Despite the volatility, August was a good month for diversified investors…
August was an eventful month for investors. Any hopes of a late summer lull were quickly dashed at the beginning of month after the publication of disappointing US economic data,together with an interest rate hike by the Bank of Japan, sparked a sharp sell-off across global equity markets. However, by month end, the market had rebounded as investors began to price in more aggressive policy easing by the Federal Reserve (Fed).
In the US, a July ISM manufacturing print that came in well below expectation (46.8 vs 48.8), anda weak July jobs report which showed the smallest payrolls increase (114k) in over three years,fuelled fears about a US recession. Moreover, on the back of higher labour participation, theunemployment rate increased slightly to 4.3%, enough to trigger the Sahm Rule indicator, an empirical observation which predicts a recession when the three-month moving average of theunemployment rate exceeds its lowest level from the prior 12 months.
At the same time, the Bank of Japan’s decision to increase its policy rate by 25 basis points (bps)and Governor Ueda’s hawkish tone led to an abrupt unwinding of carry trade positions, whichhad relied on cheap Japanese yen borrowing costs to buy other higher yielding assets.
Against this backdrop, global equity markets sold off and volatility (VIX) spiked, while globalbonds rallied. The Bloomberg Global Aggregate Index ended up 2.8% over the month as weakereconomic data and cooling inflation bolstered the case for a September Fed rate cut.
In the second half of the month the prospect of lower US interest rates helped equity marketsrebound and developed market equities closed 2.7% higher over the month. Other interest ratesensitive assets classes, such as real estate, were also well supported and the Global REITsIndex rose 6.2%.
For commodity markets, however, the weaker global growth and manufacturing momentum washarder to digest. Oil prices retreated on demand concerns, iron ore prices dropped to a two-yearlow on the back of the real estate crisis in China, and the broad Bloomberg Commodity Indexremained flat over the month.
Equity market
In a volatile month for equities, the TOPIX Index was the hardest hit dropping 12% on 5 August, itsbiggest daily drop since Black Monday in 1987. Investors also took profit in other markets whichhad performed well over the last couple of months, and the Nasdaq dropped almost 6% over thecourse of three days.
The equity market sell-off was short lived. After the initial spike in volatility investors took comfortin the prospect of lower interest rates as well as a solid Q2 earnings season that showed fewsigns of an imminent economic slowdown. This allowed most markets to recover their losses bythe middle of the month.
Globally, the S&P 500 continued to outperform, thanks to a broadening of earnings growth outside of the technology sector as we discuss in our latest “On the Minds of Investors - Does a slowing US economy challenge current earnings forecasts?”. This helped the S&P 500 deliver returns of 2.4% over the month. Asia ex-Japan and emerging market equities outperformed most of their western developed market counterparts, delivering returns of 2% and 1.8% respectively, as expectations for Fed rate cuts weighed on the dollar (DXY Index), which dropped 2.3% over the month.
Europe underperformed the US in local currency terms, returning 1.4%. Although the boost to the French service sector from the Olympics meant the eurozone composite PMI (Purchasing Managers’ Index) came in higher than expected, the overall economic backdrop remained weak and earnings from cyclical companies disappointed.
Fixed income markets
August was a positive month for fixed income investors. The volatility observed at the start of the month led to a flight to quality while ongoing concerns about the economic outlook led investors to discount more aggressive rate cuts from major central banks in the coming months. Against this backdrop, the Bloomberg Global Aggregate Index posted a performance of 2.4% last month, as its yield decreased by 14bps.
Within the developed sovereign bond market, US Treasuries outperformed other markets delivering returns of +1.3% as investors now expect the Fed to cut rates more aggressively than the European Central Bank in the coming months. European sovereign bonds benefited from the positive backdrop for bonds but to a lesser extent. Japanese government bonds rallied as demand increased from domestic investors following the unwinding of the carry trade at the beginning of August.
Global credit markets performed well, with a stable corporate earnings outlook continuing to support the asset class. The flight to quality helped global investment grade bonds which delivered 1.9% to end the month as the best performing sector. Conversely high yield lagged somewhat rising 1.6% and 1.2% respectively in the US and Europe.
Emerging market debt also posted a strong performance last month delivering returns of 2.3%, as a weaker US dollar provided a tailwind for the region.
Investment Implications
Despite the volatility, August was a good month for diversified investors as equity and fixed income markets provided positive returns. Because of the yield buffer, fixed income provide protection during the sell-off at the beginning of the month, while equities later recovered on US rate cut expectations.
Fears about a US recession appear exaggerated given the resilience of the labour market and consumption. However, GDP growth is slowing and inflation, which dropped below 3% for the first time since March 2021, is retreating. In this context, we believe the Fed is on track to deliver several rate cuts this year, starting in September. However, any further weakening of the labour market might warrant a more aggressive policy response.
So long as the earnings outlook is stable equities should be supported by falling US yields. Defensives and modestly priced quality stocks look attractive in a slowing growth backdrop. As the Fed prepares for the first rate cut, the dollar looks vulnerable because of a narrowing interest rate differential. US dollar hedged strategies and greater international diversification can mitigate this risk for investors. While a soft landing scenario is still our base case, extending out of cash and locking in current yields in high quality fixed income is an attractive way to increase portfolio resilience against volatility and a negative growth shock.
