What a difference a week makes. The month of August started with a bang, falling 6% within the first three trading days, before stabilizing and regaining a portion of the declines. In a matter of just three trading days, the market narrative shifted dramatically. Was the change in the economic news so drastic as to justify the sell-off? Were investors overly Pollyannish on Artificial Intelligence and the prospects of an economic soft-landing? What happened during the last week of July that could derail the economy, the stock and bond markets?
In short, a Federal Reserve meeting, softer economic data, a slight uptick in the unemployment rate to 4.3%, and a surprise rate hike from the Bank of Japan all combined to muddle what had been shaping up to be a pretty good year. The real question on investor minds is, do we buy the narrative of an economic soft landing or is this the beginning of a more drastic adjustment?
On July 25, the Bureau of Economic Analysis released data on second quarter Gross Domestic Product (GDP), which showed that the U.S. economy grew at an annualized rate of 2.8%1 , well above the consensus estimates of 2% growth. The stock market was making alltime highs; including somewhere north of 35 separate new highs in 2024. The rally was gaining steam and market breadth (the number of companies participating in the rally) was expanding. No longer were gains concentrated to only a handful of the biggest companies at the top of the market, but small- and mid-capitalization stocks were joining in on the returns. The Russell 2000, a proxy for small-capitalization stocks, increased more than 10% in July, while the S&P 500 was up just more than 1% for the month. According to a report from Strategas Securities, as of July 29, nearly 70% of corporations were outperforming the S&P 500 over the previous 20 trading days. That was not only the best reading in several years but was unmatched dating back to early 2001.2 In July, real estate, utilities, and financials were the three top performing sectors in the market, appearing to reflect anticipation of interest rate cuts to come, while information technology and communication services were the worst. Inflation was moderating and corporate earnings growth was running at around 11%. Finally, while the unemployment rate had ticked higher, reaching 4.3% in July, on balance, employment trends remain healthy with a better balance of job openings and available workers. All in all, things were looking pretty good.
Source: Bloomberg
Up to this point, pullbacks in the market were orderly. Despite a pullback in the S&P 500 early in July of 4.9%, and a decline of 10% for the Nasdaq over the same period, each decline was modest and controlled. By July 31, the S&P 500 was higher by more than 15% for the year and the growth-heavy NASDAQ was up a bit more at 16%. Pullbacks were being bought and sell-offs were “garden variety.”
As we monitored the weekly flow of economic data, we grew increasingly confident an economic soft landing was materializing. Back in April, we discussed how the Federal Reserve had deftly navigated raising interest rates just enough to slow economic growth and soften inflation, all the while maintaining a job market that was near full employment. This is a logical sequence of events: the Fed tightens interest rates, inflation slows, economic growth slows and job growth begins to stagnate. In that order. Those events have played out, as expected, and despite some modest cracks in the labor market and ongoing softness in the manufacturing economy, we remained comfortable with our two percentplus outlook for economic growth in 2024 and 2025.
Further, we were gaining more clarity into the outlook for rate cuts. It was a matter of when, not if, rates would be cut. What remained less certain was the magnitude and pace of rate cuts. Only a few weeks ago, Bloomberg estimated the chance of a Federal Funds rate cut of 25-basis points at its upcoming September 19 meeting was nearly 100%3 and interest rate probabilities showed three cuts by January 2025. Our conviction that rate cuts were coming was confirmed following the Federal Reserve Open Market Committee meeting on July 31 when Federal Reserve Chair Jerome Powell provided dovish comments and left open the door to the possibility of rate cuts ahead. As markets tend to do, they reacted. Yet, to the surprise of many, stocks sold off and bonds rallied (i.e. yields fell). Curious behavior if the economy was not broken, as we expect, and was indeed on solid footing.
More importantly, something else happened coincident with the Fed Meeting on July 31; the Bank of Japan unexpectedly raised interest rates by 25 basis points and for only the second time in nearly two decades. On the surface, this may not seem like a big deal, but in our opinion, this was the catalyst that set the markets in motion. We believe it was a key contributor to starting the major decline in stocks, the huge rally in bonds and the spike in volatility. When trading opened on Monday, August 5, the Nikkei in Japan fell 12.5%, its worse session since October 1987, and in total, had fallen nearly 25% since July 11.
So why did this 25-basis point increase by the Bank of Japan matter so much? Two-words: carry trade.
