Confusing Times!
Author: Tom McGrath – Chief Investment Officer, 8AM Global
Market Review
It was challenging to make sense of the financial markets last week, which I guess is hardly surprising for a period that saw a failed assassination of a Presidential ‘would be’ and the most prominent tech outage on record. The markets chopped around a lot, but the overall theme was negative. We went into it expecting a continued rotation into small and mid-cap equities, and indeed the Russell 2000 outperformed the broader S&P 500, but scratch a little deeper, and you would see that the Russell US small cap index fell -3.5% from Tuesday, as investors also gave up on this end of the market too. Arguably, the actual rotation last week was more into value as the Dow Jones finished the week higher, but it, too, fell in line at the end of the week.
Bonds were broadly stable but didn’t exhibit any inverse correlation as equities sold-off, and gold and oil remained fairly stable, drifting off a little. The sell-off was also geographically widespread, with the UK, Europe, and even Asia and the Emerging Markets all taking a knock, possibly as nothing substantial came out of the Chinese Third Plenum meeting.
Be careful what you wish for!
I have been arguing for a while that markets, especially US tech, have been running a bit hot this year and that a consolidation or minor pullback would probably be healthy in the long run, and mitigate the risks of a ‘melt-up ‘, but still, it’s nasty as it happens.
What started as a rotation out of large-cap tech and into small-cap seemed to morph into a sell-off of everything last week. At an index level, the falls are nowhere near official correction territory (-10%), but some of the market darlings have entered that realm, with Nvidia down 8.5% last week, now off more than 16% from its peak in late June.
Could the wobble turn into a correction?
For a few years now, the ‘buy the dip’ mentality would have served investors well, and I have a hunch that this wobble could provide another such opportunity. But to challenge that theory and in the absence of any significant economic news out last week (with due apologies to the UK, where we got encouraging softer wage growth numbers, and Europe, where, as expected, the ECB didn’t move rates), I thought I would focus on the US and take a look at what might turn this wobble into a correction. The biggest potential risks are no rate cuts forthcoming, disappointing earnings, lack of liquidity, economic slowdown, and whatever the next ‘black swan’ event is!
So, first up, is there a risk that we don’t actually get any rate cuts?
Here, we can assign a very low possibility of no rate cuts. Inflation has been behaving recently and coming down predictably. Predictably, mainly as the biggest component (cost of shelter) is a lagging indicator, and we have informed current outputs that this will continue to fall. Also, the Fed has a dual mandate, not only to bring inflation down but also to provide employment stability. Unemployment has been ticking up lately (more through a rise in immigration than an absence of jobs), and J Powell is keen to ensure this doesn’t become an issue. He recently said he was prepared to cut rates even if inflation didn’t hit 2%.
With market probabilities almost nailed on at a 100% chance of a rate cut in September, and a chairman who doesn’t like to spook the markets, I think there aren’t going to be any negative surprises on this front. Whether we get another rate cut this year is less obvious. Currently, markets are pricing in one more rate cut before the end of the year, but that probably depends on inflation continuing to behave and/or unemployment spiking. The more pertinent point isn’t so much whether we get a rate cut as the Fed will cut if needed, as we can be comforted from rhetoric that they are very willing to do so if required. That potential alone should support the markets.
Q2 earnings are coming in thick and fast
So far, so good here. It’s early days – with 14% of S&P 500 companies having reported – but 80% have reported a positive earnings per share surprise. Although we have only heard from Netflix from the mega caps, their numbers were good, and the bellwether chip maker TSM also came in with strong results and raised forward guidance. Bank numbers were strong, and it increasingly looks like we will get an increasing number of companies across various sectors delivering results ahead of expectations. FactSet is projecting a growth rate for the S&P 500 of 9.7%, which would be the highest year-over-year earnings growth rate reported by the index since Q4 2021. We will soon hear from the likes of Alphabet, Tesla, Microsoft, Amazon and Apple, with Nvidia due next month, and I think if we get good numbers from them, that might be the news that steadies the ship. Of course, there is a risk of disappointment, but there is probably a greater chance of some investor-calming results.
