Our sign-off last week was supposed to be cautiously optimistic – predicting a bumpy ride to a decent destination in markets – but friends told us it read a little negatively. Cue the worst daily loss for the S&P 500 in nearly two years on Monday after a terrible session in Japan, and sharp losses for most other major indices. US recession fears – stoked by a distinctly disappointing jobs report last Friday – formed the backdrop for the sell-off, however, market liquidity concerns emanating from Japan’s actions were the spark.
But then global stocks staged a promising recovery for the rest of the week, and the S&P had its biggest daily gain since late 2022 on Thursday. A bumpy ride indeed. The jury is still out on the destination.
Volatility returns on liquidity fears.
After exceptionally low volatility in 2024, the VIX index, which measures expected swings in US stocks, spiked into Monday. Recession signals clearly played a role, but the immediate story was about market liquidity. The Bank of Japan raising rates from ultra-low levels hurt the ‘carry trade’ (borrowing where rates are low and putting the money into risk assets elsewhere) which has been a source of funding for hedge funds this year. The drying up of liquidity made trading more volatile and, when volatility metrics increase, hedge funds’ risk protocols often require them to dial down their investment positions.
This went hand in hand with a reduction in US liquidity. The Federal Reserve is still taking money out of the system through quantitative tightening, despite its recent dovish signals. Meanwhile, the large pots of cash that households received during the pandemic (which could not be spent immediately and so were saved) have been declining. Indeed, as a whole, the US appears to have stopped taking out of the cash pots since the early summer. Nevertheless, the reduced cash savings may have been part of a liquidity shortage which, last week, was suddenly revealed to markets. Investors’ perception of risks grew, and we had one of the steepest increases in volatility we have seen. This was across most regions and almost all asset classes, from commodities and cryptocurrencies to equities and bonds (albeit bonds were volatile to the upside).
Interestingly, we suspect that the growth of day trading instruments like so-called zero-day options and high-frequency trading have contributed to the substantial swings in implied volatility (as measured by the Vix, rather than just recent historical swings). The timelines between trades have been shortened, and volatility is always measured as movement within a certain time-frame. So, higher frequency trades can exacerbate spikes in volatility, which in turn increase markets’ reactiveness.
But recession still not likely.
We say almost all asset classes were highly volatile, because there is one notable exception. Corporate credit spreads – the difference between corporate and government bond yields – increased earlier in the week but, in fact, corporate bond yields have fallen in aggregate (and so prices have gained) from a week ago, thanks to the sharp fall in the ‘risk free’ rate of government bond yields. Credit stress is one of the hallmarks of recession, so the fact corporate credit has behaved well tells us that recession fears might be overblown.
Economists at JPMorgan made a stir this week by suggesting there was around a 35%-50% chance of US recession by the end of 2024, and undoubtedly a near-term contraction is a higher risk now than a few months ago. But it remains unlikely and the base case is still a ‘soft landing’ (growth slows enough to lower rates, but not enough to trigger recession).
Survey data from US manufacturers, particularly on employment expectations, was one of the factors behind recent market pessimism. But survey data from the much larger services sector continues to be strong. The situation will only be helped by the Fed’s all-but-certain rate cut in September. Some market-based indicators have been relatively positive, too. Bitcoin, for example, wobbled like everything else this week, but its recovery has been strong. That has been a good recent indicator of investors’ capacity to take on risk (rather than risk appetite per se).
A decent enough outlook.
Markets were spooked earlier in the week, but there is a fair amount to be positive about. Global recession is still unlikely, and rate cuts will offer relief. Moreover, the knock to growth expectations has translated into a steep fallback in yields.
These should provide some support for equity valuations, and also economic activity. US housebuilding, for example, will benefit from lower mortgage rates – and could release a lot of bottled up activity. US mortgages track 10-30 year treasury bonds and have fixed rates, but have a “callable” structure which allows borrowers to refinance if rates fall. For lenders, this has the counter-intuitive consequence that when yields rise, the expected risk (duration) of their mortgage book rises and so the lenders charge more for that risk. Thus, the spread applied to new mortgages also rises. In 2023, the difference between mortgage rates and Treasuries reached an all-time high of 3% after the huge rise in bond yields, but that has now declined below 2.5%.
Now that US long bond yields have turned lower, there is a good chance of a substantial fall in mortgage rates. Mortgage holders have begun to refinance old mortgages more often, as this week’s “refi” data showed. Outright mortgage rates have fallen to 6.6% but could drop to 6% in the next few months, even if longer-term treasury yields remain around 4%, because the 30-year average spread is 1.4%.
But not out of the woods yet.
This feels like a market shakeout that has been brewing for a few weeks. Goldman Sachs and Variant Perception (one of our research partners) pointed out this week that risk signals – of the kind that feed into the models used by many hedge funds – had been rising since June. Essentially, their models look for signals of herding behaviour (known as LPPL models). Some hedge funds had therefore been reducing their exposure to risk assets ahead of the sell-off and so had room to buy back into equity markets, as others were being shaken out.
Thus we have seen a reasonably quick settling back down in actual volatility and in expected volatility implied by options trading. After sharp falls, equity prices tend to swing up and down for a while, and those swings get smaller, like a pendulum coming to an eventual stop. This week has seen a quicker than usual dampening, suggesting that fears of financial instability have dissipated rapidly.
However, we think we are also in a different phase for the equity markets’ medium-term outlooks. Valuations based on recent earnings are lower but not cheap; they still carry optimism about earnings growth. The fall back in yields helps support the valuations, but should also reduce the likely average path for earnings growth. Maybe we end up with somewhat higher valuations but with future earnings lower than previously expected. That leaves us with positive but (slightly) lower expected returns, and perhaps with a different set of likely winners.
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