Global stocks have swept higher since the start of this year, defying almost universal expectations of a decline and stirring fears that complacency has been setting in among investors. This week suggested those fears are well-founded.
Growth worries in Europe, monetary policy shifts in Asia, and nerves over rising bond yields and the government’s credit rating in the US combined to cause one of the worst weekly sell-offs in stocks so far this year.
The declines were still fairly modest — the MSCI World index dropped 2.3 per cent overall — but it was still the worst week since March. Wall Street’s S&P 500 suffered its first one-day decline of more than 1 per cent since May, and the Vix index of expected future market swings rose to its highest level since May.
The volatility marked a sharp contrast with the atmosphere barely a week ago, when consensus was converging on optimistic predictions that central banks were almost done lifting interest rates and the Federal Reserve was on track to deliver a soft landing — the rare feat of bringing inflation under control without causing a recession.
“Yes, a soft landing is more likely,” said Keith Balmer, multi-asset portfolio manager at Columbia Threadneedle Investments. “But I think everyone [was] maybe getting a bit ahead of themselves.”
Most big investment houses and bank analysts started the year with a negative, or at most neutral, outlook on US stocks. They assumed the historically aggressive campaign of Fed interest rate rises would inevitably hurt companies, households and growth. Many took the low level of long-term US government bond yields in relation to shorter maturities — the so-called inverted yield curve — as a sure-fire sign of recession ahead.
In hindsight, it now appears the weight of that consensus was overwhelming and that those concerns over Fed excesses had already been reflected in last year’s 19 per cent drop in US and global stocks.
Instead, by the halfway point of 2023, US and global stocks were up by 14 per cent, led by a scorching rally in a clutch of tech stocks, particularly those linked to the development of artificial intelligence. Even Europe — a perennial underperformer in global markets — had ground out gains of 9 per cent in the Euro Stoxx 600 index while Japan’s Nikkei 225, which has frustrated optimists for decades, had gained almost 30 per cent.
The increasingly rosy outlook on inflation, particularly in the US, has been the driving force, bolstering expectations that interest rates are, in most countries, at or close to their peak. Generally, investors would expect that means bond yields will stall or fall, making it easier to justify buying riskier assets.
Some of the most prominent pessimists started to believe their bearishness had missed the mark. Nomura noted this week that hedge funds with negative bets on stocks were capitulating at a “substantial” pace.
Morgan Stanley’s Mike Wilson, who had long predicted a reversal in the S&P 500, also wrote that “our more bearish views on the broader US equity market have been wrong this year”.
Derivatives markets also highlighted the extent of the positive consensus — and the risks. By some measures, the price of hedging against a decline in the S&P 500 last month hit its cheapest level on record. Nitin Saksena, Bank of America’s head of US equity derivatives research, said the drop reflected a widespread belief that any recession would be “shallow and shortlived” if it arrived at all.
But it also suggested the upbeat environment was starting to seem a little overdone. BofA argued in a note to clients that “we find it sensible to buy” the cheap protection.
“There’s a lot that is unknown — you can see it in the [economic] data volatility and the challenges of forecasting, but it seems to have been increasingly lost on the market and equity investors,” Saksena said.
“The towel throwing seemed to be a classic case of a change in price causing a change in sentiment,” said Kevin Gordon, an analyst at Charles Schwab. “Investors started to chase the rally more aggressively about a month ago. That, in our opinion, was the last item on the checklist of froth.”
Some of the froth has been knocked off this week as several factors punctured the feel-good vibes. On Tuesday evening, Fitch Ratings cut the US government’s credit rating, an announcement which knocked confidence despite being dismissed by many as a backward-looking and relatively meaningless change.
The US also raised its debt issuance target for the coming quarter, with the prospect of increased supply driving the 10-year Treasury yield to its highest level in nine months. Higher yields reflect lower prices, and make riskier assets like stocks less appealing.
Meanwhile a policy change from the Bank of Japan damaged another pillar that had been helping to prop up risk assets. The central bank late last month relaxed its cap on local bond yields, encouraging Japanese investors to bring cash home at the expense of other markets.
“The adjustment to yield curve control is a significant development. The Bank of Japan has provided a global anchor to yields which is now being adjusted,” said Jean Boivin, head of the BlackRock Investment Institute. “Part of the soft landing discussion has been a view that rates are not going up much. I think the BoJ decision questions that part of the soft landing hopes.”
Boivin argued that the global economy has entered “an environment that is intrinsically more volatile from a macro perspective than what we’ve been used to for a long period of time”, a trend which is likely to lead to more volatility in markets even if the optimistic soft landing scenario eventually occurs.
The latest data on the strength of the US labour market on Friday highlighted the uncertainty. Jobs growth was weaker than forecast for a second consecutive month, which would seem to point towards a gradual reduction in labour market tightness and an economy heading for a soft landing. But the unemployment rate and wage growth were both stronger than expected, which could be seen as a sign the Fed will need to be more aggressive with further cuts.
With policymakers currently highly sensitive to economic data releases, even snippets of information on the health of the economy can generate outsized market reactions. That risk is particularly acute over the summer, when trading volumes are lower.
“This is the summer. Volumes are low, and people are nervous because markets have had a great run,” said Patrick Spencer, vice-chair of equities at Baird. However, he stressed that “it’s normal to have a correction of 3 to 5 per cent”, and remained confident that stocks were firmly entrenched in a new bull market.
Paul Donovan, chief economist at UBS Global Wealth Management, said some efforts at pinning rationales on to short-term market moves are a form of summertime “silly season”. But he added that an important reality is sinking in: “Equity markets have stressed the ‘soft’ part of an economic ‘soft landing’ scenario,” he said. “Perhaps equity markets are finally listening to economists, who note that a soft landing is still a landing.”