Apologies in the height of summer for a somewhat longer than normal commentary but there is rather a lot going on, which merits a more detailed look than normal.
The correction in equities has gathered momentum. Global markets last week lost 2.3% and 1.6% in local currency and sterling terms respectively, and UK and European markets are down a further 2.5-3% this morning. However, the Japanese market is down as much as 12% today. Including this morning’s movements, global equities are now off around 7% in local currency terms from their mid-July high and 5% or so in sterling terms.
Asia and Emerging markets held up better than elsewhere last week but in good part this was just because the US fell 2% on Friday when these markets were closed. More meaningful has been the divergence in sector performance. The defensive and interest rate sensitive sectors, such as consumer staples, healthcare, utilities and property, which have lagged this year, were actually up over the week.
By contrast, the previously high flying Magnificent Seven fell a further 3% and are now down some 15% from their July high. Small cap stocks also reversed some of their recent sharp bounce.
Meanwhile, bonds performed exactly as one would hope and provided a useful offset to the losses in equities. Government bond yields declined significantly – the 10-year US Treasury yield fell as much as 0.4% to 3.8%, its low at the end of last year – leading to Gilts and Treasuries returning 2.1% and 2.7% respectively. Gold also did its job, providing some protection against the falls in risky assets, with a return of 1.7%.
So, what was behind all this? Setting the scene for the decline in equities was growing scepticism about the AI-related optimism which had driven the sharp gains in the Magnificent Seven tech stocks earlier in the year. These doubts were initially fuelled by Alphabet’s results and then reinforced last week by relatively lacklustre results from Microsoft and Amazon. Problems at the semiconductor chip producer Intel, whose share price dropped 25%, also didn’t help.
The results of Meta (Facebook) and to a lesser extent Apple were rather better although any relief on that front was tempered by news that Warren Buffet had halved his holding in Apple. Overall, last week’s news only served to heighten investor worries over the scale of the investment being deployed to reap the benefits from AI which as yet seem few and far between.
Then, on Thursday and Friday, fears of a US recession made a surprise reappearance. These were sparked by a smaller than expected gain in US payrolls in July, along with a rise in the unemployment rate and an unexpected drop in manufacturing business confidence. Recession, of course, is the bogeyman which markets had been so fearful of in 2022 and, to the market’s delight, has as yet failed to materialise.
While the US economy is now slowing following last year’s unexpectedly strong performance, there seems little reason to fear a recession. The numbers which spooked the markets were undeniably weak but not alarmingly so and it is dangerous to read a trend into just one month’s data. A couple of other indicators are indeed flashing red but they have been doing so erroneously for two years now and there’s little reason why they should finally be heralding the truth.
Also very importantly, the Federal Reserve has the scope to lower rates considerably to head off a recession. It held off cutting rates last Wednesday but left a cut firmly on the cards for its September meeting. The recent favourable inflation numbers mean the Fed will cut rates if necessary partly because, unlike most central banks, it has an explicit mandate not only to pursue stable prices but also maximise employment.
The market is now pricing in US rates being cut by as much as 0.5% next month and by 1.25% by year-end. The Fed does look likely to cut rates rather faster as a result of the slowdown in growth but the market is probably over-egging it. This wouldn’t be the first time as the market was wildly too optimistic back in January over how soon the Fed would start easing policy.
Here in the UK, where recent economic data has been stronger rather than weaker than expected, the Bank of England lowered rates by 0.25% to 5.0% in a close 5-4 decision. Although this should mark the start of a steady decline, the BOE was at pains to emphasise that this did not herald the start of a rapid succession of cuts. Even so, faster cuts in the US would make it somewhat easier for the UK to reduce rates and the market now sees a 50-50 chance of another reduction in September.
Whereas the BOE move had only minimal impact on markets, the same cannot be said for the decision by the Bank of Japan to raise rates from 0-0.1% to 0.25% and halve the pace of its bond purchases as it winds down its quantitative easing program. Although the move was not a massive surprise, it served to propel the yen higher.
The Japanese currency had already been strengthening on the prospect of a rather narrower interest rate gap between the US and Japan and a further surge today leaves it up close to 15% against the dollar from its low in July. This sharp rise is behind today’s large fall in Japanese equities.
The surge in the currency is forcing investors to close overseas investments which had been financed by borrowings in yen and is very likely exacerbating the declines now being seen in previously high-flying areas of global equity markets. This, along with the fact that it is peak holiday season and trading liquidity on the low side, means the current bout of volatility/weakness in equities could well yet have to further run.
But for longer term investors such as ourselves, the important thing is to look through this volatility and assess whether or not the medium term outlook has changed significantly. We don’t believe it has.
We still think the underlying macro backdrop remains fairly positive. Global growth should hold up reasonably well, not least because inflation pressures have eased sufficiently to allow central banks to start cutting rates.
The sharp run-up in equities earlier in the year left them vulnerable to a correction and as yet this decline is nothing out of the ordinary. Equity valuations outside the US are not expensive and in some cases such as the UK remain downright cheap.
Corporate earnings growth should in time drive renewed gains in equities. Indeed, it is worth noting despite some notable disappointments, US earnings have overall beaten expectations in the second quarter and should be up a robust 12% on a year earlier.
As for the Magnificent Seven, we stick to the view that, although these companies are much better positioned than their equivalents in the 2000 tech bubble, the AI-related optimism had become overdone and valuations too high. We continue to believe renewed gains in equities over the coming year will be led by the cheaper areas of the market outside the US.
Finally, a word on bonds. These have proved their worth as a diversifier in the last week and the outlook remains favourable. As we have just seen, now we are in a rate cutting environment, attractive starting yields (2 and 10 year gilts yield 3.9% and 4.5% respectively) should be supplemented by capital gains as yields decline.
This coming week, there is little out in the way of data and attention will be focused on the fall-out from the recent sharp market moves. Some quiet time may hopefully also allow investors to pause and reflect on how much has actually really changed.
Rupert Thompson – Chief Economist