Global equity markets have sold off sharply in the past couple of weeks on a potent combination of worries surrounding US growth, skepticism about the corporate outlook, disruption of the yen carry trade, and rising geopolitical tensions – not to mention rapidly changing developments in the US political landscape – against a backdrop of increasingly elevated valuations, particularly for growth stocks.
The S&P 500 has fallen nearly -9% (as of 8/5/24) from its mid-July highs, while the Nasdaq Composite is down an even sharper -14%. The US Treasury market has been quick to price in significant Federal Reserve (Fed) rate cuts, and futures markets are pricing in roughly 100-150bps of cuts by December, compared to expectations of three rate cuts (totaling 75 bps) prior to the recent market turmoil. Consequently, the two-year Treasury yield has dropped sharply to 3.88% from 4.74% a month back, while the 10-year yield fell to 3.76% from 4.43%.
Markets spent a good part of the first half of 2024 worrying that inflation was not only sticky, but remained well above the Fed’s 2% policy rate target. Nevertheless, the Fed’s tightening measures over the past two years began to take hold, slowing the economy, with GDP growth moderating to 2.1% in H1 2024 from a 2.5% pace in 2023 and beginning to put downward pressure on inflation. With the Fed data dependent in starting the rate cut cycle, the markets were in “bad news was good news” mode through mid-July as slower growth data was seen as confirming Fed rate cuts. The Citigroup Economic Surprise Index was at its lowest level in nine years in early July, even as equity markets rallied.
But more recently, bad news has again become bad news as a combination of corporate and labor market data contributed to the sharp equity market sell-off during the past couple of weeks. Initial unemployment claims, which are seen as an early warning sign for the health of labor markets, have risen to around 250,000 from 194,000 in early January. The July employment report was consistently weak, with both the household and establishment surveys pointing to labor market weakness and the unemployment rate rising to 4.3%, triggering the closely watched Sahm rule for the onset of a recession.
While recent US labor market data have raised the specter of recession, expectations are for growth to come in around 1.5% in the second half of the year. PGIM Quant’s NLP-based recession sentiment indicator has picked up the recent growth concerns with sentiment deteriorating. However, current levels are still consistent with those seen at the beginning of the year and well above the lows seen during the growth scare of 2022. While there are still risks to the consumer outlook, our assessment is that recession risks have gone up modestly, while the equity market sell-off and bond rally are more in line with a sharp downturn in the economy.
Meanwhile, the corporate outlook has also come under increased scrutiny despite stronger-than-expected corporate results for many companies in the S&P 500. There has been increased skepticism about capex by large technology companies and their ability to monetize these investments. Some of these concerns manifested in a rotation away from large-cap tech into small cap, even before the sell-off. The bevy of bad news, including NVDIA’s chip delay, Intel layoffs, and Alphabet’s adverse Department of Justice ruling, has added to the pressure on markets.
While it is still early days to judge the success or failure of firms’ ability in monetizing AI-related investments, current expectations are for the Information Technology sector to post mid- to high-teens earnings growth in the next four quarters. S&P 500 earnings expectations for upcoming quarters have been revised lower in the past several weeks in anticipation of the growth deterioration. Earnings growth from H2 2024 to H1 2025 is now expected to be approximately 12%, down from around 14% in early July. Revenue growth expectations over the same period are still solid at around 5%. And despite some recent comments from company management, PGIM Quant’s transcript sentiment has improved further during the current earnings season and remains well above the levels seen during 2022 in the midst of growth concerns. While it’s still possible for expectations to come down sharply or for firms to cut payrolls and adopt other cost reduction measures to protect margins, current expectations seem consistent with an environment of moderate growth. Despite the post-sell-off improvement, valuations are still elevated and it remains to be seen if they justify the expectations of ongoing capex translating into earnings.
Another driver of the intense volatility has been the fallout from the Bank of Japan’s (BoJ) rate normalization process. The yen had already started rallying in early July on the back of soft US inflation data. This rally only intensified over the month as US growth fears took hold, finally driving the hawkish BoJ to hike rates in late July, resulting in a sharp unwinding of carry trades. Some sell-side reports suggest that there has been significant unwinding of positions by risk-control and CTA funds, which had been positioned significantly long going into this period of turbulence. This all seems to be reflected in the swift repricing of risk assets seen recently, but there could still be more pain to come.
On the fixed income side, Treasuries have rallied sharply, having priced in significant Fed rate cuts on recession worries. Even as recently as the July FOMC meeting, Chair Powell had maintained that the Fed will be data dependent and not data point dependent. We expect Fed officials to jawbone markets in the run-up to its Jackson Hole meeting, setting the stage for signaling the start of rate cuts at Jackson Hole. It remains to be seen (from the September SEP) to what extent the Fed agrees with the extent of rate cuts that are currently penciled in by the markets. With Treasuries rallying sharply over the past month, it’s possible that yields are towards the bottom of their range for now. With equity-fixed income correlations normalizing from the strongly positive correlation seen over most of the past few years, we expect asset class diversification to benefit portfolio construction going forward.
As we approach the November US presidential election, we are likely to see increasingly defensive positioning and listless markets. Despite the sharp sell-off we have seen in risk assets in the past couple of weeks, the broader macro environment and corporate outlook still remain supportive, so risk assets could stabilize and perform well over the rest of the year.
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