It is tricky to know where to start in providing some context and useful perspective for what has transpired over the past week. As they say, ‘success has many fathers, but failure is an orphan’—well, in this case, many culprits have led us to this point. 

But where I’m going to start is with the Japanese markets and their central bank.  Last week, the Bank of Japan raised interest rates for the second time in 17 years to around ‘0.25%’ from a range of 0 – 0.1%.  For all intents and purposes, this recent hike was the first legit interest rate hike in nearly two decades, and arguably, the rationale for the hike was to defend the Yen, which had weakened to its worst level relative to the U.S. dollar (¥162 USD/JPY) in nearly four decades. Since its peak in mid-July, the Yen has rallied nearly 14% to just under ¥142 this morning, a dramatic move in just over three weeks.  This has caused massive deleveraging and degrossing across global capital markets, given that the yen has served as a currency of carry for investors worldwide. Japan’s Nikkei hit an all-time high on July 12th (days after the USD/JPY hit its lows) but has since given up 25% of its gains after plunging almost 6% on Friday and another 12.5% today.  

This, combined with weaker U.S. economic data, solid but not gangbuster corporate earnings, and a Federal Reserve that looks woefully behind the curve in instituting calibration rate cuts, you have the ingredients for the nasty correction currently underway in risk assets.  As of this morning’s lows (assuming they hold), the Nasdaq has corrected more than 15% from its July 10th high.  The S&P 500 was just shy of hitting a 10% correction, and the Russell 2000 is down 13% since last Wednesday – so much for the broadening all the talking heads were gushing over less than a week ago.  Look, now is not the time to play Monday morning quarterback, but rather focus on the here and now with your sights set on navigating the rough seas we’re in.

Without question, things changed last week, and the stock market suffered a lot of serious technical damage that will take time to repair.  The S&P 500 and Nasdaq are near critical levels of breaking long-term support while being dramatically oversold at the moment.  For the S&P 500, the 200-day moving average is around 5140, although 5100 is the big psychological area (this would be a 10% correction level, give or take).

The NASDAQ crashed through the 100-day moving average last week and traded below the 200-day this morning. No one likes the strategy of catching falling knives, but investors should note that the NASDAQ is down to the big trend line that has been in place since early 2023.

The RSIs of the S&P 500 (top panel) and Nasdaq (bottom panel) are at the most extreme levels we’ve seen in a while.   

The incoming economic data has been weak, full-stop, but it’s not recessionary at this time. True, weak is a pit stop on your way to recession, but I remain of the view that the totality of the economic backdrop remains too clouded to definitively draw a convicted conclusion either way.  I will admit that the trend in the underlying data doesn’t look great, and those who remain in denial about how important asset prices are for the economy better wake up because the deeper and more protracted this correction gets, the quicker it raises the probability we slip into a recession.  Spending, confidence, investment, as well as hiring and firing decisions have become extremely sensitive to asset prices, not to mention credit creation and money supply (asset prices are the collateral for most borrowing), so this slide in asset prices can/will have implications if it gets much more dramatic than it already is.

I’m hearing and reading a lot of comments calling for the Fed to implement an inter-meeting rate cut, with Jeremy Siegel on CNBC this morning suggesting the Fed should cut 75bps immediately.  Look, I’m with the camp that thinks the Fed is behind the curve again, but I also believe that an emergency ‘panic’ cut would do more harm than good.  It didn’t make a whole lot of sense to me last Wednesday when Jay Powell told us that a rate cut was actually on the table for discussion at the Fed meeting. However, policymakers decided to stand pat because they still lack confidence that inflation is falling sustainably towards their target.  Really?  The bond market begs to differ, and the yield curve screams that you are too tight.  This is what Jay Powell said about the yield curve back in March 2022 at the NABE Annual Conference:

“Frankly, there’s good research by staff in the Federal Reserve system that really says to look at the first 18 months of the yield curve […] It makes sense. Because if it’s inverted, that means the Fed’s going to cut, which means the economy is weak.”

