Market Pulse: Market Volatility in the Spotlight Again

Stock market volatility is back in the spotlight, so we would like to provide some additional context on the underlying drivers and historical perspective.

A combination of events from last week have led to a spike in stock market volatility, starting with the meeting by the Federal Reserve where they decided to keep interest rates unchanged. More importantly, the Fed failed to deliver more clarity about future interest rate cuts amidst growing signs the labor market is slowing down.  As has been true in the past, the tone of the Fed’s communication, apart from any changes to interest rates, can have an impact on markets and investors’ psyche.

Furthermore, weaker than expected labor and manufacturing data raised concerns the economy is slowing down and the Fed is “asleep at the wheel.” Given that the next Fed meeting is in September, there is limited opportunity to reduce interest rates in the near future without a high risk of giving the impression of panic.

Concurrently, the Bank of Japan made a surprise decision to hike interest rates, which has triggered the unwind of a highly popular carry trade involving Japanese Yen. Simply put, for years investors were trying to take advantage by borrowing large sums of money in Yen at 0% interest rate and reinvesting proceeds into riskier assets they believed to have better return potential.

With the BoJ increasing interest rates, some of those investors were caught “off guard” and forced to liquidate their positions. Given the size and liquidity, the carry trade involving Japanese Yen is one of the largest carry trades in the world, hence resulting in a more significant impact on global equity markets.

On the surface, this seems to be a “de-leveraging” trade where the market is flushing out excess speculation. At the same time, we haven’t had meaningful market volatility in more than 18 months, so this confluence of events was the perfect spark.

Economic fundamentals remain relatively good. The second quarter earnings season underway the S&P 500 on track to report 12.9% year-over-year earnings growth and 5.1% revenue growth. The economy may be starting to show some signs of a slowdown, but it is still growing. The latest projection for Q3 is pointing to 2%+ real annualized GDP growth (see following chart). The focus appears to be shifting away from inflation towards the broader economy and the labor market. The primary risk is that the Fed waits too long to cut interest rates.

During periods like today, it is helpful to take a step back and consider historical perspective. The current 8% drop in prices is well within historical norms.  While the current market volatility is unsettling, 10% or bigger drawdowns occur almost every year.

We simply haven’t had meaningful volatility in over 18 months, defined as a greater than 2% daily move in the stock market, and markets were past due by historical standards.

In environments like today there is always a natural tendency to “do something”, which comes at the high risk of getting whipsawed by market volatility. The best and worst market days primarily occur during periods of high volatility.

It is worth pointing out that when we structure your portfolios, we plan and prepare for significantly worst market environments than today.  We do this through broad diversification among many types of investments that react differently in various market environments and by maintaining appropriate short-term stable cash and near-cash reserves.  If we do experience a more prolonged drop in equity markets, high quality bonds are in a much better position to provide a buffer and serve as a haven compared to the previous two bear markets in 2020 and 2022.  Additionally, volatile market periods present other opportunities to add value through tax-loss harvesting and rebalancing.

If you have any questions or would like to discuss the environment further, please reach out to your investment advisor.