If you’d chosen to be on holiday over the past two weeks, you might wonder what all the fuss was about. A fortnight after the biggest fall in the Japanese stock market since the 1987 crash, shares are pretty much back where they started. The summer squall has blown through.
What a difference a week makes
Last week was the strongest for global stocks since November. Wall Street ended the week 3.9% higher and is back within 2% of its July all-time high. Japan added nearly 8% last week. Europe was 2.4% up week on week.
It was a week in which investors decided that they had over-reacted to fears of an impending US recession. A spate of good data - inflation under 3%, strong retail sales - pointed instead to renewed hopes for a soft economic landing.
For investors it has been a wake-up call but one without serious financial cost - for those who held their nerve. Volatility has increased, and with it the need to prepare for further ups and downs ahead. But, unusually, we have been given a pain-free lesson in how markets operate.
What happened?
There are a few explanations as to why markets performed as they have over the past two weeks. Investors have become instant experts in arcane subjects like the ‘yen carry trade’. But perhaps the most compelling explanation came from the FTSE 100 listed investment trust Pershing Square this week.
It pins a lot of the blame on the increasing importance of index tracker funds. These hold a growing proportion of the shares in all companies in the market, but they are indifferent to valuation fundamentals. This means that other investors - including highly leveraged, short-term traders like hedge funds - have a bigger influence on price than they used to. And because they are often heavily borrowed investors, they have a low tolerance for losses and so move in and out of the market quickly. Result: volatility.
Looking ahead
In the short-term, the biggest influence on the market is likely to be what Jay Powell, chairman of the US Federal Reserve, has to say at this week’s Jackson Hole economic symposium in the Wyoming mountains.
Always a focus for investors, Jackson Hole matters more this year because interest rates are at a watershed. Poised to fall from their 23-year high, US rates are expected to decline by three or four quarter-point increments over the rest of the year. Two weeks ago, there was talk of an emergency half point cut but calmer markets have probably put paid to that for now.
Further out, attention is increasingly on what is certain to be a bitterly contested US Presidential election, against a backdrop of geo-political tensions in the Middle East and Ukraine. There is still plenty that could go wrong. That explains why the best-performing sectors in August have been the defensive areas of consumer staples, healthcare, and utilities. Nerves remain on edge.
Earnings growth in the bag
The good news is that corporate earnings are finally picking up the baton from higher valuations as the main driver of the stock market. As the second quarter earnings season draws to a close, profits have emerged more than 13% higher than a year ago. That means earnings are doing the heavy lifting in supporting the market. Valuations can ease back from here without the market falling further.
In other markets
Bonds have played their traditional balancing role during the market turmoil. As shares fell two weeks ago, bonds rallied on the back of lower interest rates expectations. Then as shares rebounded, so too did bond yields and bond prices consequently gave back their gains. That all helps deliver a smoother ride for diversified investors.
Also marching to a different beat has been gold, which continues to hit new highs. Breaching US$2,500 an ounce for the first time last week, the precious metal is benefiting from lower interest rate expectations. Paying no income, gold tends to do well when competing sources of yield are harder to find.
