Deep Breath | July 2024
For the past couple of years, we have warned investors to be prepared for wild bouts of volatility. With the economy at an inflection point and central bankers engaged in a delicate balancing act, we expected each data point to be over-scrutinized and prone to overreaction.
So far, the economic data has been mixed, showing signs of strength and weakness, causing the pendulum to swing from one extreme to another. It has been sufficient to give investors a healthy dose of indigestion.
And anyone hoping for a summer hol’ from all the vol has been sorely disappointed. After euphoric stock markets hit record highs in mid-July, August began with headlines of panic and routs before finding some semblance of calm.
These wild swings and shifts in sentiment are both confusing and unnerving—feelings further exacerbated by the financial media’s penchant for hyperbole. With this in mind, we thought it appropriate to take a deep breath and offer some context for the most recent gyrations.
The sky was falling.
In 2022, central banks launched aggressive rate-hiking campaigns to tame the inflationary beasts. The foregone conclusion was that such restrictive policies would plunge the economy into a recession. Yield curves inverted, and the S&P and Nasdaq dropped 25% and 35% respectively.
Towards the end of the year, the inevitability of a hard landing was being questioned, and the prospect of a soft landing gained credence. This sparked the beginning of a market rally.
Never mind, it’s Nirvana.
The optimism and exuberance reached the point where a soft landing or no landing (Nirvana) was accepted as fact. For months and months, markets ignored signs that higher rates were restraining and even slowing the economy. The euphoria drove equities to new highs, with the S&P and Nasdaq rebounding 60% and 80% from their 2022 troughs, peaking on July 16th of this year.
The recalibration.
Since then, equities have taken a downturn, dropping 6-10%. A weaker-than-expected July jobs report reminded investors that the economy is slowing, and the probability of a recession was adjusted higher.
While the financial press wrote about routs and panic, we saw this is a more rational recalibration of the risk premium. With the downward trend in employment continuing, it seems reasonable for markets to factor in the possibility of a hard landing of unknown depth and duration. This recession repricing was further exacerbated by the unwinding of the yen carry trade.
Now what?
So, where do we go from here? Back to our original warning: be prepared for more volatility ahead. Each economic data point will continue to be over-scrutinized, leading to market gyrations as investors rejig the odds of a recession. The risk is that the longer markets remain overly sensitive to each data release, the greater the odds that rational recalibrations become irrational emotional responses.