The first week of August has proven to be a wild ride for global markets, leaving many investors with a sense of unease. However, understanding the forces behind this volatility and the recent rebound can offer some valuable insights. 

Shifting sentiment 

The market's rapid mood swings in recent weeks, flipping between optimism and pessimism, highlight the fickle nature of sentiment. Headlines have attributed this volatility to various factors, including the Bank of Japan's rate hike, the US jobs report, and the Fed's decision to hold rates steady. We should also remember that markets had moved sharply higher over the past year and were somewhat vulnerable to a bout of profit taking or a correction. 

Rising Middle East tensions 

While tensions in the Middle East between Israel and its neighbours are sadly not new, the conflict  has arguably reached new heights as the prospect of direct conflict with Iran looms large, threatening further instability. The region's geopolitical significance, particularly regarding oil production, is increasing investor anxiety and has supported assets like gold.  

Japan's yen surprise & unwinding ‘carry trades’ 

The BoJ's rate hike and the subsequent appreciation of the yen led to the unwinding of carry trades, sparking volatility across markets.  The yen ‘carry trade’ has been a popular investment strategy where investors borrow money in Japan, taking advantage of its historically low interest rates. They then convert this borrowed yen into other currencies, like the US dollar, and invest it in assets with higher yields, such as US stocks or bonds. The profit comes from the difference between the low borrowing cost and the higher investment return.  However, when the Bank of Japan surprised markets last week by raising its key interest rate to 0.25%, the higher cost of borrowing yen reduced the attractiveness of the carry trade, forcing traders to unwind their carry trades (i.e. buying back the yen they had borrowed).  

While we do expect the BOJ to tighten policy over the period ahead and the Fed is likely to begin its easing cycle, Japanese policy makers are likely to tread carefully, keen to avoid undermining their achievements on inflation and growth over recent years. 

US jobs report & recession fears 

The weaker-than-expected July jobs report raised concerns about a potential US recession. However, a closer look at the data reveals a nuanced picture. The rise in the unemployment rate was primarily due to an increase in the labour supply and strong immigration, rather than a large drop in labour demand. To be sure, the US economy is slowing and we should expect weaker data going forward but the recent labour market report is not consistent with a recession at this stage. 

Economic drivers & market outlook 

While the Fed's focus on the employment market is understandable, it's important to remember that jobs data are a lagging indicator. Other indicators such as consumer spending and business investment are still growing. Looking at a broader range of economic drivers, we still believe the US economy remains on a soft-landing path, which is outcome of central banks raising interest rates just enough to bring down inflation to their target levels, without causing a major recession or meaningful increase in unemployment levels. 

While our base case scenario for the US (and indeed for Australia) remains a ‘soft landing’, modest recession is a risk we cannot ignore and this is why we have been steadily increasing our allocation to high-quality government bonds, known for their resilience during economic downturns.  

Markets reassessing risks around soft-landing 

We think the recent market volatility represents a reassessment of the risks around the soft-landing base case. Remember already this year markets have swung from “soft-landing” to “higher for longer/no-landing” back to “soft-landing” and just recently, towards “hard-landing”. This reminds us that markets are forward-looking and in an uncertain environment are constantly weighing up risks and opportunities, leading to sometimes violent swings in sentiment and volatility. Our task is to acknowledge the uncertainty, separate noise from real change and build and maintain diversified portfolios that we expect can perform well over the medium term. 

Staying the course in turbulent times 

As the market navigates through this period of heightened volatility, we encourage clients to stay calm and focused on your long-term investment goals. By doing so, you can position yourself to weather the storm and potentially benefit from future market rebounds.  We are actively reassessing our market outlook amid this turbulent period to best position client portfolios.