In practice, a carry trade is simply when investors borrow in a currency with low interest rates (in this case, Japan), and invest in a currency with relatively higher interest rates, like the United States (or Mexico). When the Bank of Japan surprisingly increased rates, the Japanese Yen strengthened significantly against the U.S. dollar. When these trades unwind rapidly, it’s fodder for a margin call forcing borrowed yen to be repaid, which drives yen buying — and in this case, a yen spike.
This unwind of the carry trade can be super-fast and fierce, and it can have other unintended consequences which may yet to be fully known. The good news for investors is that this type of short-term panic is not catastrophic and typically leads to opportunities to add great companies that are temporarily “on sale”. In most cases, the decline in the stock price likely had very little to do with a deterioration of the fundamentals of a company, and the price declined mainly due to forced selling.
It should be noted that there are always a handful of factors that contribute to any pullback (or rally) in the market. When we add a few seemingly unrelated but still relevant facts to the recent correction, the pullback in the market makes a bit more sense. Seasonally, August and September tend to be amongst the worse months for market performance. The dog days of summer are in full effect, and market corrections are not unusual. The stock market was frothy and overbought, in my view, and valuations were by no means cheap. Stocks were pricing in a lot of optimism and anticipated good news. Accordingly, this provides little margin for error, and unexpected bad news can have a more dramatic impact on stock prices.
Let us not forgot that markets are inherently volatile. During periods of low volatility, investors can become complacent. This chart from Strategas, FactSet shows the number of days we had gone, 354, without a 2% decline for the S&P 500. This was the second longest period between 2% declines going back to 2006. A sizable daily correction was long overdue. The Fed meeting and the Japanese rate hike may have just provided the reason.
Source: Strategas, FactSet
For investors, this is a good time to be on guard. Pullbacks are more frequent during the summer months and liquidity is lower, so it is unlikely this will be the last pullback we experience. Further, we are less than three months from a presidential election, and the political environment is unprecedented. Whether the assassination attempt on Former President Trump’s life, or President Joe Biden’s announcement that he would not accept the Democratic Presidential nomination and would step down in favor of Vice President Kamala Harris, there seem to be surprises around every corner. Finally, let’s not forget the potential for a flare-up in the Middle East that could put global markets further on edge.
The Cambridge Trust team continues to monitor these and other events for any signs of market stress, or anything that might cause us to reassess our positioning. These warning signals could come in the form of further slowing in the job market and an acceleration in the unemployment rate, deteriorating economic activity, widening credit spreads, or signs that corporate earnings are set to roll over. For now, we believe these are not apparent, and they, as always, should be monitored.
In terms of our asset allocation, portfolios remain modestly overweight to equities based on the current expectations that the economy will slow, but not go into a recession. We maintain healthy exposure to high-quality investments and fixed income holdings designed to serve their role as portfolio diversifiers during periods of market volatility.
As long-term investors, we remain constructive on equities and are evaluating opportunities to broaden exposure and move down the capitalization scale from large-caps to mid- and small-caps, where merited. The prospect of rate cuts should encourage the rotation out of big technology names and into other areas that may benefit more from lower borrowing costs.
We can never ignore the risks that are present across the investing landscape, but history has shown that investors are rewarded for time IN THE MARKET and not trying to TIME THE MARKET. The message: stay invested. A strong economy, robust corporate earnings growth and the potential for lower interest rates is a winning combination, especially for stocks. While we may have just hit turbulence on the approach, we still at present anticipate a soft landing ahead.
1Bureau of Economic Analysis, July 25, 2024
2Strategas Securities, Technical & Macro Research – Daily Report, Chris Verrone, July 30, 2024
3Bloomberg, World Interest Rate Probabilities, 8/2/2024
Cambridge Trust Wealth Management is a division of Eastern Bank. Views are as of August 2024 and are subject to change based on market conditions and other factors. The opinions expressed herein are those of the author(s), and do not necessarily reflect those of Eastern Bankshares, Inc., Eastern Bank, Eastern Bank Wealth Management, Cambridge Trust Wealth Management or any affiliated entities. Views and opinions expressed are current as of the date appearing on this material; all views and opinions herein are subject to change without notice based on market conditions and other factors. These views and opinions should not be construed as a recommendation for any specific security or sector. This material is for your private information and we are not soliciting any action based on it. The information in this report has been obtained from sources believed to be reliable but its accuracy is not guaranteed. There is neither representation nor warranty as to the accuracy of, nor liability for any decisions made based on such information. Past performance does not guarantee future performance. Investment Products are not insured by the FDIC or any federal government agency, not deposits of or guaranteed by any bank, and may lose value.