ClockWise: Volatility spikes amid recession fears

There has been a decisive shift in the mood in market sentiment over the past few days, with the sell-off gathering pace at the start of this week. Japanese equities fell over 12% to start the week, adding to the deep sell-off experienced last week, following on from last week’s Bank of Japan rate hike that sent Japanese yen substantially higher. In the US, the tech-heavy NASDAQ index fell by more than 3.5% on Monday. 

The equity market volatility index (VIX) had surged through 60% intraday – a level of panic not seen outside of the Great Financial Crisis in 2008 and the initial onset of Covid in 2020. We had shifted our view to be neutral on equities at the asset class level ahead of the recent sell-off, having previously held a positive view since Q4 2022. Similarly, we had turned more neutral on Japanese equities ahead of the steep relative losses. Broad diversification can help in these environments, with UK property most likely untroubled by the events shaking the stock market.

As the sell-off in stocks continues, the  future profitability of AI-related stocks remains a concern for investors, who now have fresh concerns about a US recession, following a weak ISM manufacturing print and the US labour market report. 

The decision by the Federal Reserve to hold rates and open the door for a cut in September was largely expected by the market participants but are now seen by some as being ‘behind the curve’ and too slow to counter the recession risk. At the same time, the surprise hike from the BoJ led to an unwind of the previously profitable ‘carry trades’ by borrowing in low interest rates currencies like the yen and investing in high-yielding currencies and other assets.

Last week’s US employment report showed the unemployment rate unexpectedly rising to 4.3% in July from 4.1% previously. This has brought the ‘Sahm rule’ into investors’ attention. The rule states that if the 3-month average of the US unemployment rate rises by 0.5% above the lowest 3-month average over the prior year, a recession has started. The latest data suggest that this recession rule has been triggered (chart 1).

Chart 1 

Our Investment Clock has seen a similar development as it moved from Overheat to bond-friendly Reflation quadrant, but it remains close to crosshairs (chart 2). As a result, we see bonds performing better in these circumstances while commodities could have a hard time, except for gold – where positive indicators remain. In our view, given the seasonally volatile summer period, a cautious stance makes sense for now.

Chart 2

With that said, while the US payrolls report was a certainly weak one, a significant portion of the impact on the US labour market may be due to temporary factors related to weather and structural changes to supply of labour due to immigration. Last week’s Atlanta Fed US GDP nowcast is still looking healthy at 2.5%. It’s possible that investor nervousness on the US recession risk is overdone despite bond investors starting to price in emergency intra-meeting rate cuts by the Fed.

When this sell-off began, our investor sentiment indicator was in overly euphoric territory and despite a sharp correction in markets, we note that our indicator has not yet triggered a contrarian buy signal. This suggests that we are not yet at the levels to consider becoming more positive on equities, though we wouldn’t be surprised if we get there soon – especially if the US recession risk is overdone.

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