce their corresponding investments in other, riskier, markets.
Japanese equities as well as long positions on the Australian dollar and Mexican peso have been the most affected by brutal capitulation, which has spread over other asset classes, especially those which have so far benefited from strong momentum. The yen’s recent appreciation against the U.S. dollar started in early July and has accelerated over the past week. Prospects of further BoJ tightening, U.S. Fed easing, and increasing geopolitical tensions in the Middle East are all spurring the sell-off of the safe-haven yen. Government bond prices in the main developed economies have also rallied month-to-date, with the U.S. 10 Year Treasury yield heading below 3.8% by August 5th.
While there is in fact some weakness in the jobs market, we are not yet shifting our outlook nor ruling out the possibility of a “soft landing.” Our second quarter investment commentary covers some of the risks to the economy, including the high level of interest rates and cracks in the labor market. And with the Fed continuing to keep rates high, they are walking a fine line between fighting inflation and risking economic weakness. While near-term inflation has been under control, the CPI may continue to decline over the remainder of the year. Looking ahead to the last few months of the year, the Fed is expected to be cutting rates, with the only questions on timing and magnitude of those cuts. Meanwhile, the economy is continuing to grow, albeit slower than the last two years, and corporate earnings are expected to finish the second quarter at a healthy 11% year-over-year rate.
Market declines and periodic corrections are normal, and yet this recent volatility seems to be quite a strong reaction to only one month of data. With that said, there has been a lot of volatility this year following the release of economic data points. Recall that at the beginning of the year, the market anticipated up to 7 cuts for the Fed Funds rate, then went to expect almost no cuts, and now is expecting 125 bps cuts for the rest of 2024 with a high probability of a 50bps cut in September. We expect there will be more ups and downs in the main financial parameters in the coming months as the market attempts to forecast the outcome of the Fed’s actions.
In sum, the current take on recent volatility is that we have not yet seen sufficient evidence to shift our view of the economy, but as always we keep a close eye on economic data. It’s worth a reminder that periodic shorter-term volatility is normal part of investing in stocks and other risk assets, and selling when short term discomfort is high can significantly compromise long-term returns. Our approach is to remain on the lookout for opportunities that present themselves in the financial markets, and to take advantage of them if we are convinced doing so will increase longer-term returns.