Stocks have roared back with a vengeance from the worst August start since 2002, but don’t let the bounce disguise a crucial change in the way markets are now interpreting economic data.
“We’re at an important inflection point that consists of markets recognizing that we’re now, number one, in an environment where we’re sort of sticking the landing on inflation, and, number two, a slower economic environment,” said Tony Roth, chief investment officer at Wilmington Trust Investment Advisers, in an interview.
Most Read from MarketWatch
Solid progress on inflation is good news in that it clears the way for the Federal Reserve to begin cutting interest rates. But the focus on slowing growth means investors are now much more attuned to fears that a widely hoped economic soft landing could instead turn into a recession.
That means the market “pivots from an inflation risk to a growth risk,” Roth said. Wilmington Trust expects U.S. gross-domestic-product growth to slow to a 1.5% annual rate in 2025, but warns there is a 1-in-3 chance that the economy does indeed slide into recession.
“We’re going to be in a different kind of volatility regime than we’ve been in the past,” he said. “The margin for error is less.”
As many investors and strategists have argued —and the market itself has demonstrated in recent weeks — bad news is now bad news for stocks, while good news is good news. Previously, bad news was more likely to bolster stocks and other assets perceived as risky because it helped make the case for Fed rate cuts; good economic news tended to have the opposite effect.
Now, bad economic news serves to instead underline recession fears. The switch appeared to flip on Aug. 2, when a somewhat softer-than-expected July jobs report accelerated a stock-market selloff that culminated when markets reopened the following Monday.
The selloff, which seemed to be exacerbated by the violent unwind of the popular Japanese yen USDJPY carry trade, led to cries that the Fed had made a policy mistake by leaving rates unchanged at its July meeting. Fed-funds futures traders briefly priced in the possibility of an emergency August rate cut and ramped up bets that policymakers would cut by 50 basis points, or half a percentage point, rather than a quarter point at their September meeting.
Meanwhile, a better-than-expected reading on first-time weekly jobless claims this week and last helped lift stocks, as did a handful of other positive economic readings. As stocks recovered and fears of an imminent economic downturn eased, traders unwound bets on an emergency rate cut and now see the Fed as most likely to cut by a quarter point in September — followed by quarter-point cuts in November and December, as well. Meanwhile, expect Fed Chair Jerome Powell to be in the spotlight Friday when he delivers a speech at an annual economic symposium in Jackson Hole, Wyo.
It all made for a jaw-dropping first half of August. The S&P 500 SPX dropped 3% on Aug. 5, while the Dow Jones Industrial Average DJIA tumbled more than 1,000 points that day. The S&P 500 and Nasdaq Composite COMP logged their worst three-day starts to any month since August 2002.
But Aug. 5 appeared to mark the low. Stocks subsequently found their footing, with the S&P 500 on Friday extending its winning streak to seven sessions as that index, the Dow and the Nasdaq all posted their strongest weekly gains since November, according to Dow Jones Market Data.
Meanwhile, expected volatility — as measured by Wall Street’s so-called fear gauge, the Cboe Volatility Index VIX — is back below its long-term average.
Read: Why a historic surge in the VIX wasn’t the signal investors thought it was
“July was peak optimism about a U.S. soft landing. August to date has seen one of the sharpest, if short-lived, growth scares we’ve ever witnessed in [more than] 30 years on Wall Street,” said Nicholas Colas, co-founder of DataTrek Research, in a Friday note.
To be sure, investors have noted a sense of relief after the initial August carnage. In particular, the unwind of the yen carry trade appeared to cause no major systemic ripples as hedge funds, trend-following commodity trading advisers (CTAs) and other players were forced to rapidly unwind trades.
“With a large part of this price action relating to a widespread closing of trades across hedge funds and CTA accounts, there is a sense that positioning is much cleaner now than it was a couple of weeks ago,” said Mark Dowding, BlueBay chief investment officer at RBC Global Asset Management, in a Friday note.
“In this way, markets feel a bit battered and bruised, but are probably now in better shape than was previously the case,” he wrote.
Dowding argued, however, that economic growth is likely to retain its momentum, which means investors’ expectations for rate cuts could be disappointed.
Wilmington Trust’s Roth said further “growth scares” are likely. That means sustained periods of subdued volatility are unlikely to return, though the backdrop remains in place for a continued stock-market rally.
It also means that labor data remains “in the driver’s seat,” taking over from inflation as the most important market driver because labor data serves as the best proxy for overall economic activity. The Federal Reserve has a dual mandate in maintaining both price stability and full employment.
DataTrek’s Colas also sees scope for a bumpier ride.
“We would not be surprised to see another growth scare before the end of the third quarter, which suggests defensive groups will continue to outperform over the near term,” he wrote. “Past that, we see a robust, growth-stock-led rally into the end of 2024.”
Most Read from MarketWatch
Source Agencies
