From Goldilocks to growth scare

Goodbye Goldilocks?

For much of the past few months, investors have been betting on a ‘Goldilocks’ scenario, where economic growth would remain strong and inflation contained. However, recent US economic data has cast doubt over the likelihood of this scenario.

Data for the month of July showed that US jobs growth slowed and the unemployment rate increased. This triggered concerns that the US economy was on the cusp of a downturn, with stock markets falling sharply lower and bond yields plummeting. Note that past performance is not a reliable guide to future performance.

What explains such an aggressive reaction? Well, historically, labour markets tend to deteriorate non-linearly and it can become self-fulfilling. So economic risks are rising, but nothing is a foregone conclusion.

For instance, US jobs data is notoriously subject to data revisions and there were adverse weather effects that may have distorted the overall picture. If labour markets were to stabilise from here, then recession fears would likely dissipate. Nevertheless, this is something investors are still trying to figure out.

Our in-house indicators show that markets have probably got ahead of themselves with this ‘growth scare’. The signal from our sentiment indicator is flagging excessive pessimism amongst investors, which suggests a lot of negative news is priced in – at least in the short term.

Have bond markets overreacted?

Investors are pricing in 2% worth of interest rate cuts over the coming year from the Federal Reserve (Fed), with two 0.25% cuts in September alone. But we think that this market pricing is starting to look a bit overdone.

As long as labour markets and broader economic conditions hold up, there’s scope for some of this aggressive easing (i.e. rate cuts) to be pared back.

On the flipside, we think that faster easing is warranted in the Eurozone. Markets currently expect fewer rate cuts here compared to the US, but this appears at odds with the deteriorating Eurozone growth outlook.

What has driven the aggressive rally in the Japanese yen?

Another key source of global volatility has been the strengthening of the Japanese yen, which is not unusual during periods of declining risk sentiment. However, we note several catalysts that have been behind these market moves.

First, the gap between US and Japanese interest rates has been closing as the Bank of Japan (BoJ) hiked rates, while expectations for the Fed to cut rates have increased.

Second, Japanese yen carry trades (where investors borrow in yen and invest in higher yielding foreign assets) have been rapidly unwound, which has added to market volatility.

Third, such moves have been exacerbated by trend followers and systematic traders, which respond to the increase in volatility.

Japanese stocks also tanked after these moves given their high export revenue exposure and vulnerability to a stronger yen.

Investment conclusion

Times like these are uncomfortable but can provide opportunities. We would discourage making any wholesale changes to portfolios as our Tactical Asset Allocation (TAA) process is designed to take advantage of such short-term opportunities at the edges of portfolios.

Besides, sharp falls are not unusual in equity markets. In fact, the price of long-term gains is volatility and this time is no different. For investors, the key message is to stay invested and not let your nerves dictate when to get in or out of the market.

Such episodes are also a stark reminder of the benefits of diversification. For at least a couple of years now, questions have been raised over government bonds' worth in portfolios. This latest bout of volatility has answered those questions.