Liquidity – is everyone already invested?
One of the most significant risks to stock markets, especially when setting new highs, is that no one is left to buy. Even if sentiment indicators are roaringly positive, if everyone is fully invested, it doesn’t take much selling to cause a downward spiral. The sentiment surveys are showing more polarisation; there is still a high degree of bullishness, although bearishness has also risen as the number of neutrals dwindles. But when we look at the amount of money on the sidelines parked in money market funds, it doesn’t suggest any absence of potential buyers. Given that the returns on offer from cash funds are likely to decline as interest rates come lower, I think a few people who have been sat on the sidelines watching the equity markets roar ahead may be eyeing up the recent setback as an opportunity to get in.
Maybe there is a recession coming?
For much of this year, many economists and market pundits have prematurely challenged the strength of the US economy. I am not in that camp, and I have long argued that one should never underestimate the power of the US consumer to continue to do what they do best; namely buy lots and lots of goods and services. I was, therefore, unsurprised to see that US retail sales came in higher than expected last week.
Now, I acknowledge that there is a growing disparity between the ‘haves and have-nots’ in the US and most major Western economies, and for many, higher interest rate payments are exacerbating the debt burden, but in the aggregate, people are increasingly becoming better off as wages are now rising faster than inflation. That greatly explains the increase of cash in money market funds. Given that there is still a high degree of job security and expectations of higher wages, perhaps even a Trump bump if he gets in, we can fairly safely assume the primary engine of the US economy will keep firing.
But there is also a vast swathe of the US population, namely the Baby Boomers, who have seriously benefited from the substantial increase in asset prices and the income they derive from their wealth; including rental income, dividends and interest earned from cash savings. They are moving from accumulators to spenders of their exorbitant wealth or passing it down to their children and grandchildren, who are also spending. The numbers are enormous; over $75 trillion is a rough estimate, which many economists overlook.
Official US GDP figures are lagging indicators; the last number for Q1 was growth at a disappointing 1.4%. We will get the first estimate for Q2 on Thursday, which is expected to be a little stronger. The Atlanta Fed produces a timelier estimate, aptly named the ‘GDPNow’ data series. Although not wildly accurate, this has shown a strong recovery since the beginning of the month, with the latest reading of 2.7% growth. That is hardly suggestive of any imminent recession, quite the opposite, and remember dear reader, that recessions are the most significant cause of market corrections.
Black Swan Event
A quick summary of ‘Black Swan Events’;
A “black swan event” is a term used to describe an unpredictable and rare event with severe consequences. Nassim Nicholas Taleb popularised the concept in his 2007 book, “The Black Swan: The Impact of the Highly Improbable.”
Characteristics of a Black Swan Event:
• Rarity: Black swan events are extremely rare and lie outside the realm of regular expectations. They are outliers because nothing in the past can convincingly point to their possibility.
• Severe Impact: These events have a massive impact on society, the economy, or an organisation. Their effects are typically profound and transformative.
• Predictability in Hindsight: After the event has occurred, people often look back and rationalise it as having been predictable (the hindsight bias), although it was not predictable before it happened.
Examples of Black Swan Events:
• 2008 Financial Crisis: The collapse of Lehman Brothers and the subsequent global financial crisis were largely unforeseen by most economists and had far-reaching consequences.
• 9/11 Terrorist Attacks: The September 11 attacks in 2001 were unexpected and had a significant impact on global politics, security measures, and economic conditions.
• COVID-19 pandemic: The outbreak of the coronavirus in late 2019 and its rapid spread globally had unprecedented health, economic, and social impacts.
