Navigating market volatility: Insights for investors

• While risks have risen, we believe the market has overreacted to a small number of weaker-than-expected datapoints, not a drastic change to the macro outlook.
• Much of the recent moves have been driven by technical factors and systematic investors, belying the fact that fundamentals remain broadly constructive.
• Volatility may persist as narrative and technicals can dominate in the absence of additional data. We advocate staying invested through the market tumult. Investors can consider tilting toward quality and there may be a greater role for bonds as portfolio diversifiers with stock bond correlation returning to negative territory.

If you’ve been out on holiday, focused on the Olympics, or just not paying much attention, you might be wondering: What the heck just happened?

The stock market, which has been under pressure since mid-July, continued moving lower to start August. The S&P 500 has fallen 7.6% and the Nasdaq 100 is down 12.6% since peaking in mid-July.¹ The CBOE Market Volatility Index (VIX), which had been below 20 since October 2023, briefly rose above 60 on Aug. 5, its highest level since March 2020.²

Dog days of summer, indeed.

Stocks rebounded on August 6 and the VIX retreated back below 30.³ But the recent spike in volatility may persist in the near term given heightened uncertainty over geopolitics, the state of the economy, and the outcome of the U.S. election.

What explains the recent market volatility?

Here’s a recap of recent developments, followed by some ideas for how to navigate this latest bout of market volatility.

While the stock market swings dominated headlines, the bond market has faced its own bout of drama this summer.

Since touching 5% on May 29, the yield on the 2-year Treasury has fallen more than 100 basis points, which is a big move in the often-staid world of Treasuries.⁴

The sharp fall in 2-year yields — which move in opposition to the bond’s price — reflects heightened concerns about the U.S. economy and the Fed signaling its willingness to start cutting rates; we believe most likely at the September FOMC meeting.

The July jobs report catalyzed fears the economy may be heading into sharper slowdown that expected. The U.S. economy added just 114,000 jobs in July, much lower than forecasted, and well below the three-month average of 170,000.⁵ Additionally, the unemployment rate jumped to 4.3%, while average hourly earnings rose just 3.6%, the lowest in three years.⁶

Adding insult to economic injury, there were downward revisions to previous month’s payroll growth and the July ISM manufacturing report fell to 46.8, much weaker than expected. Some of the ISM report’s forward-looking indicators, such as new orders and employment, were also soft.

While recession risks have risen, the fundamentals haven’t changed since we released our Mid-Year Investment Directions. Economic data point to gentle deceleration rather than deep contraction (see figure 1) and we note:

• Second-quarter GDP surprised to the upside.
• The July ISM’s services index rose to 51.4, suggesting the critically important services sector remains in expansion.
• Inflation remains well above the Fed’s 2% target.
• Consumer confidence is low, but spending data remains relatively resilient and is simply normalizing from post-Covid trends, in our view.

Figure 1: U.S. recession monitor pulse check

While industrial production and small business optimism tighten and contract below our level of concern, a strong labor market, lending standards, and personal income buoy consumer resilience.

For these reasons, we disagree with recent speculation the Fed will cut rates before its September meeting and think it’s unlikely the central bank will cut by 50 basis points.

The big news in July was the rotation from large to small cap. The big news in August (even the first few days) was the rotation from cyclicals to defensive sectors. We aren’t ready to embrace small caps and cyclicals, as historically they’ve needed both falling interest rates and strong growth to outperform for an extended timeframe.

On the earnings front, U.S. corporations are on track to post double-digit earnings growth for Q2, led by healthcare (29%) and tech (20%).⁷ We have been of the view that as more sectors post positive earnings, this could mean the market broadens out in the second half of the year, as has been the case since early July.

What remains to be seen, however, is how much rotation moves away from growth to other parts of the market.

The AI trade has come into question in a meaningful way this summer. The mega-cap tech giants have mostly reported still-strong growth, but the priced-to-perfection names were met with negative price action on guidance concerns:

• Google, Microsoft and Amazon, for example, delivered their smallest earnings beats in over six quarters.⁸
• Investors are increasingly worried about the path to monetization of AI-related capital expenditures, weighing on the feverous optimism that gripped the complex just months ago. Just prior to earnings season, sell-side analysts noted that capex was revised higher at nearly a 9:1 ratio relative to future revenue revisions.⁹ In other words, more spending on AI wasn't clearly translating to future revenue growth.
• Consumer softness was another undercurrent of the reporting season — guidance highlighting softer consumer spending spooked some investors.¹⁰

In our view, AI is poised for growth over next 5-to-10 years and can drive earnings for companies that are spending heavily today. But timing is everything as the saying goes. That is, the time between when the AI costs are incurred vs when companies are able to reap the benefits of this capital expenditure cycle.

When markets are in “risk off” mode, investors tend to sell what they own — both to take profits and to reach for liquidity. And what many investors own — especially those invested in market-cap weighted indexes like the S&P 500 — are large-cap growth and tech stocks. In moments of rising volatility, as we’ve just experienced, this kind of positioning can translate to aggressive selling in the year-to-date winners.

The recent market drama was not just — or even primarily — a U.S. story. The strengthening Japanese Yen has been a point of focus for investors as the “carry trade” unwind is driving some part of the market volatility. A “carry trade” is when an investor borrows in a lower-yielding currency, such as the Japanese Yen, and invests the proceeds in a higher-yielding one. We believe the sharp move higher in the Yen since the middle of July, exacerbated by the hawkish shift from the Bank of Japan and expectations of aggressive rate cuts from the Fed, are leading investors to unwind their long-held carry trades, further exacerbating market volatility.

Against this backdrop, we encourage investors to stay invested, but focus on being nimble through this period of market volatility. We think an active investment style is key here as the market narrative shifts (seemingly) by the hour.

Rather than moving into — or staying in — cash, investors may consider buffered strategies, which look to track the return of a broad market up to an approximate upside limit, while seeking to maximize the downside protection against potential price declines.

For investors looking to take a more tactical approach, consider the following:

Lean into quality in equities: Quality sectors have been over-punished in recent weeks, in our view, given that fundamentals remain strong. We focus on margin resilience and profitability and continue to like the tech and healthcare sectors as expressions of this quality view.

Focusing on defensive sectors for those wanting to reduce risk: Defensive sectors like utilities or broad minimum volatility exposures can benefit portfolios in periods of extended volatility. Consider gold as a geopolitical hedge.

Stay nimble in fixed income: Rates have already moved a lot in anticipation of the Fed being more aggressive with rate cuts, starting with its September meeting. We like the belly of the Treasury curve.

In periods of heightened market volatility, selling may seem indiscriminate. Be surgical and measured on the way back up. Sharpen your pencil, make a shopping list of what you want to own for the long term and consider using any additional short-term dislocations as an entry point. For investors with lower risk appetite and/or shorter investment horizons, that can mean utilizing buffered strategies or minimum volatility exposures.

For longer term allocations, it’s important to note bonds and equities have recently returned to their historical relationship of negative correlation.¹¹ Although the bond market has rallied sharply in recent weeks, we believe it's important to continue to hold onto those positions to help diversify any potential further downside risks in equities.