September 2024
This article appeared in the Sunday Times on 1st September 2024
Anyone who went on holiday at the end of June and returned at the end of August might think it was a quiet summer in the markets. The S&P 500 is up just under 3% over those two months, continuing this year’s positive trend. However, this increase masks what was actually a tumultuous period, possibly signalling further volatility ahead.
The first half of the year was particularly strong for equity markets. Investors grew confident about a soft landing in the US economy, and falling inflation raised hopes that the Federal Reserve would soon cut rates. The strong performance of the "Magnificent 7" stocks, especially Nvidia, driven by AI optimism, pushed the S&P 500 to a 17% return.
However, sentiment shifted abruptly in July. The S&P 500 fell by about 10% between mid-July and early August, while in Japan, the Nikkei was down over 25% from its July highs at one point. Reflecting the fear in markets, the VIX, Wall Street’s gauge of volatility, rose to levels not seen since the onset of COVID-19. One prominent market commentator even called for an immediate 0.75% cut from the Fed to calm the panic.
Cboe Volatility Index (VIX Index) June 2005- August 2024
Source: TradingView
What changed?
First, the Bank of Japan raised interest rates by 0.15% in late July. Though small, this move was seen as another step towards normalizing Japanese rates after decades of zero interest rates. This prompted a major unwinding of the "Yen carry trade," where investors borrow in low-yielding yen and invest in higher-returning assets overseas.
Second, the Federal Reserve held rates steady. Days later, that decision looked like a policy error after data showed weak US employment growth and a rise in the unemployment rate to 4.3%, its highest level since 2021. The data triggered a closely watched recession indicator, the Sahm Rule, which suggests that the economy is likely in recession when unemployment rises by a certain amount.
Other factors fuelled risk aversion. The spike in volatility led hedge funds to unwind trades that had been predicated on a continuation of a stable low-volatility environment. At the same time, investors rushed to lock in gains in technology stocks after their strong run-up. Disappointing earnings from Intel added to the gloom.
However, since then, optimism has returned. Other economic data point to a slowdown, but not an outright recession in the US. Consumer spending has held up and the services side of the economy is still solid. Investors have also taken comfort from comments by Fed Chairman Jerome Powell, signalling that a rate cut should be expected in September.
Yet, the summer wobble may be a warning shot for investors. Although the economy may not yet be in recession, economic cycles are inevitable, and a recession will come at some point. Historically, when the unemployment has risen from below 4%, it has tended to keep rising, so the odds of a downturn are increasing. The summer gyrations in markets also highlight how calm conditions can sometimes encourage greater risk-taking, which sow the seeds for the next period of volatility.
US Unemployment Rate, 1948 - 2024
Source: St. Louis Fed
It is worth bearing in mind that although equities have bounced back quickly, major downturns in markets are often preceded by sudden spikes in volatility. The post dotcom selloff between 2000-2002 was preceded by volatility from the Asian Financial Crisis. Stresses began to appear in the markets in the summer of 2007 before the Global Financial Crisis unfolded through 2008. In 2018, equities rebounded after a volatility spike in February, only to turn down again in Q4.
For investors, this episode underscores the importance of having a plan and sticking to it. For some, that means taking a long-term view, avoiding knee-jerk reactions, and staying patient. However, enduring significant equity drawdowns poses a psychological challenge. Major markets have seen two 50%+ drawdowns in the last 25 years, which are tough to endure. Moreover, when markets hit their lows, it’s impossible to know if the worst is over, and forecasters often predict further declines. It takes a particularly resilient investor to withstand such volatility.
For others, a reasonable plan involves diversifying portfolios wisely. Historically, government bonds were the go-to safe asset, but their dismal performance in 2022 highlighted the limitations of relying solely on them. Allocating to assets like gold or alternative strategies like global macro that are generally uncorrelated with equities and can perform in times of stress can add value to portfolios.
Investors can also limit the emotion by following a rules-based approach, or investing with an investment manager who does this. For example, systematic trend following strategies use a set of trading rules to manage portfolio exposure based on market trends. Having an investment in such a strategy can provide investors with a systematic dynamically managed portfolio without second guessing every turn in markets.
While it is impossible to know whether the summer slump in markets will be remembered as a blip or a harbinger of trouble, it serves as a timely reminder for investors to remain vigilant, disciplined, and strategic in their approach to asset allocation. By maintaining a well-thought-out plan, diversifying effectively, and leveraging systematic strategies, investors can better navigate uncertain markets.
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