Well, let’s update the math for anyone unaware. When Powell made this comment in March 2022, the part of the yield curve he referenced was positively sloped by more than +200 basis points. As of today, this part of the yield curve is inverted by -140 basis points, which “would mean the economy is weak” and that the Fed should cut.   

Central banks around the world aren’t nearly as interested in dragging their feet, with 28 having already cut rates ahead of the Fed – 67 moves in total, accumulating to 3,000 basis points in rate relief.  The Fed will get there as well, and Powell made this clear in his press conference last week, but by the looks of it, the market doesn’t seem to have the same level of patience. 

“I would say again, I think you're back to conditions that are close to 2019 conditions, and that was not an inflationary economy. Broadly similar labor markets then, I think inflation was actually, core inflation was actually running below 2 percent. So we don't think, I don't now think of the labor market in its current state as a likely source of significant inflationary pressures. So, I would not like to see material further cooling in the labor market, and that's part of what's behind our thinking. The other part, of course, is that we have made real progress on inflation.”

 Blackrock CIO Rick Rieder summed it up well with the following post on X:

Meanwhile, the 10-year Treasury note yield recorded its biggest weekly fall since March 2020 and has declined nearly 100 basis points from its peak at 4.73% on April 25th to just under 3.70% this morning.  Between the Bloomberg Commodity Index declining 12% since mid-May and this fall in yields, the market is telegraphing that growth and inflation are under assault.  Tack on the fact that China’s bond yields have fallen to record lows of 2.11% as investors respond to defla­tion­ary forces in the second-largest eco­nomy and treat all of these repeated attempts of small-scale stimulus measures as bringing a butter knife to a gunfight.  Deflation is the operative watchword, not inflation, which has been put back into the genie bottle. There is no structurally based inflation when the trend in unit labor costs is now running close to zero, and practically every company in the retail sector is experiencing a loss of pricing power in rather dramatic fashion.

So, what should an investor do? For starters, don’t panic. This morning, the VIX jumped above 65 (up 160% from its close on Friday) in what was its third-largest jump in history (see chart below).  This is what panic looks like, and such a jump doesn’t mean that the pain is over, but it most certainly means that anyone panicking from here is too late to do so.    

Other metrics like the S&P500 vs. the 3-months VIX vs VIX ratio (I know that’s a mouthful) are triggering panic levels and are yet another signpost that a lot of unwinding and degrossing has already occurred. 

As for sentiment, it too has been drastically reset with the Fear & Greed Index tipping into extreme fear for the first time since October 2023 – just before markets took off to the upside last fall.  I’m not saying a repeat is in store (sentiment isn’t the only factor that matters), but it does indicate that a lot of froth has been cleansed from risk assets. 

Keep in mind we are in the part of the calendar where seasonality is weak, not to mention the election uncertainty looming large overhead. 

The biggest question investors need to consider is the risk of a recession. If we don’t slip into recession in the next six months, then this is nothing more than a standard correction within an ongoing bull market (see the chart below from JP Morgan). 

However, if we’re tip-toeing our way into recession, then this is likely just the end of the beginning, not the beginning of the end.  I’m in the camp of the former at the moment and see this as more of a buying opportunity for investors to add risk incrementally in anticipation of a year-end rally.  I do think weakness and chop could persist into the middle of September, so I wouldn’t be deploying all my idle capital here and now. Still, I do think we’ve seen enough of a pullback in price, rise in volatility, resetting of sentiment and positioning that the setup has become much more constructive than a month ago.

Furthermore, interest rates have repriced dramatically, with Fed fund futures pricing in five rate cuts before year-end.  I don’t think that is way off base, but recognize that this is now in the price, so I’m not a buyer of bonds or fixed income at current levels.  A lot more has to go wrong for yields to fall further, likely a dramatic rise in recession probabilities.  So, pick your spots to add risk.  Be patient, disciplined, and methodical in your deployment strategy.  But above all, don’t forget where we likely are in the cycle – to me, it still looks like we are late cycle – so getting to your max risk exposure is not what I’m suggesting.  This view is more tactical, in that I think we have another leg higher into year-end before recession risks take center stage.  As always, if the facts change, then it's incumbent upon you to change with them – I know I will. 

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