Macro
This week, the market has dealt with tremendous volatility, most of which was a repercussion of the Bank of Japan’s previous week’s decision (Wednesday, 31st of July) to hike for the second time in 17 years and bring interest rates to 0.25%. This decision made ‘carry-trade’ more expensive, causing Nikkei to sink 8.3% in the following 2 days (-2.49% on Thursday 01/08, and -5.81% on Friday 02/08). The magnitude of change was highest on Friday as a sharp rise in the yen started the unwind of the Japanese yen carry trade, causing panic amongst the momentum traders. Panic spread across global markets and was amplified later that day (Friday 02/08) when BLS (U.S. Bureau of Labor Statistics) reported a disappointing nonfarm payroll increase of only 114k and a 20 bps unemployment rate increase of 4.3%.
Repercussions of unwinding the yen carry trade have rippled through the global markets in a wave of volatility, which started at the end of the previous week but was amplified on Monday after markets fully incorporated negative news. Nikkei declined -12.40% on Monday, dragging down all major global indexes. Wall Street’s ‘fear gauge’, the VIX index, had the highest intraday peak-to-through move in history and achieved the third highest reading (the biggest since the pandemic market crush) to plunge down on the same day. Treasury Market equivalent MOVE Index has increased in just a few days from under 100 (in mid-July, it was in the 90-95 range) to hit 121 on Monday.
What also added to the equity ‘wobble’ was that July’s payrolls reported triggered the Sahm Rule, which dominated financial media commentary over the weekend. The Sahm Rule signals an early recession when the unemployment rate rises by at least 50 bps above the previous month’s low. This triggered a growth scare and led to a sharp decline in risk assets. Markets concluded that the FED has been slow to respond to signs of economic weakening.
This time, however, the rule is more challenging to interpret due to a significant increase in the supply of workers, which impacts the unemployment rate. Supply is driven by increased immigration and boomers re-entering the workforce. Therefore, the labour market is cooling, and unemployment is rising, but this might not signal a recession.
As the deterioration in the economic fundamentals (which began in April) continues, the economic surprise index turned negative, and markets are grappling with how the FED is going to respond. The rolling over of the U.S. economic growth is viewed through the lens of soft-vs-hard landing dynamics. The fears of hard lending come from believing that the Fed is well behind the curve and does not have sufficient appetite for significant rate cuts. Additionally, following July payrolls, many investors are calling for a much faster FED action and accelerated rate cuts.
Wednesday’s jobless claims helped boost investors’ sentiment and recover from a bearish outlook after last week’s labour market report. Jobless claims fell from 250k to 233k, below the expected 247k. On a positive note, the TIPP economic optimism index increased from 44.2 to 44.5. All of this signified that the growth scare from the previous week and the start of this week was overblown.
Wednesday’s jobless claims report helped restore investor confidence, as claims fell from 250k to 233k, below the expected 247k. The TIPP Economic Optimism Index also rose slightly, suggesting fears of an economic slowdown were overblown.
Rates
Last Friday, markets rapidly repriced rates following a weak June U.S. labour market report. The U.S. 10-year yield dropped by 18.5 bps, and the 2-year yield fell by 27 bps. The 2Y-10Y spread, which had been inverted for the longest time on record, briefly turned positive (disinvested) on Monday. That day, the expected rate cuts for this year were revised to 1.17%, implying two large 50 bps cuts and one 25 bps cut across the three remaining FOMC meetings. These rapid changes in yields and rate cut expectations signal a resurgence of recession fears, warning the Fed to lower rates.
The significant rate decline and yield curve steepening were overdone in the short term. This overshooting began to normalize by the end of the week, and rates are likely to recover further next week, with yields slowly creeping back up. We may see some further reversal or a pause over the next week or two. However, after stabilization, a return to bull steepening is possible. Recent updates highlighted the opportunity to extend duration when the 10-year yield hovered around 4.5%. With the market adjusting to economic weakness, a similar opportunity exists around the 4% level.
The correlation between the USD and the 10-year yield is at a record high. As these correlations tend to revert to the mean, the dollar will likely strengthen as the economy weakens and yields drop. This aligns with the “safe haven” theory, where capital flows from risk-on assets to the world’s reserve currency. Given this setup, the dollar will strengthen over the next six months.
One-day yield declines exceeding 15 bps have occurred less than 1% of the time or 65 times since 2000. Notably, 20 instances occurred post-COVID, when bond volatility significantly increased compared to historical levels.
Credit
Credit markets performed well from a risk perspective despite the week’s volatility. High-yield spreads widened from 310 to 380 basis points, a move within one sigma for the month, while Treasuries saw two sigma moves, and the VIX exceeded four sigma. High-yield bonds have since retraced half of the spread widening and are now around 340 basis points.
This week, high-grade bond issuance was led by Meta, which issued $10.5 billion in bonds, pushing 2024’s credit issuance past $1 trillion. As risk flared in global markets, high-yield bond spreads temporarily jumped to their highest level since November last year. Anticipating this correction, credit investors quickly capitalized on the higher spreads, pushing up issuance oversubscription rates of 6 to 7 times—compared to the 3 to 3.5 times average in recent years—as investors rushed to lock in spreads at their highest since 2023.
