Anatomy of a rout | Invesloan.com

Good morning. Unhedged called for calm yesterday and, boy oh boy, did no one listen. But, with stocks in Asia recovering in early trading today, is the shock behind us? Read on, and email us: [email protected] and [email protected].  

Picking through the rubble 

The timeline goes like this. The manufacturing ISM report last Thursday and the employment report on Friday together cast the shadow of recession over the US economy, which up until then had been, in the eyes of the market, gliding to a perfect soft landing. Stocks fell hard, Treasuries rose sharply. Over the weekend came the news that Berkshire Hathaway had sold much of its immense stake in Apple. On Monday, Japanese markets sold off in historic fashion, and much of Asia followed. The US, which you might have thought was done freaking out on Friday, freaked out again yesterday. 

Here are the most important US price moves from what is now a two-day rout. 

It feels, from the tenor of the media coverage, that stocks should be down in the double digits. Yet the S&P is down just 5 per cent through Friday and Monday. Here is the performance by sector:

There is a tricky overlay here. On the one hand, classic defensive sectors and those that benefit from lower rates performed the best (staples, healthcare, utilities and real estate), just as you might expect if what we were seeing was pure fear of recession. But the sectors that did worst were those dominated by the Big Tech stocks (info tech and consumer discretionary). Would economically sensitive industrials be outperforming the index if this was all a declining growth story? 

Here is the performance of the seven stocks formerly known as magnificent: 

Three of the seven are doing very badly: Amazon, Tesla and Nvidia. Amazon reported so-so earnings on Thursday. Tesla is a massively speculative stock. Nvidia has no particular excuse, other than the fact that it is the mascot of the AI trade, which people want out of all of a sudden. 

What is interesting is that the Vix index, a measure of how much it costs to place a short-term hedge on the S&P 500, rose mildly on Friday and then very sharply on Monday (before subsiding somewhat). This is odd on its face: not much changed for the S&P over the weekend, other than the discovery that Warren Buffett likes cash right now and that Asian stocks are having a major unwind. It looks a little like fear of fear itself — concern that losses will start feeding on themselves as position limits and margin calls are triggered. 

Another interesting point: even as the stock sell-off accelerated on Monday, the move into US government bonds did not. Treasury yields ended the day flat, including the rate sensitive 2-year. We’re not sure exactly what that means, but it is not consistent with the emergency rate cut that some were calling for at the start of the day.

The situation with corporate bonds was somewhat different. High-yield spreads widened another 21 basis points on Monday, after widening 37 basis points on Friday: 

Note that corporate bond yields, unlike stock prices, are directly attached to the real economy. If the cost of raising debt keeps rising, that has repercussions for growth, and the Fed will have no choice but to take notice. But spreads were equally high as recently as December, as the chart shows. Spreads had been driven to historic lows by the wild demand for fixed income driven by the rapid rise in rates. Now they are returning to reality, though perhaps a little too quickly for comfort. 

What does the market think the Fed is going to do? Since Thursday, the futures market has priced in another one or two cuts of 25 basis points apiece by year end. Again, on its surface that’s a sharp change — but one that puts interest rate expectations in the middle of the range we have seen in the past year, not in panic territory:

What it all means

Markets are under no obligation to make sense, especially over a span of just a few days. After a shock, finding the new equilibrium takes time. That said, with the data we have before us, we might ask: how much of the rout has been driven by:

1. The perception of increasing recession risk in the US, versus 

2. The unwinding of the yen carry trade as the spread between Japanese rates and US rates shrinks, versus

3. Internal dynamics in a market dominated by momentum trading, risk parity strategies, passive investors and other wicked inventions that suppress volatility before suddenly releasing it, versus

4. The unwinding of a very crowded, concentrated, and overpriced Big Tech trade?

Recession worries are clearly a contributor, but perhaps not a huge one. The move in the Treasuries, corporate bond spreads and rate expectations would have to be larger before we concluded that recession fears are the biggest driver here and, as we argued yesterday, the economic data is mixed rather than bad.

The unwinding of the yen carry trade could well have contributed to the wider sell-off, as investors were forced to sell off assets they had bought with borrowed yen. It makes sense that this would be happening, but it is difficult to prove the scale of effect — we have not seen hard data on the trade. But there is reason to believe the carry trade unwinding was a bigger deal than previously thought. The Mexican peso and the Brazilian real, two higher-yielding currencies commonly bought with borrowed yen, fell to multiyear lows yesterday despite maintaining high interest rate differentials with the US. Might equities have been swept up as well? Of course, it is possible that the direction of causality went the other way: that it was the sell-off in equities that turned the carry trade upside down, by erasing gains earned on assets paid for with an increasingly expensive yen loans. 

As we have seen with the suppressed Vix of recent years, structured products and quantitative investment styles have changed the ways that markets work. James Athey of Marlborough Group sees that at work in the last few days:

Investment styles which are systematic or technical in nature use price and volatility triggers and are increasingly dominant in daily flow . . . they create lots of momentum, which “value” investors might try and oppose but rarely succeed at first, which creates a survivorship bias for investors willing to go along with the momentum regardless . . . which creates a market increasingly one way and susceptible to trending

We’re just not sure about this. The long bull market has not provided a very rich sample of wild momentum events. There may be more soon, though. 

That leaves the Big Tech sell-off. It has been violent and the value changes are immense, at least in dollar terms. It has echoed in Asia in the form of sell-offs of big semiconductor companies, as our colleagues at Lex have pointed out. This was a trade that funds hoping to beat the index had little choice but to join. And those funds had big profits this year they would have been keen to lock in. If you must point to a single perpetrator, point at Big Tech. 

What next? 

There were some signs of stabilisation in the market yesterday. The services ISM index released yesterday still showed service companies in expansion mode, if barely, and its employment subcomponent was firm. Earnings reports on Monday contained no nasty surprises and one or two positive ones (Tyson Foods, Palantir). The stock market did not close at its low yesterday. The Vix cooled somewhat. The stability in the bond market helps. Finally, as of late Monday evening New York time, Japanese and other Asian stocks are staging a comeback.

But an expensive market in a slowing economy does not need any particular reason to fall, just as a cheap one in an accelerating economy needs no special reason to rise. Even if the wild spasm is over, it would not be surprising to see more risk come off the table. 

One good read

Bangladesh.

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