In the end, some of 2024’s winning trades were unwound fairly quickly. Japanese equities and the Nasdaq erased nearly all their six-month gains within days. The so-called ‘Magnificent 7’, while still buoyed by Nvidia’s year-to-date gains, fell nearly 25% from their peak, underperforming the S&P by 15 percentage points and highlighting the risks of concentrated markets1. In bonds and currencies, the yen retraced to its January levels against the dollar, while 10-year Treasury yields tumbled to their December lows.
What has driven the price action and how seriously should investors take it? Three drivers stand out.
First, investors have reappraised the growth trajectory of the US economy. Labour markets have been slowing all year, and weak ISM data and the low number of jobs added in the non-farm payrolls revived recession fears. Wage growth has also slowed to an annualised rate of 3.6%, finally triggering Claudia Sahm’s recession indicator. Meanwhile, the earnings season brought a spate of weak results from consumer companies like McDonalds and Pepsi. Companies benefitting from higher-income spending, like Pool Corp, which builds swimming pools, or AbbVie, which makes Botox, also highlighted weak consumer demand in the US.
Combined with the growth scare, investors are also worried the Fed has moved too slowly on launching its cutting cycle and will need to catch up. At the end of H1, Fed Funds Futures were expecting two 25 basis point cuts at most by the end of the year. Markets now expect four.
The second factor driving the price action is an almighty positioning unwind in a number of interlocking financial assets. The AI trade had been undergoing reappraisal since mid-July, as analysts grew more sceptical about its value-generating ability. This scepticism was quickly vindicated by the hyperscalers’ Q2 earnings, which revealed a 50% increase in capital expenditures against a debatable demand backdrop. Moreover, possible US restrictions on selling AI memory chips to China threw a further spanner in the demand picture, which was not helped by Intel’s weak outlook and planned downsizing in its second quarter earnings.
In addition, the BOJ’s decision to raise rates in response to persistent domestic inflation lowered real interest rate differentials between US and Japanese sovereign bonds, putting upward pressure on the yen. When combined with an existing carry trade funded in Japanese yen, this caused a major positioning unwind across global markets. For instance, price action since mid-July has unwound nine months of gains in the MXNJPY cross, while a liquidation of domestic Japanese assets by foreign investors has not been matched by domestic buying. Carry trades are inherently short volatility, and their unwind contributed to the VIX spike. All this has been exacerbated by thin liquidity during the summer months.
Furthermore, changes in the market structure have contributed to the sudden jump in volatility. The growth of passive investing and systematic trading strategies has depleted the capital available to active discretionary investors to fight momentum with contrarian views, increasing the latent potential for volatility. The self-reinforcing nature of different systematic strategies has amplified the low volatility bias in markets and contributed to their unwind. For example, volatility-targeting funds enable higher leverage and dip-buying during quiet market regimes, but also require liquidations of those levered strategies during periods of higher volatility.
Changes on the market-making side are as important as those on the investor side. With risk capital shifting from banks to multi-strategy firms, market-making capital is becoming more concentrated in a small number of funds, albeit funds with historically strong risk management practices. Still, it is a truism of finance that concentration exacerbates volatility.
Despite the growth scare, we believe the US economy is not as weak as current fears imply – the data is mixed rather than dire. For instance, the Atlanta Fed’s GDPNow tracker for the third quarter is currently at 2.5%, and high frequency consumption data (e.g. card spending, restaurant bookings, airline passengers) are not showing signs of slowdown.
The private sector financial imbalances also remain low, particularly in the household sector, where debt service ratios are in the bottom quartile of outcomes since 1980.
Finally, there appears to be significant pent-up demand for some rate-sensitive products, particularly in the property market, which has been restrained by high mortgage rates. This is likely the result of a demographic mini-cycle, where millennial homebuyers are leveraging to form households. If rates ease in response to a growth scare, we believe this will likely lead to a surge in realised demand.
Beyond demographics, other structural tailwinds, such as a capex supercycle, are on the horizon. While extreme market ructions can sometimes impact the real economy, investors have reason to view the decline with scepticism…
