BY FERNANDO DE FRUTOS, CFA, PhD | 05 AUGUST 2024
• Markets have experienced violent gyrations over the past sessions. Equity markets have suffered
steep corrections, and interest rates have fallen sharply. The VIX index, a gauge of market
volatility, has spiked, indicating heightened investor anxiety.
• Although the correction has been severe, it was not unexpected. Equity valuations have been
very stretched, and the market was vulnerable to a repricing. The trigger has been a combination
of weak macroeconomic data, disappointing results from some of the tech behemoths, and fear
of a policy mistake by central banks not being responsive enough to the deterioration of the
economy.
• With stock prices and interest rates falling, valuations have now improved. The economy still
seems to be far from entering a recession, and the Fed has plenty of room to stimulate the
economy now that inflation is under control.
Equity markets have undergone significant corrections over the past trading sessions. The selloff
appears to have peaked today, with Japan’s index closing down a staggering 12.4%, wiping out all year-to-date gains. American and European indices also suffered substantial losses, and the VIX volatility
index spiked to levels not seen since 2022.
This correction likely stems from a confluence of factors. Firstly, valuations had become stretched.
Over the past quarters, stock prices consistently outpaced earnings growth while interest rates
remained elevated. Disinflation stalled, preventing the Fed from commencing anticipated rate cuts.
Additionally, the earnings reports of four out of five major tech companies driving the market
(excluding NVIDIA) fell short of market expectations, with only Meta exceeding them. While the others
did not necessarily disappoint, they failed to convince investors that investments in AI would yield
sufficient returns. This could signal a potential exhaustion of the AI narrative that has propelled
markets since last year.
Furthermore, macroeconomic data has been deteriorating in recent months. Both forward-looking
indicators like Services PMI and hard economic data, particularly related to the labor market, have
shown weakness. Though the Fed was aware of this trend, they lacked access to the latest data
(unemployment rate and ISM Services PMI) before their July 30th meeting. Consequently, markets
became apprehensive of the Fed falling behind the curve again – this time, by delaying rate cuts
needed to prevent an economic stall.
Beyond fundamentals, technical and liquidity factors also played a role. The same day the
disappointing labor report was published, the Bank of Japan (BoJ) unexpectedly raised interest rates
for the first time since 2007 to support the Yen and combat inflation. Since the Yen is a popular funding
currency, the move triggered a wave of liquidations in both Japanese and international stocks.
Overall, with equity indices falling alongside interest rates and corporate earnings remaining positive
(Q2 YoY growth remains in double digits), valuations have returned closer to historical averages. The
equity risk premium, which had turned negative for the first time since the dot-com bubble, has
rebounded to nearly 1%.
Investors, much like nature, abhor a vacuum. With the next FOMC rate announcement scheduled for
September 18th and NVIDIA set to report earnings on August 28th, markets have faced an “air pocket”
amid a quest for a soft landing. These clear-air turbulences are typically shorter-lived than those
caused by storms. Despite recent volatility, the economy remains distant from recessionary
conditions, and the Fed retains substantial dry powder to stimulate growth. In the absence of more
conclusive data, this correction appears more as an opportunity to buy the dip rather than a signal to
derisk portfolios.
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