In this week’s economic update, we are examining the factors that have been influencing recent market performance – specifically the role of large cap technology, interest rate policy in the U.S., and carry trades involving the Japanese market. With these insights, we look ahead towards the balance of the year and what we could expect from the global economy.
We are also sharing the latest episode of #MacroMemo from RBC’s Global Asset Management team, exploring in more depth the specific factors that have caused recent market volatility and the implications for the U.S. economy.
Lastly, a friendly reminder that our Summer Hours are in effect. Please see the details below.
Economic Update
Global equity markets have recently retraced some of their year-to-date gains, while government bond yields have fallen (i.e., higher bond prices), as investors gravitated towards the safety of high-quality bonds. This market action can be attributed to a mixed earnings season, where results from several highly valued mega-cap tech companies underwhelmed relative to elevated expectations, and conflicting economic signals from the U.S. amidst persistently high borrowing costs. Below, we address what has driven this latest round of market unease.
Technology and interest rate policy impacting equity markets
Several factors have contributed to the recent weakness in equity markets. In the U.S., the S&P 500 Index began its retreat in mid-July as earnings reports from the tech giants were less well received than usual. More specifically, management teams’ commentary left investors wanting more clarity on when the companies’ substantial spending on artificial intelligence would yield returns. Then, following the U.S. Federal Reserve’s decision to hold its policy rate unchanged on July 31st, disappointing jobs and manufacturing data renewed investors’ concern regarding the U.S. economy’s ability to achieve a soft landing – where inflation returns to target without a significant economic downturn, especially in terms of job losses.
A resilient but potentially slowing U.S. economy
However, these weak reports were balanced with other better-than-expected data releases on the services sector, which makes up roughly three-quarters of the U.S. economy. Meanwhile, U.S. GDP grew at a solid 2.8% annualized pace in the second quarter, consumer spending remained robust, and productivity growth exceeded expectations at a 2.3% annualized rate. While we will keep a close watch on upcoming labour market data for deteriorating trends, we continue to see a resilient, albeit slowing, U.S. economy.
Large-cap tech and carry trades contributing to volatility
What else is contributing to market volatility? Two popular trades this year, particularly among hedge funds, have included buying large-cap tech stocks and positioning for declines in the Japanese yen. These were profitable trades until mid-July when relative performance trends began to favour non-tech segments of the equity market. Around the same time, the yen started to appreciate as markets priced in rate hikes from the Bank of Japan, which materialized at the end of July. As market conditions changed abruptly, the unwinding of these trades by hedge funds and other investors, some of which were funded with borrowed money, amplified volatility and contributed to the speed and magnitude of price movements across financial markets in recent weeks.
Valuations remain somewhat elevated relative to historical averages
Despite the recent turbulence, the U.S. large-cap stock market remains up roughly 12% year-to-date on a total return basis (including dividends), while the Canadian stock market is up around 8%. These are respectable gains, even if no further progress is made. Looking a bit further back, the U.S. and Canadian stock markets have climbed roughly 30% and 21%, respectively, since the October 2023 lows. While valuations have adjusted downwards following the price correction in recent weeks, they remain somewhat elevated relative to historical averages. This suggests corporate earnings will take on added importance to support equity markets over the next few quarters.
Summary
Following particularly subdued levels of volatility in the first half of the year, we believe it is reasonable to expect somewhat higher volatility through the balance of the year as markets respond to evolving interest rate expectations, new economic data, and the forthcoming U.S. election. There may be some optimism around the U.S. central bank beginning to cut rates, as it is widely expected to do so in September, but we also caution that rate reductions, like hikes, take time to work their way through the economy. That does not mean we should remain passive as investors. Instead, market turbulence can present opportunities to review and rebalance holdings, ensure portfolios are well-diversified, and/or to initiate or add to positions in securities where valuations have improved. As always, we remain focused on ensuring our clients’ investments are on track to meet their long-term objectives, recognizing that maintaining discipline during periods of market instability is an essential part of successful investing.
#MacroMemo with Eric Lascelles – explaining “Unsettled times”
The recent market excitement is something worthwhile to unpack and understand. While market volatility is common and can create strong emotions, it can help to remain disciplined by understanding the underlying factors.
In the most recent episode of #MacroMemo, Eric Lascelles (Managing Director & Chief Economist at RBC Global Asset Management) explains the stresses on the markets, why the response may appear outsized, and what this could mean for a possible U.S. recession.
You can watch to the episode by clicking here.
Summer Hours Continue
A friendly reminder that Elinesky Schuett Private Wealth is recognizing summer work hours. Until September 6th, our office will be closing at 4pm on Fridays. Thank you for your understanding.
As always, we are available to connect with you personally. Please don’t hesitate to contact us at 519-822-2024 or elineskyschuett@rbc.com.
