The great unwind

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below. 

All data referenced in this article is sourced from LSEG Datastream unless otherwise stated, and is accurate at the time of publishing.

Key points

• A sharp rise in the Japanese yen and disappointing US jobs data sparked a July sell-off in risk assets and a sharp rotation in the equity market. Since then, global equity indices have moved back to their all-time highs, but a lot has changed under the surface. Sentiment remains fragile, and recession fears have increased
• Equity valuations remain elevated at the index level, heavily driven by a handful of mega-cap stocks in tech-related industries. Removing their impact, the average stock in the index is discounting a more reasonable macro outlook
• Where markets go next will depend on the economic growth outlook and the sustainability of the AI theme that has propelled markets of late. In that context, the US labour market and corporate earnings will be important indicators to watch
• With growth slowing and yields expected to decline, a defensive portfolio positioning remains warranted, alongside selective exposure to deep value cyclicals. Selectivity is key, as the bulk of the opportunities lies at the stock and sector level, as opposed to broad equity indices

The summer months have been eventful, to say the least. Global equities dropped by 8% from mid-July to early August, before recouping all their losses in the following three weeks. While broad equity indices are back to all-time highs, at the time of writing, market expectations have been reassessed, with a sharp rotation across sectors and investment styles. Sentiment remains fragile and volatility is likely to persist in the coming weeks. This article examines the drivers behind the recent market moves and their implications for investors.

While a lot has happened, our key views haven’t changed. In our Mid-Year Outlook, we highlighted a number of risks in the equity market, which warranted a more defensive portfolio positioning and a focus on ‘alpha’ opportunities. The recent market gyrations reinforce that view.

Context behind the sell-off and V-shaped recovery

Given the speed and magnitude of the recent moves, it is worth taking a step back and putting them into perspective.

From March to July, bad news on the economic front was considered good news for markets. With inflation retreating, the assumption was that softer-than-expected economic data would encourage central banks to ease monitory policy, thereby supporting markets. Equities remained buoyant despite weaker-than-expected growth in several major economies.

As highlighted in our Mid-Year Outlook, equity markets looked complacent, given expectations that growth would slow, combined with rising political and geopolitical uncertainty:

• Valuations were stretched by historical standards;
• Earnings expectations looked over-optimistic, especially for Artificial Intelligence (AI)-related businesses;
• The market was extremely concentrated, driven by a handful of mega-cap names in the broad technology sector; 
• Investor sentiment was bullish and positioning was heavy.

This confluence of factors made the equity market particularly vulnerable to any disappointment on the macro or micro-economic front.

The actual trigger for mid-July’s sell-off was the sudden appreciation of the Japanese yen, on the back of a policy shift by the Bank of Japan. This led to the unwinding of popular ‘carry trades’, in which investors had borrowed at lower rates in the country to fund purchases of higher-yielding assets elsewhere. The more fundamental reason was a weakening in US economic data, and more specifically, a deterioration in the labour market. Indeed, the unemployment rate rose to 4.3% in July, triggering the ‘Sahm rule’, a closely watched recession indicator. 

Those events raised concerns that the US Federal Reserve (Fed) had kept interest rates too tight for too long, challenging the ‘soft landing’ narrative that had prevailed in recent months. This led to a radical shift in investor sentiment, as fears of a growth shock resurfaced. 

Global equity markets to fall by 8% between mid-July and early August, while fixed income markets upped the chances of lower US rates. Investors went from pricing fed fund futures at approximately 30 basis points (bp) of cuts by the end of 2024 in April, to 116bp in early August. Some participants even called for an emergency rate cut by the Fed before the central bank’s September meeting.

However, in the following three weeks, global equity indices staged a powerful rally and recovered all their losses, as investors’ focus shifted back to rate cut expectations. While broad equity indices are now back to their July highs (at the time of writing), a lot has changed under the surface. We have seen a significant rotation out of the market winners into the laggards.

The great rotation

As is often the case in abrupt sell-offs, the areas of the market that had performed most strongly since October’s lows corrected the most (see chart). More specifically, there has been a brutal rotation out of Big Tech into the rest of the market, and more generally out of growth into value. In addition, small caps outperformed versus large caps, defensive sectors against cyclical ones, and low volatility stocks versus the rest of the market. 

