The crisis began in Asia, where Japan’s Nikkei 225 plunged more than 12 percent, its worst day since 1987, while South Korea’s KOSPI fell more than 8 percent, prompting a brief midday trading halt. Following this grim development, the sell-off quickly spread around the world.
Australia’s S&P/ASX 200 fell 3.7 percent on Monday and Europe’s STOXX 600 lost 2.17 percent after recovering some of its early losses. In the US, all three major market indices fell more than 2.5 percent, with growing recession fears blamed for the collapse after a less than stellar July. Job report End of last week.
However, there were a number of underlying causes – and exacerbating factors – that combined to cause chaos in global markets on Monday.
“A series of events appears to have reached a climax, forcing a brutal shift in risk appetite. The ‘Wall of Worry’ certainly has a sufficiently broad base at this point,” said Jack Janasiewicz, chief portfolio strategist at Natixis Investment Managers. Assets in an email.
From lofty and perhaps unattainable earnings forecasts to rising volatility amid looming conflict in the Middle East that has led to the unwinding of some popular trades, here’s a look at what’s causing investors’ black day.
1. Earnings were strong, but perhaps not strong enough
Of the S&P 500 companies that have reported second-quarter earnings so far, 71% beat Wall Street’s high earnings expectations, according to Bank of America’s earnings tracker. The S&P 500’s annual earnings growth rate also reached an impressive 11.5%, according to FactSet. Data.
“Earnings season is far exceeding expectations,” said Eric Wallerstein, chief investment officer at Yardeni Research, Assets.
However, the average S&P 500 company beat consensus earnings per share expectations by just 2%, according to BofA. That’s the smallest overachievement since the fourth quarter of 2022. And while forward guidance was strong — 30% more companies were above consensus than below — Wall Street’s expectations for many S&P 500 companies may be too high to keep up.
“Stocks have an expectations problem, not a growth problem,” said Bob Elliott, chief investment officer at Unlimited Funds AssetsThe longer-term earnings forecasts are AI hype– and finally, it’s time to pay the price when they go under.
The experienced hedge fund manager explained that this has led to a reassessment of risk among investors on Wall Street and, combined with falling stock prices, has created a negative feedback loop in the markets.
“What happens in many places is that the risk manager goes to the portfolio manager and says, ‘We need to reduce risk because our risk assessments have gone up.’ And then the portfolio manager starts selling, and that reinforces the momentum,” he explained.
Elliott said he believes this feedback loop began a few weeks ago when investors began turn Exiting technology stocks and entering small caps in anticipation of possible interest rate cuts by the Fed.
The former Bridgewater Associates executive believes we are witnessing the bursting of a bubble in risky assets, especially large U.S. technology companies and AI stocks, after two years of solid price increases coupled with rising earnings expectations and valuations.
He pointed to disappointing results from technology companies working on AI, such as Amazonwhich missed its second quarter sales forecasts and issued a disappointing forecast, and Intelwhich slashed its dividend and 1,800 employees last week.
2. Fears of recession are back in fashion
The decline in consumer spending and a weak July jobs report have put recession fears back on the agenda after most Wall Street forecasters abandoned their predictions for 2023. The U.S. economy added just 114,000 jobs in July, far below the 175,000 forecasters had expected and not even the 179,000 jobs created in June.
Slowing job growth also caused the unemployment rate to rise to 4.3% last month from 4.1% in June. This increase triggered a key recession indicator, the so-called Sahm rulewhich sparked fears about the stability of the US economy and led some to believe that Federal Reserve Chairman Jerome Powell had made a mistake by Interest rate cut Last month.
There were clear signs on Monday that traders were betting on a weakening economy and further Fed rate cuts this year, leading to falling yields on U.S. Treasury bonds. Janasiewicz, investment manager at Natixis, noted that fears about economic growth were also widespread and contributed to the global stock market crash.
“Weaker global data reinforces concerns about weak [purchasing manager indexes] from Asia, coupled with repeatedly disappointed hopes for economic stimulus in China,” he said.
But like his mentor, Wall Street veteran Ed Yardeni, Eric Wallerstein remains optimistic about the market outlook and predicts a “Roaring Twenties” triggered by a productivity boom.
