Recent Equity Market Declines

Equity Market Declines

Equity markets have declined sharply since peaking on July 16^th.  From July 16^th through July 31^st, the declines were orderly (down 2.0%) and driven more by a rotation from US large-cap equities into smaller-cap and non-technology stocks, both of which are perceived to benefit more from interest rate reductions.  However, the declines since the end of July through August 5^th have been swift and widespread.  The MSCI ACWI Index declined by 6.4% over three trading sessions (down 8.3% since July 16^th peak), and the declines have been consistent across all major regions (in USD terms), with US large-cap stocks, international developed equities, and emerging markets equities all down between 6.1% and 7.4%.  US small-cap stocks have reversed their July outperformance and are down 9.5% since month end.  These equity market declines largely followed the much weaker than expected US July jobs report, which was released the morning of August 2^nd US EST time.  Following this report, investors sold equities and further flocked to bonds with 2-year and 10-year US Treasury yields declining by 35bps and 25bps respectively. 

There are three main reasons driving these swift moves:

Increased fears of US and global recession:

The recent US jobs report indicated 113K jobs were added in July, far lower than the 178K estimated.  The unemployment rate increased from 4.1% to 4.3% (for reference, the low was at 3.4% earlier in 2023).  One should caution that monthly job reports have been highly volatile and subject to large revisions.  Having said that, the trend over the past several months has clearly indicated a cooling US labor market.  Furthermore, the recent unemployment data triggered the “Sahm Rule,” a measure which indicates that increases of more than 50bps in the three-month average of the unemployment rate within a twelve month period has historically led to recessions within the next six to twelve months (it should be noted that other statistical measures have also suggested recession over the past 18 months, but that has not materialized thus far).   In addition to the jobs report, US manufacturing data (ISM index) weakened further in July although services data strengthened.  Finally, European economic data has slowed recently, and China is experiencing slower growth with the government yet to dramatically increase stimulus.  Taking everything into account, investors are more nervous about a US / global recession rather than the Goldilocks scenario previously envisaged.

Unwinding of the levered Japanese Yen carry trade

Global investors have long employed this trade to enhance returns. Essentially, investors borrow in a currency such as the Yen where interest rates are cheap and use the borrowed proceeds to invest in a variety of other higher-returning asset classes, typically in other currencies.  These trades are typically highly leveraged, amplifying small changes in the underlying legs of the trades.  As the Bank of Japan held rates at extremely low levels in contrast to other central banks which raised rates significantly, the Yen sharply depreciated vs. major currencies, especially the USD.   Following the jobs report and other generally weak US and European market data coupled with hawkish Bank of Japan actions, the Yen has surged rapidly vs. the USD.  Yen weakness peaked vs. the USD on July 10th at 161.69 JPY/USD. The Yen then appreciated to 143.40, a 13% strengthening in less than a month, effectively increasing cost of repaying Yen borrowings.  While most of the appreciation occurred in July, the recent US jobs report and other soft US data may have stoked panic regarding further Yen strengthening potential.  As such, traders have been rapidly unwinding the short yen positions and liquidating other assets including global equities.

Questions regarding AI’s near-term benefits vs. high costs

During 2023 and through Q2, US large-cap technology stocks had benefitted sharply from AI-driven enthusiasm.  Semiconductor companies (NVIDIA, Micron, Broadcom) benefitted substantially as did cloud hyperscalers and internet companies (Microsoft, Amazon, Meta, and Google).  Operating fundamentals were also very strong for these companies as demonstrated by exceptional YOY earnings growth from Q2 2023 through Q1 2024.  However, while companies are spending aggressively on AI infrastructure and solutions, the benefits have yet to broadly manifest themselves across software providers and a wider range of industries.  With YOY earnings growth comparisons becoming much tougher, Magnificent Seven’s earnings growth premium relative to stocks from other industries was expected to slow.  In their Q2 earnings reports, several of the Magnificent Seven flagged continued high AI spend while some had difficulty quantifying expected revenue and earnings benefit.  As such, investors had been rotating equities away from the Magnificent Seven even prior to the weak jobs report.  Given the high concentration of the Magnificent Seven in equity indexes (31% of the S&P 500 and 19% of MSCI ACWI), weakness in these stocks affects broad market measures significantly (on a weighted average basis, the Magnificent Seven are down 9.0% since July 31^st and 18.0% from the July 10^th peak).     

