Following a turbulent week in equity markets punctuated by a late week sell-off on a shaky July jobs report that stoked recession concerns, global equity markets continued to tumble in this week’s early trading as disappointing economic data has been exacerbated by an unwinding of a crowded carry trade and pressure on large tech stocks. On Monday, a surge in the Japanese yen triggered a flash crash in the Japanese stock market in which the Nikkei stock index plummeted by 12.4%, the market’s worst one day decline since 1987. The reverberations of Japan’s sell-off extended to the U.S. where the S&P 500 dropped 2.6% on Monday and the tech-heavy Nasdaq fell 3.4%, while the CBOE Volatility Index (VIX) hit as high as 65 (a level only reached during the pandemic and the Global Financial Crisis) before easing lower to close at 38.6. Monday’s losses follow last week’s declines of 2.0% and 3.3% for the S&P 500 and Nasdaq. Economically sensitive small caps fared worse as the Russell 2000 fell 3.3% on Monday on top of a 6.7% decline last week following strong gains in July. However, stocks are gaining back some of the lost ground in today’s early trading, led by a 10% bounce in the Japanese Nikkei Index.

Meanwhile, despite the Federal Reserve’s decision to hold off on rate cuts at the FOMC meeting last week, market participants have ratcheted up their expectations for more rate cuts before year end as the tepid jobs report increased concerns that the Fed has held rates at restrictive levels for too long and may need to play catch up with rate cuts. In fact, markets now anticipate four rate cuts before year end compared to just one to two rate cuts just a month ago. In response to expectations for more cuts and a dimming growth outlook, the U.S. 10-year Treasury yield dropped to 3.78% on Monday (and even dipped below 3.70% at one point) from 4.2% a week ago, and the 2-year Treasury yield plummeted to 3.88% from 4.39% in the week prior.

While the recent sell-off is unnerving and economic growth is certainly cooling, there are several important considerations to recent weak data that help temper concerns of a recession. The July jobs report fell well short of expectations as net new payrolls grew just 114k compared to the consensus forecast of 175k and the unemployment rate rose for the fourth straight month to 4.3%, up from 3.7% to start the year and the cycle low of 3.4%. However, the recent rise in unemployment has been mostly driven by a growing labor force that is outpacing labor demand and by an increase in temporary layoffs (potentially stemming from Hurricane Beryl and summer auto plant shutdowns) as opposed to permanent layoffs. Additionally, while it was reported last week that U.S. manufacturing activity fell further into contraction territory in July as the ISM Manufacturing PMI slid from 48.5 to 46.8 (readings below 50 imply contraction), the much larger U.S. service sector is looking healthier with a July ISM Services PMI reading of 51.4 (compared to expectations of 51.0), including solid hiring activity.

Beyond the fundamental data, the recent market rout also points to the unwinding of a popular, crowded trade after the Bank of Japan (BOJ) decided to raise rates last week with the goal of boosting the yen. For years, many global investors have borrowed at ultralow interest rates in Japanese yen and used the proceeds to invest in higher-yielding currencies and other more risky assets, like U.S. tech stocks. This trade, known as a carry trade, was caught offsides last week when the yen appreciated almost 8% against the U.S. dollar, which pushed traders to reverse the carry trade by selling risky assets and purchasing yen to cancel their debt, thereby further boosting the Japanese currency.

The unwinding carry trade put more pressure on the U.S. mega-cap tech stocks, which had already been reeling from recent profit-taking and growing investor scrutiny on AI capex as well as a handful of company-specific issues. Over the weekend, Warren Buffett’s Berkshire Hathaway disclosed in its quarterly earnings report that the company had sold roughly half of its substantial stake in Apple. Meanwhile, Nvidia tumbled on news that it was delaying the launch of its next generation of GPUs called Blackwell due to design flaws, and Google-owner Alphabet lost an anti-trust case against the DOJ relating to its Search business.

While the sell-off has taken some air out of extended U.S. stock market valuations, second quarter corporate earnings results have broadly brought mostly good news as a source of support. The S&P 500 EPS growth rate is tracking toward 11.8% year-over-year in the second quarter, an acceleration from the first quarter’s growth rate of 7.0% and outpacing consensus forecasts coming into earnings season for 8.9% growth. Furthermore, this growth is not solely attributed to the Magnificent Seven that drove the bulk of market earnings growth for the past 5 quarters. Excluding those seven mega-cap tech stocks, the rest of the market is on pace for 7.2% EPS growth year-over-year.

So how do we believe investors should respond to the recent uptick in volatility? Our investment team continues to emphasize a balanced approach and would caution against extending exposure in higher risk areas of the market beyond one’s long-term strategic targets. While we continue to keep our eyes on opportunities in high-quality individual businesses selling-off in indiscriminate broad-market moves, U.S. equity markets overall still sit at elevated historical levels even after the recent dip. Additionally, volatility is likely to remain elevated in the near-term as markets gauge the softening trajectory of global growth and the central bank response, in addition to assessing the implications of the upcoming election. As such we think investors would be better served with a patient and selective mindset with regards to additional risk, and now is an opportune time to ensure sufficient diversification of equity portfolios after an extended stretch of concentrated stock market returns. Over the past year, we have been leaning constructively into high-quality investment grade bonds to lock-in higher yields ahead of the decline in market rates, and we have generally sold lower quality the high-yield junk bond exposure in the current context of very tight credit spreads that offer limited additional compensation for higher default risk. As always, we will continue to keep you apprised of our thoughts on the ever-changing market and economic landscape. Please don’t hesitate to reach out to our team of advisors if you have questions or concerns.