What's suddenly spooked markets?

How did we get here?

For months the market narrative has been focused on a soft landing for the global economy, especially in the US. While there was some evidence that the ‘perfect trilogy’ of healthy growth, slowing inflation and gradual rate cuts was possible, we viewed this as a narrow path – one that was vulnerable to being blown off course.

In equity markets, the trend was your friend. Momentum – buying equities that were rising and selling those that were falling – was a popular strategy for many stock investors. Underpinning this extraordinary gain were the persistent increases in tech stocks and weakness in areas such as US small caps and more defensive sectors.

That trend had not been as evident in other asset classes. Credit spreads had tightened to levels where we believed they were approaching a realistic floor. Bond yields wavered with the ebb and flow of central bank rhetoric. The Japanese yen was an exception, persistently weakening, reflecting the wide gap between Japanese interest rates and the rest of the world.

This all changed, starting in mid-July.  

What triggered the change?

It’s hard to pin this on any single event, but we have a few culprits. Recent weeks have seen a subtle but important shift in some of the assumptions investors held in building up significant – in some cases leveraged – positions in a concentrated selection of trades.

1. There is something almost inherently tricky about gains driven by momentum. If the best reason to buy something is, in essence, because everyone else is doing so, any shift in the assumptions underlying the winning trades can precipitate a rush for the exits
2. The valuation gap between big tech stocks and small caps had been consistently widening, with some investors baulking at the difference. With the Magnificent 7 stocks* around four times larger in size than the entire Russell 2000, a small change in preferences led to a huge rally in small caps in July. More recently, a number of US tech companies, notably Amazon* and Intel*, reported earnings numbers below expectations, undermining the core belief in the first half of the year that tech could outperform come what may
3. In Japan, policymakers moved, first through currency intervention and then rate rises, to counter the persistent drift lower in the yen. Not only did this challenge the direction of what had been a momentum trade, it also undermined the carry trade (borrowing in a low-yielding country to invest in higher-yielding assets elsewhere)
4. Back in the US, the flow of macro data has clearly disappointed investors. Most notably, nonfarm payrolls missed expectations last week, dashing hopes for a ‘soft landing’ and triggering a much-publicised recession indicator called the ‘Sahm rule’. Despite holding off from a rate cut just last week, markets are now expecting the Federal Reserve to rapidly cut rates in the coming months to fight back against recession concerns

The combination of these events has driven a significant and self-fuelling cycle of price declines and forced selling across equities and credits, with the traditional safe-haven assets of government bonds and defensive currencies – including the Japanese yen – moving equally sharply the other way.  

What’s the impact for investors?

For many investors, portfolio risk is likely to be dominated by equities. There is little escaping the fact that a sharp drop in stocks is likely to be painful for equity-heavy investors. Credit markets are also showing sensitivity, with spreads widening from very low levels to year-to-date wides.

For multi-asset investors, however, there has been reassurance among the chaos. Unlike the broad-based, inflation-induced sell-off in 2022 that dragged both equities and bonds lower, this more classical growth-driven sell-off has seen government bonds cushion the blow by moving in the opposite direction.

Yields have fallen sharply, even in Japan. US 10-year yields have fallen by over 0.50% in two weeks; UK gilt yields have fallen by around 0.40%. Many alternative and defensive equities have also fared better, with the likes of listed infrastructure outperforming relative to what might typically be expected when equities fall so sharply.

What’s next?

It’s notable that geopolitics hasn’t played a part in this bout of volatility, but as many investors know, there are plenty of potential flashpoints around the world that could potentially add to the volatility in markets.

Meanwhile talks of a possible recession are bubbling among investors. While we have long believed the path to soft landing was fragile, and the economic data was starting to sour, we don’t yet believe the fundamental bedrock that is supporting the economy has been truly shaken.

There is a risk that some areas of the market might quickly move from pricing an overly rosy picture of the economic outlook to an overly negative one. Our economists note that while the data in the US has been slowing for some time, one payroll number (itself weather-affected) should not itself plunge the US into recessionary conditions. But forecasting recessions is notoriously difficult, and rather than focus on one outcome, we continue to see a broad range of potential macroeconomic scenarios ahead of us.

We entered this period of volatility with somewhat cautious positioning, including a positive view on government bonds. With yields moving lower so quickly, we have lifted some of that positioning but retain our overall defensive stance.

The return of market volatility has provided investors with a much-needed reminder that chasing momentum at the expense of diversification only works until it doesn’t. Outside of Japanese equity, tech stocks have borne the brunt of the drawdown, exposing the risk of increasingly concentrated equity markets, about which we have been concerned for some time.

As a result, we stay focused on maintaining diversified exposure across a range of asset classes and regions.[1]

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.

[1] It should be noted that diversification is no guarantee against a loss in a declining market.