- Global Investment and Multi-Asset Strategist
United Kingdom, Institutional
Change
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The broad market sell-off is still evolving, but it’s a good moment to review the catalysts, the technicals at play, the fundamental picture, and what, if anything, allocators could consider doing. As of this writing, over the past three days, the Nikkei was down 20%, the yen was up 4.5%, the S&P 500 was down 4%, high-yield spreads were wider by around 50 bps, and the US 5-year Treasury yield was down around 35 bps. Bottom line: I think markets have overreacted relative to the fundamental backdrop.
Catalysts — As is often the case with significant sell-offs, this one has been driven by a confluence of factors. At the top of the list is the increase in the US unemployment rate from 4.1% to 4.3%, the Bank of Japan rate hike of 15 bps, and fear of a policy error by the Fed after it opted not to cut rates at last week’s FOMC meeting. Other concerns include some megacap tech earnings disappointments, the expanding Middle East conflict, and lower odds of a Trump presidency after Kamala Harris entered the race as the likely Democratic candidate.
Technicals — A long period of benign, trending markets can encourage investors to add risk. But when volatility spikes and trending markets reverse direction, forced selling may be triggered, which can exacerbate the moves as selling begets more selling. Selling by hedge funds and systematic strategies appears to have played a large role in the magnitude of the sell-off. Hedge fund gross leverage has been running at higher-than-normal levels. So-called “CTA” and “vol-managed” approaches, which “automatically” de-risk during sell-offs, seem to have played a sizeable role. Also, yen appreciation caused unwinds of yen carry trades where the cheap yen is sold to fund investments in higher-yielding instruments.
Fundamentals — The US employment picture has been weakening but is not, in my view, cause for panic. A host of indicators have been showing the labor market normalizing from overheated conditions, including fewer job openings and lower quit rates, slower hiring rates, and lower wage increases. As of this writing, 75% of companies have reported Q2 earnings, which have surprised to the upside across all sectors. The consumer sector has disappointed as consumers, especially the lower income cohorts, have gotten squeezed by high prices and are pulling back. We are watching credit card data, which suggests that consumer weakness has been migrating to higher-income consumers. As noted, tech earnings have been closely scrutinized and there have been some disappointments relative to expectations, but the long-term earnings growth trajectory remains intact in my view.
Investment implications
- While there has been some deterioration in fundamentals, I think the sell-off is being exacerbated by technicals. Central banks are also in a good position to lower rates and cushion the economy should fundamentals deteriorate meaningfully. On balance, I think this could be an opportunity to add risk in equities and credit, though it’s important to be mindful that technicals will need some time to normalize.
- The rally in US rates may warrant a pause in long-duration positions. Given that almost 125 bps of rate cuts are being priced by year end, I would consider turning neutral on duration and waiting for a better entry point to go long again.
- The sell-off in Japanese equities, in particular, seems like an overreaction to the BOJ’s rate hike. I would consider this an opportunity to gain exposure to this market.
- Remember the long term. While volatility can be unpleasant, these are also times to step back and consider what has really changed. To the extent that fast-acting players or strategies are forced to sell, this can be viewed as an opportunity for allocators with multi-year investment horizons.
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Andrew Heiskell
Nicolas Wylenzek