Credit card delinquencies are steadily rising but remain low relative to historical standards. This trend reflects growing financial stress among consumers, particularly those with cards issued in the past few years, although the overall level of delinquencies is still manageable and remains low relative to historical levels.
In the private credit space, momentum is gathering around “capital solutions” strategies. These approaches rely on a deep understanding of the legal landscape, aggressive negotiation tactics, and a willingness to take on significant risk, often leading to legal battles. Funds employing these strategies are adept at restructuring company debt in ways that favour their positions, a critical skill as more companies face margin pressure from serving increasingly price-sensitive customers.
Investors believe recent rate developments are net positive for credit markets, as the Fed’s expected easing could provide a tailwind. Moreover, there could be a substantial pent-up demand for credit, with $6 trillion still locked in money market funds poised to flow into the credit markets if economic conditions remain stable while interest rates decline.
Equities
After a volatile week marked by a sharp collapse in Japanese equities that dragged down global markets, we saw a rapid recovery, with markets ending close to where they started.
The broad-based sell-off began in Asia, with Japan’s Topix falling 12.2%, erasing all its yearly gains. The Nikkei 225 plunged 12.4% on Monday, its largest single-day drop since “Black Monday” in October 1987. The Bank of Japan (BoJ) was surprised by the market’s reaction to its modest rate hike, but BoJ Deputy Governor Shinichi Uchida reassured investors that no further hikes were planned, helping to stabilize the market. This was extremely effective, as the Nikkei 225 rebounded 10.23% the next day. Positive economic data, such as Japan’s services PMI at 53.7 and a 4.5% year-over-year rise in labour cash earnings, further boosted sentiment. The Japanese yen appreciated 12% against the dollar since its July lows.
The BoJ’s 25 bps rate hike triggered a significant market reaction comparable to the GFC or the global pandemic. However, U.S. equities were less severely impacted. This divergence was driven by technical factors, such as the unwinding of multi-trillion-dollar yen carry trades, which triggered margin calls and a domino effect across risk assets. Investors took advantage of discounted Japanese stocks, with Nikkei 225 Index ETFs and CSI 300 Index ETFs seeing $2.2 billion and $1.4 billion in inflows, respectively.
In the U.S., the S&P 500 dropped 3% on Monday (the worst daily decline since September 2022), with 95% of stocks declining. Nvidia, one of the year’s top performers, fell 15% during early trading before closing down 6%. Despite the worst and best days in two years for the S&P 500, U.S. stocks ended the week largely unchanged. Wall Street’s VIX index, known as the “fear gauge,” jumped to its highest level since the pandemic, peaking above 65 before closing at 38—nearly double the historical average of 20.
By the end of the week, the VIX had retreated to 20.4, and the futures curve reverted, signalling that the worst of the panic was likely behind us. The spread between 2 and 8-month futures visible on the VIX curve below reflects that the equity market remains in stress mode.
In contrast, a few weeks ago, investors’ sentiment was extremely bullish; the VIX was sitting around 12, the most number of stocks had been above the 200 DMA since 2021, and the market had not visited the 50 DMA in over 2.5 months.
Despite heightened volatility and Monday’s intensified sell-off, investors remain bullish. U.S. households and financial intermediaries have record-low levels of liquid investable funds relative to market capitalization (lower than at 2021 and 2000 lows). This reflects heavy market exposure, with little spare cash to support additional inflows. There is a similar picture if we would compare U.S. equity market capitalization to M2 money supply. One, however, must be careful to interpret those numbers as a clear bearish signal. Although investors are very bullish on U.S. stocks, those equity-to-liquidity ratios also result from the success of the long-running bull market, where investors have remained invested for the long term.
The U.S. earnings season is winding down, with over 90% of companies reporting their Q2 results. While 60% of companies reported revenue beats (with an average surprise of 0.6%), and 78% reported earnings beats (with an average surprise of 3.5%), the size of the beats was below average. Q2 S&P 500 earnings grew by 10.8%, but Q3 guidance has moderated to 5.2%, down from the 7.8% expected in May.
Despite most companies having reported, major U.S. bellwethers like Home Depot, Walmart, and Target have yet to release their results.
Amid fears of an economic slowdown, investors remain cautious about potential profit shrinkage, though the likelihood of a hard landing remains low. Volatility might persist until the elections. The equity market responded positively to Thursday’s jobs report, as growth concerns appear to be the main driver of sentiment.
As mentioned in previous updates, August and September tend to be negative due to seasonality. This period often sees earnings revisions deteriorate, which could be particularly dangerous given the stock market’s reliance on a few richly valued stocks, making them especially vulnerable to earnings misses. In contrast, the outlook for small caps, financials, and industrials is more optimistic, while the Mag-7 may struggle to maintain leadership.
Like last week, mega-cap tech stocks have continued to disappoint. However, the outlook remains positive for small-cap stocks, financials, and industrials. With a significant decline in rates expected, there is potential for a 30-40% rally among profitable small-cap names.
From the global market perspective, European equities recovered from last week’s declines, ending the week relatively flat. China’s markets rebounded, especially on Friday, when CPI and PPI data exceeded expectations, lifting investor confidence.
Investors should now focus on upcoming economic data, including July’s retail sales (due Wednesday) and inflation figures (PPI on Tuesday and CPI on Wednesday).