Flash update

In the last Macro Monthly we covered the technical fragility of markets from the combination of crowded positions and a currently illiquid seasonal period. Such concerns have played out more quickly and violently than we expected, with the catalyst being a weakening of PMIs and the US labor market. However, we maintain the view that the scale of such moves is largely a function of technicals.

For example, the Nikkei has fallen as much as 21% over a three-day period. We struggle to see any change in Japan’s fundamentals that justify the magnitude of this move. Instead, Nikkei weakness is best explained by an extremely crowded short position in the JPY, which had built up over the course of the year. As the Bank of Japan became more hawkish this position came under pressure and the unwind of such a large carry position has had knock on effects on Japanese equities and broad FX carry trades.

Similarly, we have seen gold prices start to come under slight pressure in the last two days. Gold usually behaves as a protective asset in times of declining real yield and rising economic concern. However, as there is an extended net long position in gold it has struggled in this instance, reflecting the indiscriminate nature of asset selling in these deleveraging episodes. Additionally, the tech sector, which has enjoyed large inflows year-to-date, is underperforming many cyclical assets, the latter of which would be expected to underperform on recession concerns.

We acknowledge that economic data have started to weaken, and that the loss of momentum does increase downside risks to the economy. That said, we do not want to react too aggressively to one month’s data. This is particularly the case for the US labor report where we scope for irregularities in the data relating to weather effects and temporary factors. In addition, there is not clear evidence of a large pickup in permanent layoffs, as evidenced by JOLTS and Challenger data for July.

Absent an increase in layoffs, it is difficult to tell whether the cooling of the economy is just a normalization, or if we are on our way to a hard landing. At this point we think the odds still point toward a soft landing given slower but still very healthy income growth, an elevated level of job openings, corporate revenues and guidance which is decelerating but far from signaling impending doom, and strong balance sheets.

While we downplay the severity of recent data weakness, we are mindful of market feedback loops onto the economy. Should the magnitude of the sell-off worsen on a sustained basis, consumers and corporates would face a negative wealth effect and pull back on consumption or investment. We are presently far from this scenario; nonetheless, should it occur, we would expect to see the Federal Reserve and other central banks cut rates more aggressively to counter the tightening of broad financial conditions.

We think this would provide an effective circuit breaker for the market for three reasons. First, inflation dynamics have already allowed a move toward less restrictive policy, hence such actions would not be deemed as inappropriate. Second, there is plenty of room to cut meaningfully. Third, and most importantly, we think lower rates would quickly stimulate demand as private sector balance sheets are in a strong position and do not need to go through a deleveraging cycle, nor does the economy need large fiscal stimulus.

That being said, we think it is still far too soon to position for such an environment, and think the Fed, and other central banks, will want to see more data before needing to act that aggressively. The market is pricing in over 100 basis points of easing by year end, which looks a tad aggressive if the US labor market doesn’t crack.

As things stand, markets are going through a period of illiquidity and indiscriminate selling. We think the rapid increase in the value of protection (the VIX reached a high of 65) is being driven by technicals rather than a large reappraisal of the fundamental backdrop. Accordingly, current dislocations may create excellent long-term buying opportunities. It is moments like these where active management can take advantage of market dislocations.