Market Fears Are Overstated: Stay Active Amid Volatility
Dissecting the drivers
Recent risk-off market moves, marked by equity losses, modest credit spread increases, a rally in government bonds, and a rise in safe-haven currencies, are largely due to concerns over the US economy's strength. These worries have been fueled by a faltering labor market and weak business surveys. Additionally, the initial enthusiasm for AI investments has given way to skepticism about their financial and economic benefits. Other factors include diminished expectations for pro-growth policies post-US election, geopolitical uncertainties, and the reversal of certain trades during the summer's low liquidity period.
Staying data dependent
The July US labour market data were disappointing, with only 114k jobs added compared to the expected 175k, and a 0.2% rise in unemployment to 4.3%, marking the fourth month of increase. Yet, this uptick, mainly from temporary layoffs, could be short-lived, especially as new immigrants enter the job market. Importantly, as emphasized by Fed Chair Powell, we should consider broader data sets over single data points. Encouragingly, our current activity indicator, which offers a real-time snapshot on growth by aggregating various high-frequency data points, suggests a managed slowdown in growth to about 1.2%, down from an annualized pace of 2.8% in Q2, but still well above recession levels.
Positioning for policy shifts
While the extent and pace of central banks' easing measures are evolving, the message for investors is clear: interest rate cuts have started and will likely expand, benefiting fixed income assets and making bonds more appealing than cash. In the US, we think a 50-basis points Fed cut in September is plausible, followed by potential 25 basis points reductions in November and December. Current economic data do not warrant unscheduled Fed rate cuts or adjustments exceeding 50 basis points. However, it is noteworthy that the Fed has a 550-basis points buffer to lower rates to support the economy, if necessary, a significant increase from the 175 basis points available before the pandemic and also higher than the 525-basis points before the Global Financial Crisis.1
Adopt an active, selective and opportunistic approach
In a market swayed by non-fundamental factors, discerning reliable return sources is key. For fixed income, it's important to choose carry exposures that can withstand volatility. In equities, especially tech, where mixed earnings and scrutiny over AI spending have impacted valuations, it's essential to look beyond surface-level data. Tech stocks, previously trading at a significant premium, have seen corrections, making them attractive again. Specific news within the semiconductor sector, such as Apple's AI rollout delay and NVIDIA's AI chip release postponement, has raised concerns, yet the overall tech fundamentals remain strong. Opportunities continue to arise, particularly around generative AI. In large indices, overvaluation may lead to a shift towards small caps, which offer wider economic exposure. While a dimming US economic outlook poses challenges for equities, European small caps may be less affected due to their domestic focus. Emerging market equities have shown resilience amidst global uncertainties.
Monitor market and macro moves
The Fed’s impending rate cuts should bolster the economy, in our view, and current financial stability is indicated by moderate delinquency, downgrade, and default levels. However, Q2 earnings commentaries have raised concerns, especially among lower-income consumers, which deserve attention. The labor market's condition is increasingly critical for the Fed's policy decisions, as employment and income growth are vital for consumer spending, a key economic driver. We're closely watching labor market data, with a focus on the August jobs report and initial jobless claims, though these may fluctuate due to seasonal factors. Geopolitical events, particularly in the Middle East, are also under scrutiny for their potential impact on markets and inflation. In Japan, recent equity market volatility seems driven more by currency strength affecting exporters than by a sharp change in economic conditions. The Bank of Japan's policy adjustments supporting the yen suggest that high-quality Japanese stocks may experience stable growth and possibly outperform, as inflation levels out, other countries' rate cut cycles progress, and the yen remains strong. Major indices moved higher on August 6, with the Nikkei 225 recouping part of its losses.
Navigating A Complex World
Finally, we note that navigating the post-pandemic economy is complex, with several factors influencing the US economy's trajectory over the past several years. These include fluctuating consumer spending between goods and services, a rise in immigration and structural changes such as deglobalization alongside the application of generative AI across various sectors. These dynamics have generated volatility in economic data, which may continue as they evolve or stabilize into a new normal. In this environment, we believe active investment strategies, a focus on diversification and strong risk management capabilities will be important to navigate volatile market environments and help deliver alpha. For now, our Mid-Year Outlook investment conclusions remain valid: maintain focus on fixed income, expand equity horizons, and seize evolving private market opportunities.
1 Source: Macrobond. Based on upper-end of the Fed funds rate as of August 2024, February 2020 and September 2007, respectively.