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Written by: Kevin McCreadie, CFA®, MBA | AGF
What’s behind the recent bout of equity market jitters?
There has been a shift in how investors view the current macro environment and its potential impact on global financial markets. Until recently, bad news about the economy was largely considered good news for stocks because it was believed that weaker economic data would prompt central banks to begin cutting rates – which they have in some regions and countries like Europe and Canada. At the same time, good news about the economy was often seen in a negative light because it was viewed as a deterrent to more accommodative monetary policy, especially in so far as positive economic data was linked to inflation continuing to run hotter than desired.
But this paradox – i.e. bad news for the economy equalling good news for equity markets and vice versa – has seemingly broken down in more recent weeks, and now bad news for the economy may also be bad news for equity markets as evidenced by the big selloff earlier this month that was at least partly precipitated by slumping U.S. manufacturing data and a perceived weak U.S. jobs report. Moreover, while U.S. equity markets have rebounded rather quickly since then, it’s not entirely because investors are anticipating more rate cuts from the U.S. Federal Reserve (Fed) this year than was expected before the market correction took place. In fact, while the latest inflation figures have only fuelled this anticipation, the rebound in stocks has just as much to do with a stream of economic data releases in recent days, including U.S. retail sales figures for July and the most recent weekly jobless claims that indicate the U.S. economy may not be on the precipice of recession after all.
Either way, investors seem increasingly concerned about the direct (and negative) impact of a potentially weaker economy on equity markets, as opposed to just being focused on the potential response from central banks to a slowdown in economic growth (i.e. rate cuts), which, in the past, has usually had a positive effect on markets over time.
Are there other factors to blame for the increase in volatility and the selloff earlier this month?
A few come to mind, including the Bank of Japan’s recent interest rate increase, which forced many investors to unwind their Japanese yen carry trades by selling riskier assets like stocks. There was also a growing weariness towards artificial-intelligence (AI)-related stocks following a disappointing earnings season for some of the world’s biggest technology companies.
Although the driving force behind this year’s rally, new questions are being raised about the amount of money these companies are spending on AI research and development (R&D) and whether the potential growth that may result from that spending justifies the tremendous increase in their share prices since last October.
Of course, that said, investor interest in many of these same names has seemingly returned in more recent days and many have recovered most of their share price losses as U.S. economic news has brightened of late.
What about the potential impact of the U.S. election?
Beyond that, we believe the U.S. presidential election and escalating geopolitical tensions in the Middle East and Ukraine have continued to weigh on investor sentiment, if not always asset prices themselves.
Of the former, even slight changes in polling data have had an impact on specific sectors, shifting markets in one direction or another depending on which candidate (U.S. Vice President Kamala Harris or former President Donald Trump) is leading in the latest polls and by how much.
Are investors now through the worst of this corrective phase?
It would seem so given how strongly U.S. equity markets have bounced back from the correction. Yet, we believe many of the issues that contributed to the selloff still seem unresolved despite equity market moves to the contrary.
For instance, is the U.S. economy really in such a state that it warrants a 50-basis point rate cut by the Fed in September, as is currently expected by almost a quarter of the forecasters tracked by CME FedWatch? And should such a large cut, were it to happen, possibly be viewed as a good thing if it’s a harbinger of an imminent recession?
In our view, perhaps the best-case scenario in the near term is for the Fed to cut its key lending rate by 25 basis points next month with guidance of more to come in the months ahead as inflation continues to fall toward its 2% target. Granted, this may play out much better for equity markets in an economic backdrop that remains resilient and doesn’t succumb completely to recent signs of its weakness. That doesn’t mean the U.S. economy has to start firing on all cylinders from here, but a severe downturn seems hardly a recipe for further stock market gains, even if the Fed is committed to cutting rates.
Ultimately, we believe equity markets could climb higher from here and close the year on a positive note, but there’s still room for disappointment, not only related to Fed policy and the economy, but also because of the uncertainty that continues to swirl around the U.S. election and the particular risk of a contested outcome, which could lead to civil unrest throughout the country.
Related: Most US Equity Indices Are Now Top-Heavy
The views expressed in this blog are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
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