Cigarettes, coffee and panic
The stockmarket rout may not be over
As investors pause for breath, we assess what could turn a correction into a crash
For a while on August 5th things were looking truly awful.
During the Asian trading session Japan’s benchmark Topix share index had fallen by 12%, marking its worst day since 1987.
Stocks in South Korea and Taiwan had tanked by 9% and 8% respectively, and European markets were faltering.
Before trading began in America, the VIX index, which measures how wildly traders expect share prices to swing, was at a level it had reached only early during the covid-19 pandemic and after Lehman Brothers collapsed in 2008 (see chart 1).
Ominously, though gold is usually a hedge against chaos, its price was falling—suggesting that investors might be selling assets they would rather hold on to in order to stay afloat.
The previous week’s rout in global markets seemed to be spiralling into a full-blown crisis.
The VIX fell back to only its highest during the crash of 2022; by the end of the day the S&P 500 index of large American companies was down by a mere 3%.
Over the next few days American and European stocks recovered a little, and Japanese ones bounced back.
The losses made over the past few weeks have nevertheless been brutal, stretching into the double digits for the Topix and America’s tech-heavy nasdaq 100 (see chart 2).
And as ever after a rout—while traders pause for breath and attempt to catch up on some sleep—one question looms large.
Did markets simply succumb to a brief bout of madness, or is there worse to come?
Since mid-July, three developments have combined to unsettle investors.
The first was a dawning realisation that artificial intelligence (AI), and especially the chipmaking industry that powers it, had been imbued with unrealistic hopes.
Donald Trump, the Republican presidential candidate, sent semiconductor stocks into a tailspin on July 17th by suggesting that Taiwan, where the vast majority of the world’s advanced chips are made, should pay for its own defence against China.
The Biden administration, meanwhile, was said to be planning curbs on exports of chipmaking equipment to China.
A lacklustre earnings season for America’s tech giants then added to the geopolitical woes.
Over the course of ten days from July 23rd Alphabet, Amazon, Apple, Meta and Microsoft all released results that left shareholders crestfallen.
Even Alphabet and Microsoft, whose revenues beat expectations, saw their share prices fall the day after they reported.
Those of Amazon, which undershot expectations, were punished far more.
Investors’ euphoria over all things AI was evaporating.
At the same time, a rally by the Japanese yen was roiling stocks on the other side of the world—the second development to give investors an attack of the vapours (see chart 3).
This was in part caused by the Bank of Japan’s surprise decision to raise interest rates to around 0.25% on July 31st.
A rising yen automatically depresses Japanese share prices, since many of the country’s largest globetrotting firms, such as Hitachi, Sony and Toyota, make their earnings in foreign currencies.
The third development—an unexpectedly weak American jobs report released on August 2nd—then supercharged the effects of the other two.
The report revealed that the unemployment rate rose to a three-year high of 4.3% in July, while the economy added just 114,000 jobs, against a consensus forecast beforehand of 175,000.
That put the world’s biggest economy closer to a recession than most had thought.
American Treasury yields plummeted, with the two-year rate falling to 3.9%, more than a percentage point below its level at the end of April.
And share prices around the world went into free fall.
My heart cries out
Even then, there was still room for a fair few winners.
Although America’s headline indices sank, shares in companies such as Johnson & Johnson, Procter & Gamble and UnitedHealth enjoyed a bounce on the day of the jobs report.
Such firms are in sectors well placed to weather a downturn (pharma, consumer staples and health care, respectively), and pay healthy dividends, raising their value as the Federal Reserve becomes more likely to cut interest rates.
However, by August 5th that was little help: the sell-off had broadened out.
Investors were ditching virtually every stock in the S&P 500, along with those across global markets.
What had started as the unwinding of a few popular trades had transformed into a slump encompassing pretty much everything.
Such indiscriminate selling may well resume.
Christian Raute, a trading-strategy boss at Citigroup, a bank, says that the breadth of the selling suggests professional investors have received a “tap on the shoulder” from above, ordering them to reduce their risk no matter what they need to offload to do so.
For large funds, that will take more than just a few days of sales.
In the meantime, other outfits will hesitate to buy even assets they think have become underpriced, fearing a behemoth somewhere still has a big position to dump into the market.
The gut-churning drops, in other words, appear to be far from over.
Investors may be forced out of especially crowded bets for other reasons.
The astonishing speed with which the Japanese yen has strengthened in recent weeks, for instance, is probably because of the unravelling of “carry trades”.
These involve borrowing yen cheaply and using the proceeds to buy other assets—perhaps a higher-yielding currency, such as the American dollar or Mexican peso, or even stocks.
But should the yen suddenly strengthen relative to the other asset, the trade quickly plunges into the red and may need to be terminated.
Doing so involves selling the other asset and buying yen to pay back the debt, exacerbating the move and quite possibly forcing others into the same position, creating a vicious circle.
If this generates a big loss, the investor may also need to leave other positions to meet it.
Some of the recent violent swings in the yen, Japanese and American stocks, and indeed the Mexican peso, may thus be the result of yen-based carry trades.
Moreover, any popular trade that some investors have funded through borrowing can fall victim to the same sort of doom loop.
Bets on firms linked to AI euphoria are a prime candidate.
The VIX index’s hair-raising spike on August 5th, caused by hordes of investors clamouring to buy insurance on the same stocks at once, suggests quite how crowded such positions are even after the recent unwinding.
It also shows quite how much this crowding can move markets.
And so there is plenty of potential for future sales, whether forced or voluntary, to cause further ructions.
The most dangerous escalation would come if the turbulence has left a sizeable investment vehicle unable to raise the money required to meet margin calls or close loss-making positions.
That is what happened to Archegos, a family office, in 2021, prompting fire-sales of its assets and losses for its banks stretching into the billions of dollars.
At a bigger outfit, such a collapse could spread contagion across the market and imperil other companies.
As yet, “there is not sufficient pain to suggest a big player is in danger,” says Citi’s Mr Raute.
“But if we see five more days of this, that may change.”
Nothing but joy
Another cause for panic could come from surprises on the economy, or further doubts about the viability of the ai boom.
There are plenty of potential flashpoints in the weeks ahead.
Around a quarter of firms in the S&P 500 are still due to report their second-quarter earnings.
These include Home Depot and Walmart, barometers of American consumer sentiment, and Nvidia, on which the fortunes of AI investors everywhere depend.
Inflation data released on August 14th will hint at whether the Fed can indeed cut rates by 0.5 percentage points in September, which many are convinced it must in order to stave off a recession.
Given the carnage that followed the most recent jobs report, the next, on September 6th, is another obvious catalyst.
Even now America’s stockmarket remains more expensive relative to firms’ underlying earnings than at almost any point in history.
Greed has given way to fear, and the bulls have taken a battering.
But if valuations are to return to normality, there is still a long way to go.
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