Market Turbulence Following Weak U.S. Jobs Report and Surprise Rate Hikes in Japan
What just happened?
- US Jobs report release on Friday was weaker than expected with only 114,000 new jobs added in July, compared to expectations of around 175,000
- The report triggered the ‘Sahm Rule’, a recession indicator
- Equity markets reacted negatively with the Nasdaq falling 2.4% on Friday and 3.4% for the week
- US tech stocks felt the brunt of the volatility
- Japan's surprise interest rate hike caused havoc for the stock market and carry traders
What the Jobs Report triggered?
Equity markets reacted very negatively to the jobs data, with the Nasdaq falling 2.4% on Friday and 3.4% for the week. The S&P 500 and Dow also saw significant losses but less pronounced losses and other so-called cyclical like small caps and emerging markets. This is important as it suggests that the things that have fallen the most (US tech stocks) were just too expensive and have become sensitive to just about anything going wrong. If it was just about ‘fundamentals’ and the economy, then these cyclicals would presumably be expected to fall by more.
On top of, but very much related to the success and expensiveness of these stocks, is a broad church of so-called ‘technical factors’ that include crowded hedge fund positioning, day traders and the tendency for liquidity to ebb-and-flow amongst the largest most liquid stocks. Bond yields plummeted as investors rushed to safe havens, with the 10-year Treasury yield falling 19bps on Friday alone.
Why has the Jobs report triggered this movement?
Recession fears were amplified when the jobs data pushed up the unemployment rate enough to trigger the "Sahm Rule" recession indicator. The rule states that the economy is in a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months.
For example, if the unemployment rate's lowest point in the past year was 3.5%, and the three-month moving average of the unemployment rate subsequently rises to 4.0% or higher, the Sahm Rule would indicate that the economy has entered a recession.
The Sahm Rule is designed to be a simple, real-time indicator that can identify recessions more quickly than the traditional method of waiting for two consecutive quarters of negative GDP growth. It is based on the observation that the unemployment rate typically begins to rise significantly at the onset of a recession. However, Claudia Sahm herself has acknowledged that in the context of noisy post-COVID data it might not be as reliable as it has appeared in the past.
Why does an interest rate hike in Japan matter?
The next shoe to drop was in Japan where the strengthening yen in the wake of the Bank of Japan's surprise interest rate hike, caused havoc for the stock market which was already down around 10% in the preceding weeks. The Nikkei fell over 5% last week and then plunged nearly 13% on Monday, its worst day since 1987, as the unwinding of popular yen carry trades forced investors to cover short yen positions.
The yen surged 4.7% against the dollar over the week. The market has recovered by almost 10% today local currency terms but remains almost 20% of its peak. Significantly for Australian investors, our high yielding local shares often provide the other leg to the carry trade which contributes to the pro-cyclicality of the Australian dollar and some of the selling pressure on our local shares (when ‘carry traders’ unwind their positions to buy back Yen and sell the higher yielding assets). This is another ‘technical factor’ which has, with exquisite timing, coalesced with the ‘technical’ of the US highly strung US market.
There are other reasons why our currency depreciates in times of economic malaise and stress (if companies expect to make less things they need less AUD to buy iron ore for instance). This means that unhedged overseas equities (or, in other words, exposure to other currencies) can provide a cushioning effect which is exactly what has happened in recent days.
What does it mean for clients?
As markets draw to a close on Wednesday, things look a more settled and it is important to note that a diversified investor with 70% in growth assets will be only slightly in the red for the Financial Year to Date (the 5 weeks since 30 June) and is probably still up by well over 5% for the calendar year to date. This underscores the fact that not only is there large technical element to the volatility (that could disappear as quickly as it appeared) but at a portfolio level it has not yet been a big issue.
These charts also show that there are imp differences between what passive funds typically invest in (sometimes for historical reasons) and how a composite market benchmark that we construct ourselves looks like (taking into account nuances like emerging markets exposure for instance). They clearly become less subtle in times of stress, and we have shown the difference as we think other nuances around diversification and active management are likely to become apparent in the next few days as we get unit pricing for fund holdings. Looking at the performance of shadow portfolios there is already considerable evidence that many active managers that leant against the effervescent markets of recent months have done remarkably well in recent days. In that sense much of these ructions fell like market gravity and not necessarily something to lament.
So, what now?
Today some respite has come from the better-than-expected US ISM Services data on Monday, which helped calm fears that the US is already in recession, or at least the extent of it. Fed officials also signalled they would respond if the data continued to deteriorate, and markets are now pricing in a high likelihood of a 50bp rate cut at the September FOMC meeting.
Other key events included the Bank of England implementing a 25bp rate cut despite division on the committee, and the RBA keeping rates on hold as expected. China's Caixin Services PMI also provided a positive surprise, jumping to 52.4.
Overall, recession fears are becoming increasingly prevalent, but the picture is mixed. Further volatility seems likely as markets continue to react to incoming economic data and central bank actions in this uncertain environment. The week (ahead sees US CPI data which will be closely watched for its implications for Fed policy.
Looking ahead, markets now expect the US Fed and RBA to start cutting rates in early 2025 as economic growth potentially slows. This is a notable shift from expectations just a few weeks ago and could provide some relief to tense areas like the corporate loan market. In Japan, markets actually expect lower rates long-term compared to the start of the year.
From a valuation perspective, the recent market pullback has made forward-looking returns look more reasonable, especially in oversold markets like Japan. For long-term investors, the margin of safety has improved compared to six weeks ago (as witnessed by the recent uptick in long-term expected returns implied by our recently updated Valuation Dashboard – see chart below). Overall, while concerning, the dramatic moves in early August seem to be driven more by technical factors unwinding previously stretched positioning rather than a fundamental shift in economic trajectory. A steady outlook seems warranted for now, but the situation remains fluid.
