As July closed, U.S. equity and bond investors were likely feeling encouraged by the performance of their portfolios, as continued economic strength coupled with lower interest rates on the horizon lifted spirits and prices in the month. However, the moment was fleeting, with a palatable shift in sentiment since the beginning of August forcing investors and economists alike to question conclusions made only a few days prior.

Equity markets have pulled back sharply to begin the month led lower by technology names (as represented by the NASDAQ Composite) and small cap stocks (represented by the Russell 2000 Index) while bonds have rallied strongly on lower yields. Commodities have also fared poorly in this period of heightened volatility, punctuated by a sharp surge in the CBOE Volatility Index (VIX) to 65.70 in today’s pre-market session – marking its highest level since the beginning of the Covid-19 pandemic. The VIX, which represents the implied volatility of a hypothetical S&P 500 Index stock, had been as low as 12.03 at the beginning of July.

In our view, it is important to review the confluence of events that has led to the market action over the last several days. First, there was the decision by the Federal Open Market Committee (FOMC) to hold rates at their current levels during their meeting last week. Concerns about the Federal Reserve (Fed) being too slow to act have been percolating since the spring, and there were many economists in particular who believed that the mosaic of economic data was supportive of a rate cut last week. This notion was afforded some credibility by the confirmation by Fed Chair Jerome Powell that a conversation around a July rate cut had indeed occurred, but that a consensus opinion to hold firm had won out.

Second, non-farm payrolls came in lower-than-expected, while initial jobless claims remain on an upward trend. July non-farm payrolls release indicated that the U.S. economy added only +114k jobs in the month, far less than the consensus expectation of +175k. More concerning was the meaningful increase in the unemployment rate from 4.1% to 4.3% (4.253% rounded) in the month – its highest level since October 2021. While the increase in the unemployment rate is partially attributable to another welcome increase in the participation rate to 62.7% from 62.6%, the magnitude of the month-over-month tick up created some anxiety.

Third is the changed stance by the Bank of Japan towards monetary policy. The Bank of Japan last week raised interest rates by +0.15% to +0.25% and indicated that there was “still quite some distance” before the policy rate reaches its neutral level. To put this in perspective, central bank rates in Japan have not approached 0.5% since 2008, and Bank of Japan Governor Kazuo Ueda appears comfortable with moving through that level if needed to thwart above target inflation. The result was a move back into the yen by both Japanese domestic investors as well as investors who were using the yen as a carry trade to fund purchases in other assets.

It is impossible to determine in real time the precise attribution of each of these forces on the equity and fixed income markets over the last several days. However, given the areas which have experienced the most meaningful pressure, it would appear that the flow of liquidity out of more leveraged, and to some extent more speculative, investments would likely point to the BOJ’s actions as the primary culprit. Hardest hit over the last several trading days have been mega cap technology stocks and bitcoin, both of which have enjoyed outsized returns over the course of 2024, as well as small caps which soared in July’s sharp rotation trade.

Admittedly, we believe the slowing of the U.S. economy as represented by last Friday’s non-farm payrolls report and the August ISM Manufacturing index bears worth watching, but delivery of the soft-landing scenario – and particularly at-target inflation – requires that we digest weaker prints on a year-over-year basis. In addition, as we have stated on multiple occasions, lofty valuations for some of the S&P 500 Index’s best performing stocks created some vulnerability for those names, and mixed Q2 earnings results did little to help when met with the headwind of the recent rotation. The concentration of these names within the S&P 500 Index results in an outsized impact on the broad index – on both good and bad days. Small cap names for their part benefit from lower rates, but also do poorly in sharply contracting or recessionary environments, which could account for the sell-off in the last three trading sessions.

In our view, the uptick in volatility and the move lower in equities over the last few days does not represent a meaningful shift in our expectations for the rest of 2024, although the path might be slightly different. We believe the Fed will cut rates at least two to three times, but with the caveat that those rate cuts might be more than twenty-five basis points each. Additional evidence of broader weakening could push the Fed to act more aggressively in September and November, which could further exacerbate movements in yields and currencies in the short term.

Most importantly, we do not see evidence of a looming recession in 2024. As such, we encourage clients to allocate in accordance with their strategic long-term targets and continue to deploy capital in line with long term objectives. Thoughtful diversification of concentrated equity holdings, deployment of equity capital into assets other than U.S. mega cap stocks, and allocation of cash and other short term fixed income assets (for which yields are likely to continue to fall) into modestly longer duration strategies should be the focus over the next several months.