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 may want to consider doing. As of this writing, over the past three days, the Nikkei 225 Index1 was down 20%, the yen was up 4.5%, the S&P 500 Index2 was down 4%, high-yield spreads3 were wider by around 50 basis points (bps),4 and the US 5-year Treasury yield was down around 35 bps. Bottom line: I think markets may 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 (BOJ) rate hike of 15 bps, and fear of a policy error by the Federal Reserve after it opted not to cut rates at last week’s Federal Open Market Committee meeting. Other concerns include some megacap tech earnings disappointments, the expanding Middle East conflict, and lower odds of a second term for former President Donald Trump after Vice President Kamala Harris entered the race as the likely Democratic candidate.
Technicals — A long period of benign, trending markets is an encouraging sign for investors looking 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 (FIGURE 1). 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 isn’t, 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 that 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’re watching credit-card data that suggest 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.
