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13 Aug 2024 | 5 minutes to read
After a volatile few days, equity markets staged a tentative recovery this week. Recent abrupt market moves have likely been intensified by thinner trading volumes that are customary during the summer months.
A clutch of soft US economic data sparked market worries in the week of the July Federal Reserve (Fed) meeting, with both labour market data and the ISM manufacturing survey coming in softer than anticipated. The US stock market saw a 7% decline over the first three days of August, as volatility spiked and speculation began that the Fed would have to implement an emergency interest rate cut.
A week on, stock markets have recovered somewhat – the US index is now 4% below its July close and volatility has subsided considerably. US economic data is likely a factor contributing to calmer market behavior while July’s ISM manufacturing index (a gauge of the level of the economic activity in the US manufacturing sector) saw a second steep drop. However, the services index bounced back above the 50 level associated with economic expansion, with both “new orders” and “employment” sub-indices rising. While manufacturing historically leads services demand, services is a larger share of the US economy and the survey result demonstrates how volatile survey data can be.
A second boost came from initial jobless claims. Soft July payroll data sparked concern that the US labour market was decelerating too quickly, risking a recession. However, weekly initial claims data showed little sign of a rapid slowdown, with claims falling week on week.
While US economic data does show clear signs of slowing, there is not yet evidence of a dramatic deceleration that risks a recession. Nonetheless, US data will remain key in coming weeks, as concerns shift from the persistence of inflation to the health of the US market. “Fed-speak” will also be closely monitored for clues as to how the Fed will respond, with Chair Powell’s remarks at the Jackson Hole Symposium likely to be under particularly close scrutiny.
Today, futures prices indicate the market continues to anticipate a September interest rate cut, with a “double dose” 50bps cut possible but no longer priced in. However, at least 75bps of interest rate cuts are priced for year-end, an increase from before the recent market volatility, with more cuts priced for 2025. This suggests an expectation that data will soften further, compelling the Fed to shift away from its “higher for longer” mantra on interest rates.
US data and the summer vacation season might not be the only explanation for recent volatility – liquidity could also play a role.
Given the sizable differential between monetary policy in Japan and elsewhere globally, the yen has been a key funding currency in recent years, with low Japanese interest rates providing an affordable source of liquidity. This allows market participants to borrow money in yen to buy assets elsewhere, known as a “carry trade”.
The Bank of Japan’s (BoJ) unexpected decision to increase interest rates from 0.1% to 0.25% at the July meeting likely caused some of this carry trade to unwind, as investors reassessed their positions, as well as sending the yen’s valuation significantly higher.
The question now is whether the carry trade fully unwound or if there further to go. While the BoJ acted ahead of market expectations, the scale of the rate rise was small, at less than 25bps. However, the BoJ did implement almost all of the tightening expected this year just over half way through the year, increasing the likelihood that rates could go higher that market participants had expected.
With limited new news on policy intervention, optimism around Chinese gross domestic product (GDP) growth is more measured, with expectations that GDP will be around 4.7%, below Beijing’s official 5% target. Economic data offers limited hope of an acceleration in the second half of the year, with softer external demand a hindrance. July trade data showed exports rising by 7%, down from 8.6% in June, and below consensus. In Chinese currency terms, the decline was even more pronounced. Within exports, IT products were a point of strength, with strong shipments in computers and phones, while autos and furniture exports slowed. On the import side, activity recovered, rising 7.2% year-on-year, up from a decline of -2.3% in June. Again, tech components were a point of strength, suggesting manufacturers are preparing for a new product cycle and, potentially, front loading orders in anticipation of stricter trade measures in the US and Europe. The US election could herald the announcement of further restrictions on China’s access to US tech under either a Republican or Democrat win, though a Republican win could be more disruptive and wide reaching for China. In Europe, provisional anti-dumping tariffs have been announced, along with investigations into Chinese exports or companies, sparked by concerns around state aid and market distortion. Electric vehicles, biofuels, some chemicals, and certain construction machinery are in focus, along with medical devices. Such an escalation is likely to see more manufacturing relocating outside of China.
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