Now, given that a Black Swan event is nigh-on unpredictable, it is foolish for me to attempt to speculate on what might cause one this time, but it is worth pointing out that there is always the risk of one. If pushed, I will roll out the usual suspects and the top of the list is geopolitical upset, most likely China invading Taiwan or further Middle Eastern instability. I don’t sense any heightened risk in the Middle East, and anecdotally, Russia’s attempts to conclude a significant gas pipeline deal with China have run aground over what Moscow sees as Beijing’s unreasonable demands on price and supply levels. Indeed, if China were about to launch a full-scale attack on Taiwan, the first thing it would be looking to do is speed up its energy independence.
Next comes cyber security risk and /or massive technological disruptions, which is a neat segue into last week’s CrowdStrike-caused failures. It seems almost unfathomable how a simple software upgrade from the US cyber firm to Microsoft users could bring many parts of the globe to a standstill. I guess that’s how interconnected the world has become and how reliant we are on Azure and other cloud services.
In a significant and unprecedented IT outage, CrowdStrike, a leading cybersecurity software company, inadvertently caused a global IT meltdown through a flawed update. The incident, which incapacitated airports, banks, stock exchanges, and businesses worldwide, was traced to a tiny file in an update for CrowdStrike’s Falcon sensor product. This file caused an error in Microsoft’s Windows operating system, triggering widespread rolling “blue screen of death” errors and rendering computers inoperable until (and this was the primary cause of delay) a patch was manually installed by technicians (rather than being quickly rolled out over the air).
The outage affected millions of computers and highlighted the global IT system’s fragility and the dangers of relying on a few major tech companies. George Kurtz, CrowdStrike’s CEO, apologised for the error, clarifying that it was not a cyberattack but a technical issue that had been identified, isolated, and fixed. Well, if we ever wanted evidence of the potential risks, we just got some, and as one commentator put it…
‘CrowdStrike has done more to disrupt global business than all the ransomware operators combined. This [event] demonstrates how much risk we’re carrying with this software that we’ve deployed to protect ourselves: If these guys get it wrong, they can take your business down.’
Whilst it did probably contribute to a lot of the volatility in the US equity market on Friday, and indeed we saw a sharp fall in Crowdstrike’s share price not long after it became part of the S&P 500, the most prominent IT outage ever didn’t do more than blip the Nasdaq index. In the short term, this reduces the chances of an even more significant event that paralyses the world’s computers but highlights the risks.
To finish another lengthy Market Matter (after I promised Ash that I would try to cut down the content!), the logical conclusion is that this recent wobble will not likely morph into anything more sinister. It may actually be the ‘breather’ the markets needed, and if we do get earnings coming in stronger than expected, we may still get a late summer of new highs from the US equity markets. I am comforted by the increased market breadth in the last few weeks, which underpins my optimism.
BREAKING NEWS – BIDEN STEPS DOWN!
For the second week on the trot, we felt it appropriate to add a postscript to this report (that is typically written over the weekend, to be as up to date as possible). Last week, one of the presidential candidates was shot at; this week, the other has resigned. You can’t make this stuff up!
We now know that Biden will not be the Democrats’ candidate, with Kamala Harris likely to receive the nomination. Harris differs from Biden but would represent continuity with no significant policy divergences. While her candidacy slightly increases the chances of Trump losing, the difference isn’t substantial given that she doesn’t share Biden’s age disadvantage.
Betting markets initially reacted by lowering Trump’s probability of victory to 61%, nearly the same as before the incident involving a gunman firing at him.
As it stands, Trump’s return to the White House remains the most probable outcome, as it has been throughout the year. The same holds for a Republican majority in the Senate, although Biden’s withdrawal might benefit some Democratic incumbents. It’s reasonable to say that the likelihood of a complete Republican sweep of the presidency and both houses of Congress has decreased slightly but not significantly.
Important Information
This content is intended for financial professionals only. These are the author’s views at the time of writing and may be subject to change. This content is not intended to provide the basis for any investment advice or recommendation. Any forecasts, figures, opinions, tools, strategies, data, or investment techniques are included for information purposes only.
The information presented is considered to be accurate at the time of production and has been obtained from or based upon sources believed by the author to be reliable and accurate, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. Please visit our Regulatory Information and Terms of Use pages for more information.
Production