Initial BCA Thoughts

Our initial view is that the market is going through a well-deserved pullback.   Valuations had become stretched and Magnificent Seven earnings dominance was moderating both on an absolute and relative basis, making a rotation from these stocks into other sectors and small-caps more likely.  Recent US economic data coupled with lackluster data from Europe and slower-than-expected Chinese economic growth (and the absence of blockbuster stimulus) has certainly increased chances for recession.  However, we point out the following counter arguments for why a recession is still not the base case.

• US economic growth has been solidly positive in H1 and improved in Q2 relative to Q1 (GDP growth of 1.5% in Q1 and 2.8% in Q2). Consumer and corporate balance sheets are still strong and are in far better shape than prior to the GFC.  Upper-middle class and wealthy consumers are still spending vigorously.  
• While the US labor market has cooled, layoffs are not accelerating. Rather, hiring has slowed while the surge in immigration over the past two years has largely driven the increase in the unemployment rate.   Thus far, the labor market is still strong but decelerating.
• There are no obvious bubbles. While equity valuations are high, they are not egregious as they were during the tech bubble in 1999.  Furthermore, there are no housing bubbles or excessive consumer or corporate leverage.
• Corporate earnings performance was strong in Q2 with the S&P delivering 11% YOY earnings growth thus far in the reporting season. Importantly, earnings growth was not just limited to the Magnificent Seven but broadened across other companies beyond the technology and internet segments.   While quarterly earnings are backward looking, guidance was relatively strong as well, and analyst revisions have generally been positive. 

As such, at this point, we view this market pullback as a healthy correction rather than the beginning of a bear market.  The recent sharp declines have been exacerbated by unwinding of levered trades and de-grossing by hedge funds.  Notably, caught up with the Yen carry trade, Japan’s Nikkei stock index has had the largest decline since mid-July, including the largest single-day drop yesterday which has largely been erased today.  While it is impossible to pinpoint when exactly this type of unwinding ends, historically it occurs rather swiftly and ends just as abruptly.  Often, relatively swift equity markets rallies follow over short time periods.

Finally, we do not think the Fed will make an emergency rate-cut intra-meeting.  Economic data has been decent with some positives and negatives, and it is difficult to draw conclusions from one month of volatile employment data (especially given the Hurricane Beryl disruptions).  However, we do think it is now easier for the Fed to cut by 50bps in September and then by an additional 50-75bps over the remainder of the year assuming that inflation continues to moderate as it has for several months.

Investment Implications

We generally do not make short-term predictions regarding equity market movements.  Our best guess is that markets may experience a short-term rally once the levered trade unwinding ceases.  In our recent quarterly piece, our base case was that the S&P trades within a 5,300 to 5,800 range 12 months from now (vs. a 5,585 reference price on July 11^th).   We still think this is the most likely outcome although we acknowledge that the chances of a 20%+ market drawdown have increased.   We further flag that should the Goldilocks scenario unfold, the rotation towards small-cap and non-technology sectors is likely to continue as the relative earnings growth of mega-cap technology and internet stocks is set to slow while their relative valuations are expensive compared to history.

• We do not advocate that investors change their equities exposure. At 20.0x forward earnings, S&P 500 valuations are still above historical averages of 16.5x and last-ten year averages of 18.1x.  International equities trade at modestly lower valuations relative to history.  However, their underlying earnings volatility and range of outcomes is much higher compared to the S&P 500.  Should equity market declines intensify, we will circle back with recommendations regarding attractive entry points from a mid-term perspective (7-year outlook).
• We no longer find government bonds (especially longer-term maturities) overly attractive given the recent sharp declines in interest rates. The 10-year bond is now yielding 3.78%, down from its April peak of 4.72% and June 30^th39% level.   We believe that the 10-year will likely trade in a range of 3.5% to 4.5%, and thus further reduction in yields is relatively limited. 
• We recommend that investors stay the course and continue allocating to private investment strategies where appropriate. It is important to build appropriate vintage year diversification, and several private investment strategies such as secondaries are highly compelling given the current environment.