Aug 13, 2024 Market Commentary | Volatility, Back with a Vengeance
Up until the jobs report last week, markets have maintained a calm, upward trajectory for the majority of the last 18 months. Recent equity movements mark the first market correction in two years, coming down 10% from market highs. Furthermore, it’s the first time we saw a single-day drawdown on the S&P 500 in over a year, and the VIX (a measure of market volatility, with a number over 20 representing a volatile market) reached a level of 65, one of the highest marks ever recorded. So, why the big shift over one jobs report?
In part, the lack of volatility for an extended period coupled with the lower trading volume that we see during the summer causes the severity of a small move to seem more substantial. Over the last few days, financial media has repeatedly quoted the Sahm rule, which states that a 0.5% rise in the average rate of unemployment increase usually signals the beginning of a recession. Thursday’s jobs report breached that figure, but it’s important to note that not all indicators prove correct. Most leading economic indicators signaled an imminent recession in mid-2022, which never happened. Additionally, we have never seen a period where the unemployment level started from such a low figure. The Fed has been trying to cool down the economy, and in doing so, raise the level of unemployment moderately, with their restrictive monetary policy (higher interest rates) for the last couple of years.
This jobs report reflected the trend that we have seen in the labor market this year, and aligned with the intention behind the Fed’s policy. Even still, we saw a few domino effects in reaction to the report. First, there was a substantial drop in both 2-year and 10-year treasury bond yields. The market started pricing in a 50bps rate cut for the Fed’s September meeting, followed by a few more rate cuts in the meetings to follow. The 10-year treasury bond yield fell sharply to below 4%. This led to a massive unwind of a popular “carry” trade – where investors were borrowing in low-interest Japanese Yen and buying higher-yielding US Treasuries and tech stocks. We saw Japanese markets fall 12% overnight, causing volatility to spill into European and US markets to start the week.
Source: Bloomberg
Market resets and corrections are healthy to keep risk in line. They lead to margin calls and the unwinding of leverage that builds in the financial system during times of investor excitement, euphoria, and speculation. We recently saw the price-to-earnings ratio (representative of how many dollars an investor is willing to pay for every dollar of a company’s profits) rise to 21x, 26% above the long-term average. We were due for a reset.
With all of that in mind, it is still important to review some critical factors during periods of market volatility:
Policy uncertainty is high – Markets generally do not like uncertainty, which is currently evident on both the fiscal and monetary fronts. On the fiscal front, we generally see volatility going into the election season, followed by a rally coming out of it. Monetary policy may be even more important, and although we are fairly certain that the direction of interest rates will be down, we don’t believe (nor does the market) that we will get back down to the 0% interest rate environment that we experienced over the majority of the last 15 years.
Geopolitical risk is high – We have seen increasing conflicts across the globe, and a general decline in globalist policy which favors free trade and fewer trade restrictions. We believe that trend is likely to continue regardless of who leads the next administration, which increases the overall risk to global supply chains, energy prices, and black swan events.
The economy is doing “OK” – On one hand, we were in a global manufacturing recession for the last two years and are now shifting back into growth mode. Leading economic indicators are improving, and the US consumer driving the majority of the US GDP growth continues to spend (for now). On the other, the labor market is deteriorating in a constant and proven trend (see chart here), the US deficit is at all-time highs with a substantial part of the US budget going to interest costs of servicing the debt, and the yield curve is still inverted, making it difficult for banks to lend (overall liquidity is lower).
Source: BLS, Factset
Corporate balance sheets and bottom lines look good – We are now through the majority of earnings season, and the numbers are promising. We have seen a slowdown in top-line growth, but companies are still reporting an increase in profitability across most sectors. Corporate balance sheets are very healthy, with the majority of companies refinancing their longer-term debt during the prior period of lower rates. Valuations, even in some of the growthier parts of the market, like technology, do not look dramatically overextended like during the dot-com crash.
As we consider how to position portfolios:
- Short duration fixed income still provides an attractive yield, but intermediate term fixed income looks increasingly attractive to take advantage of a rate-cutting cycle by the Fed.
- The profitability of large cap companies is more resilient than that of mid and small cap companies if the Fed only does a few rate cuts during a phase of normalization.
- Commodities do well during periods of increased manufacturing activity and in the midst of a super-cycle.
When there is much that is unknown on the horizon, it is important to stay diversified across asset classes and sectors. During times of volatility, we recommend shoring up high-quality, core positions in companies that have strong balance sheets and healthy cash-flow metrics.
At Seventy2 Capital, we run various strategies across the risk spectrum, so its important that you work with your financial advisor to align your portfolio with your investment time horizon and risk tolerance.
As always, please reach out to you financial advisor with any questions or concerns.
-The Seventy2 Capital Team
Commentary and Research provided by:
Michael Levitsky, CFA®, CAIA® - Managing Director, Investment Strategy
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