No, not right now. We continue to believe investors should: (1) keep equity allocations aligned with broad policy targets; (2) maintain modest overweights in less expensive areas within equities, such as developed markets value and small caps; and (3) maintain a modest overweight in long US Treasury securities within bond portfolios. The potential for continued market stress has increased our conviction in these views for the near term and bolstered our confidence in maintaining a highly diversified portfolio designed to weather market cycles.
Japanese markets have been the most eye-catching in this current bout of turbulence. After the yen reached an all-time low of nearly ¥162 to the dollar in early July, it has since strengthened by 12.6%. A compression in interest rate differentials, driven by both soft US economic data and hawkish Bank of Japan decisions, contributed to the large yen appreciation. This move caused many so-called carry trades—which relied on a weak yen to fund positions in high-yielding assets—to unwind. In addition, Japanese equities had been a very popular macro trade, leaving it exposed to a large deleveraging event. This is evident in the 20.3% decline in the Tokyo Price Index (TOPIX) over the last three trading days.
Other equity regions have sold off as well, although to a significantly lesser extent. Most meaningful for portfolios is the United States, due to its sheer size, connections to the carry trade, and concerns about its economy. The economic anxieties have most recently been centered on the labor market, where the unemployment rate has steadily risen, as have jobless claims, while job growth has slowed. While most, if not all, of these metrics are at otherwise normal values from a level perspective, the concern is that they may continue to deteriorate. For example, the Sahm rule, which was recently triggered, highlights that a 0.5-percentage point rise in the three-month average unemployment rate from its recent low has always led to a further material rise in unemployment and, ultimately, recession. This is a statistical regularity with a small sample size and not a law of nature. So, it is possible that the unique context of this economic cycle will disrupt that relationship. Indeed, most of the rise in unemployment has been driven by an increase in labor force participation, not layoffs, and the US economy grew by 2.8% in the second quarter and July’s composite Purchasing Managers’ Index points to continued growth for the month. Still, the Federal Reserve has ample room to respond to economic weakness, with futures markets increasing their expectations in recent days from three 25-basis point cuts by the end of 2024 to five.
In addition to economic data, US equities have also been impacted by second quarter earnings results. The central role that earnings expectations for tech stocks have played in this year’s rally meant that this season’s “Magnificent 7” results were closely scrutinized. While headline revenue and earnings results were generally solid-to-good, the market nonetheless took fright at the scale of the capital expenditures that these firms remain committed to making to achieve their AI-related objectives. The elevated valuations of some firms left them exposed to any reappraisal of the transformative effect of AI initiatives on their future earnings. As a result, the tech-heavy Nasdaq Composite was down 13.3% below its recent peak during trading today, while the broader S&P 500 Index was down 8.6%.
Given the equity sell-off, the temptation may be to cut equity risk to avoid additional losses. But we view all bets through the lens of probability, and cutting equity allocations for, say cash or bonds, has not been a high probability bet historically, even in periods of high volatility. By shifting meaningfully from stocks into cash or bonds, investors could also concentrate value added performance into one decision, overwhelming all other sources of value add, such as those linked to individual managers. Last, and relatedly, when markets move violently in one direction, they tend to correct violently in the other direction. So, cutting equity risk now could lock in large losses relative to policy that could weigh on portfolios for years.
Instead, we believe investors are best served by relying on a well-constructed asset allocation, sticking to any pre-determined rebalancing policy, and monitoring liquidity sources and needs. We continue to favor modest overweights in developed markets value and small-cap equities, both of which have compelling valuations and earnings outlooks with more upside potential relative to broad equity markets. We also believe investors should continue to hold high-quality defensive assets, such as long US Treasury securities. While long Treasury securities are less attractive today than a week ago, given the large drop in yields, we continue to see value in holding an overweight position in the next weeks given the potential for economic weakness and market volatility.
Stepping back though, chaotic periods always remind us of a key maxim—thoughtful decisions, not rash actions, are what separate top-performing investors from everyone else.
Kevin Rosenbaum
Head of Global Capital Markets Research
Thomas O’Mahony
Senior Investment Director, Capital Markets Research