Written by Ed Legget, co-manager of the Artemis UK Select Fund
A few weeks ago few of us had heard of Claudia Sahm or her rule. Today the former White House economist is suddenly a lot less obscure.
It was Sahm who, in 2019, identified that when the three-month moving average unemployment rate is half a per cent or more above its 12-month low a recession has invariably started. Jobs data released last Friday in the US triggered the rule, and markets went crazy.
If you were taken by surprise by the strength of the market recoil, you were not alone. A couple of weeks ago markets thought inflation was coming down, a soft landing was on the cards and the election result in November was a no-brainer. Biden’s performance in the debate had killed his chances. It at least brought clarity to what was coming.
Well, that did not last long! Biden has stood aside for Harris, and the gap in the polls has closed. Weaker US manufacturing numbers and Friday’s further decline in payrolls data – perhaps weather-influenced – saw sentiment change and everyone Googling “Sahm”.
Sentiment has taken a 180-degree turn – a recession is now viewed as imminent, and the Fed is seen as behind the curve. Some strategists are now calling for an emergency cut from the Fed, with the bond market pricing in 125bps of cuts in the US by the end of the year – from just 50bps at the start of July.
The changes in the economic outlook look comparatively modest and we expect a lot of the commentary is driven by the need to fit a narrative to the huge market moves. Standing back, much of the volatility can be explained by positioning, market structure and the rapid unwinding of a huge carry trade.
On positioning it has been a good year for CTAs and other trend following funds – strong momentum, clear themes (AI, GLP-1s) have generated strong performance, whilst low volatility has allowed them to expand their risk budget by taking on more leverage.
All good until the Bank of Japan caught the market off guard by raising rates and announcing QT. This brought to an abrupt end one side of a huge carry trade for CTAs, which had been borrowing the cheap yen to invest elsewhere. Much of this money had gone into things like Bitcoin, weight-loss stocks and the Magnificent Seven.
The Magnificent Seven’s share prices had soared on AI excitement and the ensuing momentum. But recent results show that managements have spent a lot on AI with so far little return. The ‘peak’ AI narrative hit the other side of the carry trade.
The sudden unwind was spectacular as stop losses were triggered and there was a stampede for the exits. That it came when many market participants were on holiday and trading volumes were thin further magnified market moves.
The events of the past few days showed that in a world where there are increasingly few active investors and far more options traders and asset allocators than historically, the moves can be sudden and dramatic when the narrative changes.
Put simply, today the majority of assets follow macro themes and momentum – as there are comparatively few trades on, they are very consensual and have a huge weight of money behind them. A 12.4% fall in the Nikkei on Monday demonstrates the market impact when a trend reverses.
In the US the rotation from cyclical to defensive stocks has not been so extreme since the start of Covid. The Vix, which measures market anxiety, has been similarly dramatic. At one point in the past week its peak was far bigger than on the day of Russia’s invasion of Ukraine.
So far the pattern in trading has followed a very similar pattern to other de-risking events. It starts with the dumping of what we call ‘liquid beta’ – think FTSE 100 financials, cyclicals and miners – and the buying of defensives, like tobacco, FMCG, pharma and utilities. Mid-caps and small-caps strongly outperform on these occasions because of lack of liquidity. Investors sell what is easiest.
Day two sees the US close lower. Investors keep selling liquid beta and start profit-taking in previous winners, regardless of which sector they are in. In the UK, think Rolls-Royce, 3i and Melrose. It seems that investors thinking the world has changed dramatically for the worse do not want equities and particularly not those at 52-week highs. Mid-caps and small-caps start underperforming as the negative mood swing finally catches up with them.
Day three sees markets open down, with beta still underperforming. However, as the day progresses and investors spot the opportunities that have opened up, higher-beta stocks catch a bid. This explains why we saw Barclays open down 7% but close down just 1.4% on Monday.
Thereafter things calm down and stocks start slowly recovering. It may take until September for markets to recover much more than half their losses due to holiday and a news flow vacuum on macroeconomic data.
But has anything really changed? This year we had been becoming more cautious on the outlook for the US, concerned by unsustainably low consumer savings rates as well as high personal debt. The US government has its own debt issues – it will have to tackle its fiscal deficit at some stage, providing a further economic drag. Whether the payrolls and manufacturing data prove to be blips or portend a significantly weaker outlook for the economy is too early to tell. I would be cautious about extrapolating from two data points that have a habit of being materially revised – the services data painted a different picture on Monday.
I struggle to see an emergency rate cut from the Fed. There is no need to bail out Magnificent Seven holders, and it has another decision point soon – in September – where it can adjust policy.
The change in the UK is actually for the better. The Bank of England has just upgraded its growth forecast for the current year to 1.25%. PMI data is strong, and the election result and interest rate cut will hopefully be the catalyst to finally get the UK consumer to start spending. Unlike in the US, Covid savings here are still in bank accounts, and the current savings ratio of 11.1% is significantly above the long-term trend and materially higher than the 3.2% in the US. On top of this, due to the different mortgage market structure, UK consumers will benefit from lower mortgage rates much faster than those in the US.
So there are reasons to be cheerful amid the gloom – especially for investors in the UK!