A radical shift in market perception leads to a brutal rotation within the equity market

Relative equity performance since the October’s lows saw an abrupt trend reversal following July's sell-off 

Encouragingly, market leadership has broadened following the recent rotation, with 46% of the S&P 500 stocks outperforming the index over the past six months, versus only 20% in the middle of July. Market breadth has also improved in Europe, but from a less concentrated starting point: 51% of the STOXX 600 stocks have outperformed the index in the same period, versus 38% in late June.

Where do we go from here?

Following the summer moves, valuations remain elevated by historical standards. Global equities trade on 17.7 times forward earnings, 22% above their 20-year average, based on the MSCI All Country World index. This valuation premium is primarily driven by the US, and more specifically US technology mega-caps. In contrast, European equities essentially trade in line with their 20-year average, while UK stocks trade at a 7% discount.

Where the market heads next will depend on two key factors:

1. The global growth outlook and whether a recession occurs
   History shows that equities tend to perform well after rate cuts, as long as growth remains supportive and a recession is avoided. 

2. The sustainability of the AI theme that has propelled markets to recent highs
   As mentioned earlier, a handful of tech stocks have driven equity markets in the past couple of years. As such, any reversal in their performance would have a significant impact on broad equity indices.

   To be more specific, at their mid-July peak, the so-called ‘Magnificent Seven’ were responsible for nearly two-thirds of the S&P 500’s performance year-to-date, and half of the returns for the MSCI All Country World index. This is striking considering that the seven stocks’ weight in those indices was only 30% and 18%, respectively. After the sell-off, their contribution year-to-date has moderated to 44% and 33%, respectively, but it remains significant.

On that basis, two indicators should be watched very closely: the US labour market and corporate earnings.

Historically, changes in the US unemployment rate have mattered for asset allocation (see chart). Stocks have tended to underperform bonds globally, in periods of severe deterioration in the unemployment rate. But while the country’s labour market has shown signs of weakness lately, our economists do not anticipate a severe deterioration in the near term.

US unemployment rate matters for markets

Historically, global equities’ performance relative to bonds has been associated with changes in the US unemployment rate  

Corporate earnings should also be watched. The 32% rally in global equity prices from their October lows has been driven primarily by valuation expansion, based on the MSCI All Country World index. Corporate earnings have risen by only 6% over the period, while price-to-earnings multiples have jumped by 25%, on the expectation of solid earnings growth in the future. This means that a significant increase in corporate profits is now required to justify the current level of equity prices at the broad index level. 

What does this mean for investors?

The recent rotation in equities is healthy in our view, as it removes some of the excesses that had been built into some parts of the market’s valuations and positioning.

Broad equity indices remain richly valued and are discounting an optimistic macro outlook, consistent with a significant reacceleration in business activity and a strong rebound in profits. But as noted previously, those indices are heavily distorted by their mega-cap constituents. Removing this distortion, the average stock in the index is discounting a more reasonable macro backdrop, consistent with muted economic expansion and earnings growth. 

This is illustrated in the chart below, which looks at the performance of the MSCI All Country World index on both an equally weighted and a market-cap-weighted basis, against its companies’ earnings growth.

This highlights the importance of remaining very selective in this environment, as many stocks are still trading on reasonable valuations, against more elevated index pricing. This is why, the bulk of the opportunities remains at the stock level, as opposed to the broad index level. 

The average stock in the MSCI All Country World index is discounting a more reasonable earnings growth outlook than the market-cap weighted index

The year-on-year change in global equity prices has tended to lead earnings growth by six months. Today, the equally weighted version of the MSCI All Country World index is providing a very different message from its market cap weighed counterpart

At the stock level, we would continue to focus on quality companies, with superior earnings power and solid balance sheets, which have proven their ability to deliver earnings growth in times of economic slowdowns. 

At the sector level, we continue to favour defensive and interest rate sensitive sectors, such as consumer staples and utilities, which generally outperform in periods of slowing growth and declining rates.

The violence of the recent rotation highlights the importance of diversification. This is why a barbell strategy might be useful, with some exposure to select deep-value cyclicals, such as energy stocks, which should behave as a hedge if our central scenario does not play out and global growth proves to be more resilient than expected.

At the regional level, UK equities appear well-positioned in the current environment, because of their defensive tilt, attractive valuations and superior dividend yield. As a low-beta market, UK stocks tend to outperform global equities during market downturns. Indeed, they outperformed in the recent sell-off. 

UK equities had been out of favour for most of the past couple of years, due to their underweight exposure to the technology sector during the AI frenzy. But, if the rally continues to broaden, the country’s stocks could benefit. A new government, with a sizable majority, should also provide more stability and help to improve sentiment. 

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