Volatility Spike: Insights on US and European Markets

After 356 sessions without a daily variation of more than 2% on US markets, the third longest period since 1990, investors were reminded of a variable inherent to financial markets: volatility. The market movement at the start of the month was brutal, with the S&P500 volatility index reaching 65, a level rarely seen since the index was created in 1989, apart from the crises of 2008 and 2020. By way of comparison, the average since its creation is 19.

The scale of the volatility movement relative to underlying market movements was surprising: at the lowest point of the day, the S&P500 was down 4.26%, a low level given volatility moves. The decline in correlation between risky and defensive assets, which began in July as a result of significant style rotation, and very weak volatility levels since more than one year exacerbated this movement. If we add to these low volumes at the beginning of August and significant unwinding of infamous carry trades generated by the rise in Japanese interest rates, all conditions were met for this mini-crash.

Concerns initially arose following the publication of disappointing indicators in the United States, raising fears of a "hard landing" for the US economy. Nevertheless, the correction of European equities was twice as severe as that of US equities. This was particularly true of the French and German markets, while the impact on Swiss equities remained fairly limited, with an index heavily exposed to a number of large defensive stocks. The European technology sector was harder hit because of the smaller size of its companies, which differs from that of the American giants. The financial and consumer discretionary sectors were hit hard by the sharp rise in expectations of interest rate cuts, which could weigh on financial institutions' interest margins, and by fears of a fall in household consumption in the event of a 'hard landing'.

Since 1928, corrections of more than 5% over a month have occurred on average every 18 months, with the last one occurring in November 2022. These episodes of high stock market volatility are therefore still relatively frequent in the markets, and do not hinder the long-term uptrend in equity markets.

The Bank of Japan reacted swiftly by communicating how it was integrating the impact of its future monetary policy decisions on the markets, which helped to quickly contain the further fall in indices, particularly in Japan. This reminded us that central bankers have a very important impact on financial markets and have the ability to act to stabilise economies and markets both through their communication and concrete measures. Against this backdrop, central bankers will meet at the annual economic symposium of Jackson Hole end of August, initiated by the US Federal Reserve, with a particular important focus this year on the theme of "structural changes in the global economy". Investors will therefore be paying close attention to speeches made by the major central bankers on how these developments and recent major decisions by central banks are likely to affect global growth in the short, medium and long term.

The markets stabilised very quickly in the wake of this mini-crash: at the time of publication of this article, August will have seen the markets post one of their worst daily performances since Covid, but also the best daily performance since November 2022! However, concerns around the scale of the economic slowdown, particularly in the United States, have not completely dissipated. The hard economic data to come will be decisive, and will help to confirm or refute soft data from recent surveys, which are behind the rise in volatility and fear of market participants.

There are a number of factors that allow us to remain positive on the economy and upside potential of equity markets, such as the leeway that central banks still have to ease their monetary policy. This should enable various economies to avoid a "hard landing" and recession feared by investors.? Furthermore, second quarter earnings’ reports from US companies were solid overall. More than three quarter of companies reported earnings per share above analysts' forecasts. Average earnings growth was over 11%, or 2% above expectations at the start of the season.

Technology stocks continue to play a significant role in market performance, particularly in the United States. Indeed, the performance of the S&P 500 in the second quarter, boosted by a handful of technology stocks, was almost 4% higher, while the median stock fell by 3.5%. In the third quarter, most of the 7 magnificent stocks corrected, causing the S&P 500 to fall by more than 3%, even though the median performance of the stocks in the index rose by 1.3%. This also illustrates the style rotation that has been taking place in the market since the summer: while small and mid-caps strongly outperformed large caps during the month of July, the correction suddenly reversed this trend.

On the bond side, the "flight to quality" movement pushed US Treasury yields down. While corporate bonds, particularly those of low to medium quality, have been rather expensive since the start of the year, sovereign bonds have become pricier as well. Although they are still attractive for portfolios thanks to the fall in correlations, their price is much less attractive when yields are below 4% over 10 years.

Aside from the conclusions of the Jackson Hole conference, which investors will be watching closely for any signals of policy changes, US elections will be the key event in the coming months. The rise in the polls of the Democratic duo Harris/Walz will lead to a more uncertain and volatile second half of the year. While the markets had assumed that the election of Donald Trump was highly likely and had anticipated an economic program of lower taxation and deregulation, favoring in particular industrial and financial companies, this reversal of trend according to the polls could reshuffle the cards between the various sectors. Kamala Harris's programme is not yet very precise and remains a source of uncertainty. Finally, market shocks remind us of the benefits of diversification within portfolios, as well as the defensive nature of duration and bond exposure. Some might argue that this was not the case in 2022, when interest rates rose and equity markets fell sharply, but we believe that was an exception.

Nicolas Bickel | Group Head of Investment Private Banking