Summertime Sell-Off

Global stock markets have experienced a significant sell-off since the end of July. As of August 5, the S&P 500 is down 6.1% for the month but still up 9.6% for the year. Although markets have partially rebounded, it is critical to understand the factors influencing our economy so we can make informed investment decisions and optimize our portfolios.

The sell-off was driven by several key factors:

• Weaker-than-expected jobs report: The U.S. economic data raised concerns about a potential recession, deviating from previous expectations of a “soft landing.” New jobs were 114,000 fewer than predicted, and manufacturing activities contracted for the fourth consecutive month.

• Downward earnings revisions in mega-cap technology companies: Major tech companies led the decline, due to investor skepticism about the return on investment (ROI) of AI.

• Unwinding of the “carry trade”: A surprise interest rate hike from the Bank of Japan led to the unwinding of the carry trade, where speculators borrowed Japanese yen at nearly 0% interest to invest in other markets, such as U.S. mega-cap technology stocks.

The recent correction could be beneficial as equity valuation was elevated and concentration risk was high, though it is contingent on the absence of significant fundamental deterioration or a severe market decline beyond 20%. It’s worth noting that declines of 10-20% can happen once or twice a year, while drops exceeding 5% can occur four to five times annually. These fluctuations can provide valuable opportunities for portfolio adjustments.

Figure 1. Number of >5% Pullbacks By Calendar Year

The U.S. economy continues to show signs of cooling: 

• Unemployment rates rose to 4.3%, higher than the 4.1% expectation as hiring further slowed.
  
• The Fed’s preferred measure of inflation, the Personal Consumption Expenditure (PCE) price index, increased 2.63% in June (Figure 2).
  
• The Manufacturing Purchasing Managers’ Index (PMI) showed that manufacturing activities contracted again, dropping to 46.8% in July, compared to 48.5% in June.

Figure 2: Unemployment (U3 Unemployment Rate, Inverted) and Inflation (Core CPI)

The Fed kept rates steady in August, but indicated that rate cuts could be possible in September. 

• Markets are now pricing in 4-5 cuts of 25 basis points (bps) by year-end, following Friday’s job report.
  
• The yield curve became more inverted, as investors bought U.S. treasury to reduce risks in their portfolios during a flight to safety (Figure 3).
  
  • 2-year Treasury yields dipped the most, from 4.7% at the end of Q2 to 3.9%.
  • 10-year Treasury yields declined from 4.3% to 3.8%.

Figure 3: The Shape of U.S. Treasury Yield Curve

U.S. equity markets rotated into smaller companies, due to their higher interest rate sensitivity.

• In July, small-cap companies gained 10.8% and mid cap companies gained 5.8%, out-performing large cap companies, which gained 1.2%). However, during the August sell-off, small-cap and mid-cap stocks underperformed large-cap stocks, declining 9.0% and 7.4%, respectively, indicating the risk-off nature of the decline. 

Figure 4: Earnings and Valuation by Size and Style

• Corporate earnings were healthy, with 78% of the companies (of the 41% reported) beating expectations.
  
• The “Magnificent 7” declined from an all-time high – following disappointing earnings growth forecasts at Tesla, Alphabet, Microsoft, and Amazon. Meta’s report beat expectations, and Apple’s was inline. With its next earnings release on August 28, Nvidia preemptively announced that the launch of its highly anticipated Blackwell AI processor may be delayed, sending the group lower (Figure 5).

Figure 5: “Magnificent 7” Performance Comparison

• Developed market equities (DM) outperformed U.S. stocks in July (+3.0%), while emerging markets (EM) increased 1.2% (Figure 6). From July to August, DM decreased by 6.5% while EM declined 5.3%.

Figure 6: Global Earnings and Valuations

• Following the European Central Bank’s rate cut in June, the Bank of England began cutting rates in July.
  
• In contrast, the Bank of Japan raised rates to curb inflation – sending stocks lower, as a stronger Yen hurts exports. Japanese stocks have dropped about 10% month-to-date, and are down 1.1% year-to-date.

Figure 7: Global Central Bank Policy Rates

Given the trends highlighted above, we are diversifying the asset allocations in our Dynamic Multi-Asset Portfolios to mitigate volatility, while focusing on long-term returns:

• Equities: We maintain an overweight position in U.S. large-cap equities and are diversifying from the index's concentration in mega-cap growth stocks. We are adding large-cap value stocks, U.S. REITs, gold, and low-volatility ETFs to reduce volatility amid higher economic uncertainties.
  
• Fixed Income: We are selective with duration based on the shape of the yield curves and prefer higher-quality spread sectors. We maintain an overweight position in short-term bonds, while gradually adding duration. We also favor short- and long-term municipals, due to the barbell-shaped yield curves. We are reducing our overweight in high yield and maintaining an overweight in intermediate investment-grade (IG) credit. Additionally, we remain overweight in bank loans, asset-backed securities (ABS), and mortgage-backed securities (MBS), given their lower default risks compared to high yield within each rating category.

As expectations adjust during the sell-off, we continue to encourage clients to stay fully invested with well-diversified portfolios, as missing the market uptick can be more costly (Figure 8).

Figure 8: Stay Invested to Not Miss the Best Days

Lauren Moone, CFA and David Darby, CFA contributed to this piece.