On Monday 5 August 2024, Wall Street closed significantly lower, capping off a global market rout that saw Japan’s main stock index experience its worst day in 37 years. The S&P 500, a key Wall Street benchmark, dropped 3%, marking its steepest one-day decline since September 2022, while the tech-heavy Nasdaq Composite fell 3.4%. The sell-off was widespread, with over 95% of S&P 500 stocks declining. Major tech companies, which had previously driven this year’s market rally, were among the hardest hit. Nvidia shares fell as much as 15% in early trading before closing down 6%. Despite the severe drop, conditions improved somewhat by the end of Monday. The VIX index, known as Wall Street’s “fear gauge,” was at 38 by the evening. Although this is much higher than its recent levels and the long-term average of around 20, it is significantly below the four-year high of 65 reached earlier in the day. Similarly, the S&P and Nasdaq recovered some of their morning losses after US ISM services sector data slightly exceeded expectations.

The key driver of the market sell-off is uncertainty about the health of the US economy and the timing of interest rate cuts as the ‘soft landing’ narrative is challenged. The US Federal Reserve (the Fed) kept interest rates unchanged last week, but weaker-than-expected US jobs data on Friday led some investors to believe the central bank should have already cut rates and may have left this too long. Equity markets, which have been rising for most of the year, declined sharply amid concerns that the Fed have been too slow to react to concerns of a weakening US economy and the potential need to implement rapid interest rate cuts to catch up. Investors are now anticipating 1.17 percentage points of interest rate cuts over the Fed’s final three meetings of the year, suggesting one or two half-point cuts and one quarter-point cut.

Adding to market pressure, Warren Buffett’s Berkshire Hathaway disclosed on Saturday that it had halved its position in Apple in the second quarter, while increasing its cash holdings to a record $277 billion and purchasing Treasuries. Retail investors were also rattled on Monday by issues accessing their brokerage accounts at companies like Fidelity and Charles Schwab.

Japan appeared to be at the epicentre of much of the movement, with a broad-based liquidation by global funds. The global sell-off was worsened by the unwinding of the Yen carry trade, where traders had borrowed in Yen at Japan’s low interest rates to invest in riskier assets. This was on the back of the recent decision of the Japanese Central Bank last week to raise their interest rate from 0.10% to 0.25%. The Yen has strengthened by about 12% since mid-July, on the back of the interest rate increase, including a 1.9% gain to ¥144.11 against the US dollar on Monday. Tokyo’s Topix index, a beneficiary of Yen weakness, subsequently plummeted 12.2%, its steepest drop since “Black Monday” in October 1987, wiping out its gains for the year.

Trading in both Topix and Nikkei futures was suspended during the afternoon session as the selling continued, triggering “circuit breaker” levels that automatically halt trading. In South Korea, similar circuit breakers were activated for the first time in four years. South Korea’s Kospi benchmark fell 8.8%, while Australia’s S&P/ASX dropped 2.5%, and India’s Sensex lost 2.7%. In Europe, the Stoxx Europe 600 index shed 2.2%, and the UK’s FTSE 100 fell 2%.

The market turmoil also affected cryptocurrencies, with Bitcoin’s price falling 14% at one point to $53,789, and Ether, another mainstream cryptocurrency, dropping as much as 21%.

What is Atrium’s view?

While the soft-landing view has been the market consensus in recent months, we have been of the view that the possibility of a moderate recession was not fully reflected in market pricing. Recent market events have confirmed this perspective. We have spoken much about the presence of severe market concentration, and the extended valuation gap between the large technology stocks – labelled the ‘magnificent seven’ and the remainder of the market was unlikely to be sustained. This also extends to the Australian market – with the outperformance of the banking sector versus the other sectors of the market. The recent market volatility is to some degree an unwinding of these themes. In addition, our expectation is that although the rate of inflation will continue to decelerate, it will remain above central bank targets in the near term. This persistent, ‘stickier’ inflation will extend the interest rate cycle and delay anticipated rate cuts, creating a more challenging economic environment for consumers and businesses in the coming year.

With these market pullbacks, we see opportunities, given our approach to fundamental and relative value assessment. While a hard landing remains a possibility, we believe it is unlikely unless a significant and unexpected event, such as an uncontainable shock to the banking system, occurs.

How are we positioning portfolios for the current environment?

We have been expecting an episode of volatility like this for some time given how stretched some asset price valuations had become. In this uncertain environment, we believe the appropriate strategy to build and protect wealth is to build portfolios that account for a range of possible outcomes as the future remains highly uncertain in the near term. This involves balancing growth exposures and diversifiers to provide smoother returns and greater investment value certainty, regardless of the future path. Reflecting this view and our portfolio positioning, we are exposed to quality stocks, including some US technology amongst a range of diversified companies and sectors. Our Yen position is performing very well supported by our Australian dollar position and are held for just such situations. We are also looking to increase our positions across various asset classes where we feel those assets have been oversold given the prospects for recession. We have maintained our exposure to traditional bond markets after increasing it last year and are monitoring for opportunities in interest rate markets. We also retain our diversifying allocation to liquid alternatives, such as trend strategies and long-short equities. Having performed exceptionally well during periods of market volatility, we believe these holdings will play a crucial diversifying role should the current volatility extend into the medium term. Private markets, offering the potential for stability and good returns, continue to be key components of our current investment allocations.

Diversification is crucial in managing the complexities of the investment landscape. By understanding and incorporating various factors—equity exposures, inflation expectations, commodity market structures, equity market sentiment, economic growth outlooks, and monetary and fiscal policies, we aim to construct resilient portfolios that navigate different phases of the investment cycle effectively.