“By and large, crises have been buying opportunities. And I’m not sure this is even a crisis,” he said. “There are definitely a lot of things putting pressure on the stock market … but the U.S. economy looks strong by historical standards and relative to the rest of the world. So we remain bullish on U.S. equities for the rest of the year and the rest of the decade.”
3. Conflict in the Middle East strains investors’ nerves
The seemingly increasing potential for an escalation of the conflict in the Middle East also weighed on investors on Monday and led to some fear-related selling.
Markets have largely ignored Israel’s campaign in Gaza. But now Iran, a major oil producer, may be on the verge of escalating the war. Israel’s foreign minister said his Iranian counterpart had informed him that Iran now “intends to attack Israel” in response to the killing of a senior Hamas leader and a senior Hezbollah leader last week. JerusalemPost reported Monday.
“If there is a real war between Iran and Israel, that is a huge risk that appears to be growing,” warned Wallerstein of Yardeni Research.
4. The carry trade is settled
While most Western countries raised interest rates for years to fight inflation, the Bank of Japan kept rates near zero. The country has long struggled with painful deflation, so a bout of inflationary pressure was not seen as something worth fighting against.
The unintended consequence of this policy, however, was a large difference in interest rates between Western countries and Japan, which encouraged foreign investors to engage in a so-called “carry trade.”
It involves investors borrowing money in a currency with low interest rates and then investing that money in other assets abroad, often in U.S. Treasuries or stocks. The Japanese carry trade, however, was a bit more complex: many traders chose to go short or bet against the yen because the central bank kept interest rates stable, putting pressure on the currency.
“It was literally the most popular and easiest carry trade. And carry trades work until they don’t. So everyone was in,” Wallerstein said. “It was super, super crowded. Everyone was overextended. And a lot of people were catching up on the trade using leverage just to get some quick leverage because they didn’t want to miss out on those gains.”
But now that the Bank of Japan is raising interest rates this year while the US Federal Reserve is planning to cut rates, the carry trade is unwinding. This means traders will either have to put up margin or close their positions fairly quickly to take profits – and that is creating selling pressure in US markets, where investors often park their money during this carry trade.
According to CFTC data, hedge funds and other investors owned $14 billion worth of options contracts speculating against the yen as of July 1. But by last week, those positions had shrunk to about $6 billion.
However, Unlimited Funds’ Elliott noted that the carry trade only exacerbated the global equity sell-off, not triggered it. “I don’t think the carry trade in Japan is the catalyst for what’s going on. It reflects the fact that leveraged asset managers like hedge funds have taken a lot of positions, the most extreme of which have actually been long positions in growth and technology stocks as they try to keep up with or match market returns,” he said.
Yardeni Research’s Wallerstein also stressed that Monday’s sell-off was fueled solely by the unwinding of the carry trade, and that it wasn’t the only trade contributing to it. “Every trade that prices were pushing into – the Nikkei, long tech, long Mag 7 and then also the Australian dollar, the Brazilian real – all of those got hit at the same time,” he said.
5. Volatility-related selling makes things worse
Increasing risks of a sustained sell-off in technology companies, a major war in the Middle East and an economic slowdown also led Wall Street Fear KnifeThe CBOE The volatility index (VIX) will rise sharply on Monday.
Wallerstein noted that several types of funds, including quant funds, commodity trading advisors (CTAs), volatility control funds and risk parity funds, were sidelined when the VIX briefly hit a four-year high earlier this week and they were forced to sell stocks.
“There are definitely a lot of volatility-triggered selling. These people have triggers to sell when volatility hits certain levels. A VIX above 30 is one of them. That’s a big one,” he explained. “I think that’s a big reason why [the selloff] was so extreme. It’s not causing the sell-off, but it’s definitely making it worse.”
The good news is that Wallerstein believes this selling pressure caused by volatility is likely to end soon.
“We definitely expect this trend to moderate and fade away,” he said, noting that these funds tend to sell quickly while the U.S. economy, the main driver of long-term stock performance, still looks “OK.”
However, Elliott of Unlimited Funds had a warning for investors who want to buy when prices fall.
“In short, when you are on the downside of a bubble dynamic and asset managers are deleveraging, it is not the time to catch the falling knife,” he said.