Growth scare catalyzes stock decline

Key takeaways

• The markets sold off sharply on Friday and into Monday as investors were gripped by two strains of fear: 1) that the Fed is behind the curve with their monetary policy while the economy is weakening more significantly than expected and 2) that the low interest rates in Japan which underpin market activity around the world are coming to an end.
• We believe the market reaction is somewhat inconsistent with the fundamental data. The July labor report was not weak, merely below expectations. Further, it was not even the softest jobs report of 2024, which further provides weight to the argument that the sell-off is somewhat technically driven (i.e., Japanese yen strength) than entirely fundamental.
• That said, the possibility that any fear of a recession could cause an actual recession just increased. If corporate managers pull back because they fear a recession is coming, it may (and historically has) caused or furthered a slowdown.
• Near-term market volatility is the cost of owning stocks. However, for long-term investors who can hold through that volatility, it’s a source of potential long-term capital appreciation, as well. Savvy investors act in a few ways in the face of that volatility: 1) do nothing (many will/generally should do this), 2) reweight portfolios to take advantage of market dislocations and/or 3) accelerate capital deployment to take advantage of lower valuations and weaker sentiment across the board, if cash is available.

What’s happening?

Markets sold off sharply, starting Friday and accelerating further on Monday morning. The proximate cause was the weaker than expected employment report in the US on Friday. However, given extremely sharp drops in Asia overnight, including a 12% drop in Japan’s Nikkei index, other market participants are pointing to the Bank of Japan’s decision to raise rates. As the BOJ raises rates while other central banks cut, that challenges the yen carry trade (borrowing cheaply in yen and reinvesting the proceeds at higher rates of return elsewhere), which has often underpinned asset prices in recent decades. We think this additional Japanese catalyst is likely a contributor to the weakness as higher rates in Japan are forcing the unwind of trades globally.

We also answered some questions over the weekend related to whether this sell-off is tied to concerns over a broadening regional conflict in the Middle East. We don’t think that is the case. If it were, we’d likely see oil prices moving higher. As of 8:30 a.m. ET, Brent North Sea Crude Oil is down 2% to $75.50/barrel. It was $87/barrel one month ago.

Recent data and how the Fed will react

While the market has begun to focus on the risk of a recession and whether the Federal Reserve is behind the curve, it’s worth a quick reminder that the labor report was “weaker than expected,” but not actually “bad.” Payrolls came in at 114K, which is around the rate at which workers enter the labor force. By comparison, prior to the pandemic and the current expansion, seven months’ payrolls in late 2018 and 2019 were below that level and the economy had not tipped into a recession. That’s not to say that one wouldn’t have come in 2020 if the pandemic hadn’t hit—in fact the odds of that were becoming increasingly likely. However, today, economic growth remains sound, the labor market has cooled from its overheated levels from the immediate post-pandemic period but remains robust, working-age people continue to enter the working labor force, and the aggregate household paycheck is growing at a normal rate. A recession in the next year is possible, but still less likely than not. And the economic future isn’t taking place in a vacuum—despite accusations the Fed is behind the curve, market-driven interest rates have eased by half a percentage point in the last week and the Fed has the ability to ease policy as needed.

All this raises the question: How does the Fed react? First, when the Fed decided not to cut rates last week, they did not have the July employment report ahead of time. Had they, they may have acted, but they didn’t. We believe over the next several weeks, Fed officials will begin setting up a cut in September. They’ll likely signal, through various speeches, public appearances, and most importantly the Jackson Hole Economic Symposium (August 24–26), a visible softening of the US economy as justification to easing policy at the next meeting. We think three cuts are likely in 2024 (at each of the remaining three meetings) with a half-point cut certainly possible on September 18. There has been some talk of an emergency, intra-meeting cut before the next formal meeting—we think that is highly unlikely, and more importantly, unnecessary given the economic facts on the ground.

How should investors respond?

Although the years since the pandemic have been relatively calm (and profitable) in the markets, sudden drops are a normal part of the stock market’s history. They happen with no advance warning. We explain them after the fact with the benefits of hindsight and a consensus narrative. As we wrote in our mid-year outlook only a few weeks ago: “Keep in mind, we could still see occasional drawdowns that cause the market to drop by ~5%–10%. Historically, such pullbacks have been random and unpredictable, making them a constant possibility.”

Enduring that volatility is the price that investors pay for the long-term capital appreciation potentials of the stock market. When we design asset allocations, we factor in volatility and drawdowns such as this. These sharp downturns can be painful, but they can also be opportunities. For investors who have been waiting with cash on the sidelines for the right moment to invest, we would encourage them to consider accelerating that deployment in the coming months. It’s often mentioned that missing the best 10 days in history would leave investors substantially worse off than they would be otherwise—missing from that story is the fact that those best days almost always follow some of the worst days. The market can spring back just as sharply as it falls.

For those with cash and/or money market investments, remember that when the Fed eases, the return on those investments declines. If the Fed cuts by 0.75%–1% over the next five months, that will be reflected in cash and money market yields. Importantly, bonds are one of the key ballasts against stocks in a diversified portfolio. In growth shocks, as stocks fall, bonds rally and tend to support portfolios. That relationship was challenged in recent years by high inflation and the rate hiking cycle. But now that inflation has been controlled, bonds are acting as diversifiers in this shock.