Investors have had a rough ride over the past few days, as fears of a US recession have sparked a global sell-off in equity markets.
The S&P 500 fell by more than 2% last week, while the Nasdaq fell by around 3.5%. It is Japan that is bearing the brunt, though, with the Topix down a whopping 12.23% today. Meanwhile, the FTSE 100 is down 1.94% so far today, at the time of writing.
It is a classic case of America sneezing and the rest of the world catching the cold. US labour market data came in weaker than expected last week, dampening hopes of a “soft landing” for the US economy. The contagion quickly spread to other markets, with the sell-off continuing into the start of this week.
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In a “soft landing” scenario, central bankers hike interest rates just enough to slow inflation, but avoid pushing the economy into recession. Increasingly, investors have been pricing this scenario into markets, hence the extended bull run we have enjoyed so far this year.
However, the bubble looks like it could be set to burst after several US economic indicators surprised to the downside last week. Investors are now wondering whether a bumpy landing, or indeed a recession, is actually in store.
“A market storm is emerging from a seemingly cloudless summer sky,” says Russ Mould, investment director at AJ Bell.
“The question now is whether this is just a tempest in a teapot, and the result of thin trading volumes as the big hitters head to the beach and leave deputies and juniors in charge, or whether it is the harbinger of a more serious – and bearish – shift in market sentiment,” he adds.
We take a closer look at the latest developments and what they mean for investors.
What has prompted fears of a US recession?
Fears of a recession emerged last week, thanks to weaker-than-expected economic data in the US.
US nonfarm payrolls, a key economic indicator, showed that fewer jobs had been added to payrolls in July than expected. The unemployment rate also increased from 4.1% to 4.3%, while the number of new applicants for unemployment benefits jumped to an 11-month high.
The latest manufacturing data didn’t help matters. The US Purchasing Managers’ Index, which indicates the health of the manufacturing and services sectors, showed that production stalled in July.
“Purchasing activity is falling and hiring has slowed amid concerns over weaker-than-anticipated sales,” says Chris Williamson, chief business economist at S&P Global Market Intelligence.
After this string of disappointing news last week, some investors are starting to worry that the economy is slowing too much. Meanwhile, interest rates remain high, keeping a chokehold on the economy.
The Federal Reserve (Fed) decided to hold rates at their current level for the eighth consecutive meeting on 31 July. Rates are currently at a range of 5.25-5.5%.
The Fed indicated it could cut rates at its next meeting on 17-18 September, however many are now wondering whether the US central bank will be forced to make an emergency cut before then.
Japanese equities are bearing the brunt
Japanese equities have taken a big hit in recent days, as US recessionary fears have spread. The Topix hit a record high in July, but in the space of a few days, the index’s gains for the year have been entirely wiped out. At the time of writing, the Topix is down more than 6% year-to-date.
The situation hasn’t been helped by the timing of monetary policy moves from the Bank of Japan, which increased its benchmark rate to 0.25% on 31 July, up from its previous range of 0-0.1%.
Other central banks around the world have been thinking about cutting interest rates, after holding them at multi-year highs in a bid to combat inflation. However, Japan has been dealing with low growth and deflation for decades. Japan’s recent interest rate hike is the first since 2007.
This has caused the value of the yen to strengthen after years of providing cheap money to investors, who have borrowed it and used the proceeds to invest in other, higher-yielding assets around the globe. These trades, known as ‘carry trades’, are now unravelling, and it is causing widespread disruption.
Unfortunately, panicked selling from more inexperienced investors could also be partly to blame for Japan’s disproportionate losses, according to Mould. “In 2014, Japan introduced tax exemptions to encourage more Japanese investors to put their cash into the market and take it out of the bank,” he tells MoneyWeek.
“That 20% exemption on capital gains and dividends (up to a certain investment level) was doubled this year and its lifetime extended... There is a nasty chance that the wobble has frightened inexperienced investors and they have fled the market, increasing the selling pressure as they go,” he explains.
Recession or short-term blip?
Investors now need to ask themselves whether the recent sell-off is just a blip, or whether the US and other global economies could be heading for recession. Some investors have already panicked and flocked into safe-haven assets in recent days, however selling too soon can result in losses, particularly if you exit your investments at the bottom of the market.
Sam North, market analyst at investment platform eToro, thinks it is too early for investors to panic, pointing out that trends are more important than individual reports. He says that the rise in US unemployment was largely due to layoffs from Hurricane Beryl, which should reverse next month. When looking at individual company performance, North also thinks that earnings remain strong.
Despite this, investors are starting to question whether US equities have become too expensive. We have seen this recently in how they have reacted to earnings announcements from the Magnificent Seven tech companies.
Amazon announced its earnings last week, with profits doubling compared to the same period a year ago. However, the stock still plunged after revenues (which rose by 10%) came in below analyst expectations. Investors also displayed some scepticism about the large amounts being spent on AI projects. We saw something similar when Google’s parent company Alphabet announced its results last month, revealing a large increase in capital expenditure.
Share prices have been racing away in recent years, giving the impression that the only way is up. But how much further can they go before something breaks? US equities are now trading at around 20 times the value of their earnings, and the S&P 500’s market cap represents around 160% of GDP – an all-time high.
“Those numbers suggest either prices must fall some way, or earnings must surge quickly for stock markets to regain their equilibrium,” says Mould. This is something for investors to keep a close eye on going forward.
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