Investors looking for stability in 2024 have been sorely disappointed, given market volatility in Q3. This volatility was due to a combination of slowing macroeconomic data, global expectations for monetary policy, and a large shift in the U.S. election landscape — all of which coalesced to spook some institutional investors to unwind favoured positions referred to as Yen carry trades. Measures of market volatility, such as the CBOE’s VIX index, jumped to multi-year highs from historically low levels.
To understand what to expect in the coming months, let’s review the events that took place in July.
U.S. President Joe Biden’s decision to exit the presidential race, paving the way for U.S. Vice-President Kamala Harris to run against former president Donald Trump, threw a wrench in polls attempting to predict the election’s outcome. The decision upset the market’s calculus of the future policy environment, including a read-through of the regulatory uncertainty domestic businesses will need to navigate, and how geopolitics and trade policies could impact the U.S. dollar and inflation.
The U.S. economic picture, including recent inflation and labour market monthly releases, has been showing gradual softening. That, combined with the economic growth slowdown underway in more interest-rate-sensitive economies like Canada, increased market speculation that the Federal Reserve would cut the federal funds rate by September and also that a monetary policy mistake was becoming more likely.
As markets began to grapple with these issues, the Bank of Japan surprised many on July 31 with a larger than expected rate hike. This increased the cost of funding carry trades in many markets in which investors had been borrowing in Yen (a low-yielding currency) and buying investments in other markets, including U.S. growth stocks, and bonds of Mexico and other emerging market countries with high real yields. For much of the last two years, the relative stability of these trades encouraged market participants to put on these positions, causing valuations to expand.
In the wake of the ensuing market volatility, Bank of Japan officials reacted to the 12% drop in the Nikkei with assurances that market stability would be a prerequisite for future policy rate hike decisions. In the following weeks, markets stabilized and recovered to a great degree; however, the question remains: Has the volatility cleared, or is the road to year-end going to be a bumpy one?
Looking ahead: A mixed picture
As the U.S. election approaches in November with an uncertain outcome, markets will likely need to include a political risk premium until the country’s policy direction is known.
Additionally, investors should take note of the Federal Reserve’s expected preoccupation with labour data in the months ahead. The data revisions by the U.S. Bureau of Labor Statistics in August emphasize the weakening employment picture, which means the Fed’s rate-cutting agenda is now more likely to embrace the maximum employment portion of their dual mandate (which also includes price stability).
On the plus side, Federal Reserve Chairman Jerome Powell’s comments in August seemed to support the market’s perception of Fed rate cuts starting in September and continuing into 2025. Importantly, the bond market has mainly shifted rate-cut expectations to 2024 from 2025, suggesting that the most likely economic scenario is still a soft landing. Bond yields have fallen since April, offering borrowers some immediate relief with the lagged but positive effects of rate cuts to be felt in the quarters ahead.
Finally, U.S. equities markets have delivered on earnings so far this year, and corporate credit fundamentals remain strong. If forward earnings can hold up to expectations, the markets’ worries over a hard landing will fade.
With this market backdrop, investors may see a broadening of the equities market upside participation away from the few names that drove returns this spring. However, this may generate more of a market churn than trend. Stocks with recently overextended valuations may find investors less willing to pay up given the current mixture of risks.
So, how can investors ride out this upcoming period of uncertainty? A neutral stock/bond portfolio asset allocation will help investors find the right balance, as bonds still offer decent yields and will provide stability in the rockier moments. Within equities, investors should consider rebalancing exposures across sectors and geographies if their positioning has become too narrowly focused on a few high-flying growth stocks.
Steve Locke is chief investment officer, fixed income and multi-asset strategies, with Mackenzie Investments.