What has the past week changed?

From the studio
Podcast: CIO First Take: Equities rebound (10:40). Following a tumultuous start to the week for equity markets, Jason Draho reflects on the rebound and the days and weeks ahead. Apple: Link / Spotify: Link
Video: What's really behind the market's volatility? (11:50). Video featuring Leslie Falconio.

CIO Client Livestream-Market swings: What’s next?
Join us on Wednesday, 7 August at 4 PM CEST/ 3 PM BST/ 10 PM SGP/HK/ 10 AM EDT/ 7AM PDT for our CIO Client Livestream-Market swings: What’s next? Global Chief Investment Officer Mark Haefele will draw on expertise from colleagues around the world and look at our scenarios for the months ahead. Add this event to your calendar.

Markets have remained volatile over the past 24 hours. The S&P 500 and the tech-heavy Nasdaq index both closed 1% higher on Tuesday. The move followed a 3% drop in the S&P 500 on Monday, driven by concerns over slowing economic growth and the unwinding of Japanese carry trades. Meanwhile, the VIX implied volatility index has dropped to around 25 after spiking above 60 intraday on Monday.

Yields on 10-year US Treasuries rose 11 basis points on Tuesday, partly offsetting their 49bps decline since a recent high of 4.28% on 24 July.

In Japan, the Nikkei 225 closed 1.2% higher on Wednesday following a choppy session-albeit with moves well below the double-digit losses and gains seen on Monday and Tuesday, respectively. The yen has continued to retreat, trading close to 147 against the US dollar, well up from Monday’s high of 141.7.

Investors may now question whether the market’s recent turmoil has run its course. Amid the volatility, we summarize what has changed, and what remains the same as prior to the sell-off.

What’s different now?
The Fed is likely to cut rates faster than previously expected
Market expectations for the pace of Fed rate cuts have shifted significantly in recent weeks. Fed funds futures markets are now pricing in 105bps of cuts in 2024 and roughly a further 100bps in 2025. As recently as 22 July, markets expected just 66bps this year, and at the start of July, the figure was only 36bps. With rates at 5.25-5.5%, the Fed has the capacity to bolster the economy and markets. Recent data should have improved the Fed’s confidence that inflation is on a sustainable path back to the 2% target.

We now anticipate that the Fed will make a 50bps cut at its September meeting, followed by an additional 50bps of easing throughout the rest of 2024, with further cuts expected in 2025.

Market sentiment has deteriorated (i.e., volatility will likely be higher for a while)
Recent movements in equities, bonds, and currencies have in part been attributed to the unwinding of widely held positions, including long positions in mega-cap US tech stocks and short positions in the Japanese yen.

The yen’s rapid appreciation from the early July high of 162 USDJPY to an intra-day low of 141.66 on Monday may well have forced investors to sell assets bought with borrowed yen. We also note that Apple’s shares fell after news that Warren Buffett’s Berkshire Hathaway had halved its holding during the second quarter.

While the extent of the impact of position squaring in recent market volatility is difficult to gauge, sentiment has become more circumspect about risky assets.

Clear indications of this shifting investor mindset are evident in the options market. The put-call skew has risen since last week, meaning investors are now willing to pay a lot more for downside protection than upside optionality. And the S&P 500 implied volatility term structure has inverted, with 3-month volatility exceeding 1-year volatility for the first time since the banking crisis in March 2023. This is consistent with concerns that the Fed is risking a policy error if it does not react quickly to slowing growth.

The cost of direct hedging has increased
Recent market moves also mean structured strategies with capital preservation features currently offer less value. Higher implied volatility and lower interest rates make these instruments more expensive. As alternative portfolio hedges, investors can consider investing in high-quality bonds and gaining exposure to gold and the Swiss franc.

For investors that share our base-case view that current market declines are overdone and that the US will avoid a recession, we do see potential merit in using structured strategies as a means of phasing into markets. Strategies such as put writing or reverse convertibles are two such examples, subject to investors’ ability and willingness to bear the particular risks of options.

What hasn’t changed?
The US economy still appears on track for a soft landing
In our view, despite last Friday’s weaker payroll data, recession risks are low. Our base case is for a soft landing for the US economy, with growth bottoming slightly below the 2% trend and inflation moderating further.

Corporate profit margins remain solid, suggesting that companies have little reason to commence job cuts. June retail sales and personal consumption expenditure data suggest consumer spending is normalizing from an elevated level, not deteriorating. Households are in good financial shape overall, with positive real income growth and average debt servicing costs that remain low relative to historical averages. And services sector sentiment is positive: the Institute for Supply Management (ISM) reported that its non-manufacturing purchasing managers’ index (PMI) rebounded in July to 51.4.

S&P 500 earnings are still likely to grow by a double-digit percentage this year
More than 80% of the S&P 500 market cap has now reported 2Q earnings. While we have seen some softening in earnings data, it is not so great as to change our profit growth outlook. We believe corporate profits are likely to grow by 11-12% in 2Q on a year-over-year basis, at the higher end of our initial estimate. While the breadth of earnings beats is in line with historical averages, the magnitude of the beats is a bit below normal.

Our base-case year-end and June 2025 S&P 500 price targets remain 5,900 and 6,200, respectively. We expect 11% S&P 500 earnings growth in 2024 (USD 250) and 8% growth in 2025 (USD 270).

Diversification remains crucial
While market moves in recent days have been dramatic and have illustrated the risks of highly concentrated equity portfolios, the recent strong performance by high-quality bonds should have somewhat cushioned portfolios that are diversified across asset classes.

In addition, we believe that other assets that are considered safe havens, including gold and the Swiss franc, can also provide hedging benefits, particularly in an environment of elevated geopolitical risk.

How do we invest?
Throughout 2024, we have reiterated the theme of “quality” in both bonds and equities. With recession fears rising, “quality” remains a key theme, and we have not changed our recommendation.

In fixed income, we expect quality bonds to deliver positive total returns in our base case, and they could rally even further if recessionary fears continue to mount.

In equities, “quality” is an investment style that has historically outperformed as a whole and with the highest relative returns during recessions.

Elsewhere, we continue to like gold and the Swiss franc. The Swiss National Bank looks closer to the end of its policy-easing cycle than most other central banks. We expect gold to benefit from central bank reserve diversification, investors seeking assets viewed as “safe havens,” and anticipation of faster interest rate cuts.