The market sell off – what does it mean for asset allocation?

Equity markets have rallied strongly over the last two years, with stock market indices in the UK, US, Europe and Japan all hitting record highs in 2024. However, in the last few weeks, volatility has increased and there have been some significant sell offs caused by a risk off move in markets.

Equity markets began to sell off on Friday 2^nd August and continued to fall on the following Monday. Japan’s Nikkei 225 fell by 12%, the US S&P 500 dropped by 3% in its worst day since 2022, and the UK FTSE 100 had its worst day since January.

There were significant moves in bond markets too. Yields fell as investors turned to the ‘safe heaven’ assets in the form of sovereign bonds. The move was particularly noticeable in the US, with the two-year Treasury yield falling 26bps on Friday as markets moved swiftly to price in an additional two 25bps rate cuts from the Fed.

At the time of writing, global markets have recovered half of the losses from the sell off, but further volatility can be expected as more key US economic figures are released later this month.

What caused the market sell off?

Market sell offs are often a combination of factors which consequently have a negative impact on market sentiment. The recent sell off was no different.

Bank of Japan (BoJ) raising interest rates

For some time, global investors have relied on a weak yen through a ‘carry trade’. This involves borrowing money from a country with ultra-low interest rates, to buy other assets in another currency with the hope of earning a better yield.

The BoJ’s surprise rate hike from 0.1% to 0.25% on 31^st July had a dramatic impact on the yen – rising around 11% against other major currencies. The decision caught many investors red handed, causing a mass sell-off as traders unwound their positions to pay back the yen they originally borrowed.

It’s difficult to know the exact size and scale of carry trades, or what assets were held as these types of trades are used by a variety of market participants – from hedge funds to Japanese households. But recent severe movements suggest too many speculators had positions they couldn’t afford to continue holding as soon as the yen started to climb. They will have learned a dear lesson, and we expect lower yen volatility as the majority of the extreme positions have now been closed out.

It seems likely the BoJ will seek to edge interest rates up further. This reduces the supply of cheap loans to buy financial assets and makes Japanese companies trading abroad a bit less competitive as the currency rises.

There are limits as to how far the BoJ dares go with raising rates though, given the overextended position it and the Japanese government have with their own bond portfolios, and given the importance of cheap or free borrowing to the Japanese state budget.

The US economy showing signs of deaccelerating

The second key event to cast fear across global markets was the US economy showing signs of slowing faster than expect. Worries that the US central bank (The Federal Reserve) had held interest rates too high for too long were somewhat confirmed by some negative economic news in the form of the ISM manufacturing survey and US employment report for July.

1. Manufacturing data

Manufacturing has been weak in the US for over a year, but there were signs more recently that things were improving. The manufacturing survey showed a sharp reversal in these recent improvements and highlighted that manufacturing may be deteriorating again.

However, this was also a month that saw some significant weather-related impacts from Hurricane Beryl, and the shutdown of the auto industry by a cyberattack. We need to see further weakness in this series to confirm that any slowdown in manufacturing is serious.

Whilst current manufacturing activity is being held back by the uncertainty over the outlook for the economy, long-term policy support for the sector remains in place.

A similar survey in the services sector showed it was healthy and expanded in July. With a 10% contribution to GDP and employment for manufacturing, services activity is a more important driver for the US economy and currently remains robust.

2. Employment data

The US employment report revealed only 114,000 jobs were added in July and the unemployment rate rose from 4.1% to 4.3% - its highest level since October 2021. Both of these readings were weaker than expected and accelerated concerns around a rapidly slowing US economy.

However, at this stage, labour market stress is not at levels we would consider concerning. Firstly, the rise in unemployment for July was largely due to the layoff of temporary workers related to one-off events. Secondly, the fact that 420,000 people decided to join the labour force, although most couldn’t find any work in the month.

The rise in the unemployment rate triggered the “Sahm rule”, which has historically had a 100% success rate in calling recessions. This states that if the three-month average unemployment rate is 0.5% higher than its lowest point in the previous 12 months, the economy is in the start of a recession.

However, the unemployment rate rose due to an increase in the size of the labour force, not due to layoffs. We haven’t seen the rule triggered in this manner before, so we remain wary of its predictive powers in this case.

We look to the trend in employment growth and will need further weakness before becoming more concerned around US employment. We view the softening in the labour market as necessary so the Fed can proceed with reducing interest rates as expected.

All through the period of high interest rates, the US jobs market has been hot, with a shortage of skilled workers meaning wage settlements have been high. This is one driver of the inflation problem the US central bank is trying to resolve. So, a slowdown in the jobs market is likely to be welcomed by the Federal Reserve.

Stretched tech valuations and mixed earnings results

The technology sector has led the recent bull run, with optimism about prospects for artificial intelligence (AI) boosting valuations, particularly the so-called Magnificent Seven – Apple, Tesla, Alphabet, NVIDIA, Microsoft, Amazon and Meta Platforms. Some of these companies have been leading the losses. The fall in the FTSE 100 has been limited compared with other major indices because of its lack of exposure to the sector.

The expected economic slowdown in the US is something the Federal Reserve will want to see if it is to bring inflation under control. However, it hadn’t been reflected in the results of the key technology companies as much. In fact, demand has been strong in relation to AI-led services, leading to expectations of significant expansion in the infrastructure needed to provide these offerings.

The recent Microsoft results disappointed due to the Azure cloud business not growing as fast as anticipated, which led to suggestions that maybe even some of the big technology names are subject to a broader growth downturn. We think it is likely that the growth slowdown will impact the earnings expectations of these companies and valuations need to be more realistic, incorporating this more cautious outcome rather than the over-optimistic scenario that has prevailed so far.

There are other factors that could dampen the outlook. There are likely to be further difficulties with manufacturing newly designed chips, as recently experienced at semiconductor group Intel. There are also tensions between Washington and Beijing to consider, with the US administration attempting to halt exports of cutting-edge technology to China, which will impact sales at Western technology groups.

Broader geopolitical concerns are also driving market falls. There are concerns about escalation in the Middle East and Russia’s war in Ukraine, which shows no sign of any resolution soon.

In broader markets, 10% corrections in a 12-month period are normal. We need to scrutinise the data for any acceleration in the downturn. The current volatility is likely to continue through the current second-quarter earnings season, but we are yet to see any strong evidence that a significant economic growth downturn lies ahead that would spark a more substantial downside move in equity markets.

Impacts to our asset allocation framework

Our asset allocation framework has been overweight fixed income and underweight equities for some time. This is down to our view of the relative value offered.

Sovereign bond markets have been pricing in a more negative macroeconomic outlook than equities for some time. This is now changing, and we may see sufficient moves in equity markets to shake out this relative value difference.

In a scenario where equity markets become more realistic around the combination of growth, inflation and rate cuts, our interpretation of their relative value vs fixed income would become more balanced.

We have been mindful of areas of the equity markets with particularly high valuations and earnings expectations – technology for example. This could be the start of a healthy revaluation in these parts of the markets that we would welcome, setting the scene for a more robust and wider medium-term recovery.

Sovereign bonds and more defensive parts of the equity market, such as infrastructure, have shown their diversification benefits during this recent sell off and remain a key part of our asset allocation.