Reflections of the CIO… July 2024

Traditionally, early summer is meant to be a quiet period for markets, with few events of note. This year proved to be the exact opposite, with at least eight market moving events conspiring to spark a selloff in global stock markets and a simultaneous flight into the relative safe haven of government bonds.

The initial bout of volatility was catalysed by what many, including ourselves, would characterise as a positive news event. On July 11^th , the  release of US inflation figures was interpreted by the market as being very benign and had been delivered without the need for a recession – a so called ‘soft landing’ for the US economy. Investors took this to mean that many stocks which had been lagging year to date could now catch up, encouraged by the lower interest rates which benign inflation would soon usher in. A very quick and large rotation between sectors subsequently took place in the US stock market, with the winners (larger companies, with a growth or tech bias) being sold aggressively to fund purchases of smaller more cyclical companies. As many of the stocks being sold were index heavyweights, the overall market began to fall, even though a broadening out of the stock rally could easily be seen as a good thing.

Unfortunately, by the end of the month, this volatile but rosy picture was punctured by a combination of technical and fundamental news. The fundamental news came via very weak survey data from the global manufacturing sector, which reported that new order momentum was stalling, and inventories were starting to rise. Investors began to take fright that what had previously been thought of as a cooling in the global economy could now morph into a full blown recession. Sentiment began to turn negative quickly, in sharp contrast to the earlier part of the month.

The technical news came from Japan, where an increase in interest rates and hawkish tone from the central bank came on the same day that the US Federal Reserve decided to leave US rates unchanged, even though they had the excuse to start cutting them. This marginal move, making Japanese cash slightly more expensive than it had been before, had a big knock on effect on many markets, as nearly all of the world’s ‘hot’ trading money has its positions funded in Japanese yen. These positions are usually leveraged up (i.e. increased in scale though borrowing) meaning that even small changes in ‘expensiveness’ have big and quick effects on the ability to keep funding positions. Given that many of the most popular positions were now under pressure from weaker economic sentiment (e.g. US large companies) the double whammy from more expensive funding and increasingly unprofitable trades prompted a huge rush for the exit. Stock markets began to wobble dramatically as over leveraged positions and over optimistic managers reassessed their views.

The flipside of this de-risking move was that the more traditional safe havens of government bond markets began to rally. These assets in general had struggled year to date as investors wrestled with opinions on the path for interest rates. Given that the latest data suggested not only that inflation was falling sharply but also that the risks of recession were climbing, the path for interest rates was becoming much clearer – they were heading down quicker and in larger chunks than previously thought. Bond markets rallied accordingly, helping offset the volatility that stock markets brought to portfolios.

Much of the market impact of the events described happened very quickly over month end and into early August. Overall, portfolio returns were actually positive for July, but this was only because the impacts of the events described happened to straddle the month end. Recession worries and the technical impact of a move in Japanese interest rates were undoubtedly the dominant influences on volatility. They were so dominant that other events, such as the shooting of Donald Trump, the withdrawal of Joe Biden from the US Presidential race and his replacement with a previously unrated candidate, the bombing of Tehran by Israel and the waning of investor enthusiasm over the AI story during the earnings reporting season, were all relegated to bit part influences on market moves.

Although we did not expect so many events to happen in one month, we had expected volatility to increase and equity markets to look for an excuse to consolidate. Sentiment and valuations seemed extended to us, and we had been steadily positioning for a rotation in stock market leadership throughout the year. As such, portfolios overall navigated the events of late July and early August with much less drama than the news headlines implied.

Looking ahead, the general outlook to us is still broadly unchanged – the glass is more half full than half empty, as we think the prospect of simultaneous global interest rate cuts by year end will do much to offset the other risks. However, the recent economic data is worthy of note, making the next few months’ datapoints important in gauging any shift from a ‘cooling’ economy into a contracting one. We would therefore expect that this period of flip flopping in market direction and mood will continue, although probably with much less drama than in recent days. There are no particularly new exciting investment opportunities thrown up by the recent volatility, nor is there a new risk that we weren’t aware of before. We will keep our eyes open in case this changes, but remain confident that, as we stand, portfolios have enough resilience built into them to ride out the current wobbles.