The Big Picture

When the past week began the U.S. economy was on a comfortable soft landing trajectory, the market was comfortable with the Fed's first rate cut coming in September, and the small-cap stocks were all the rage. When this week ended, the U.S. economy was headed for a hard landing, the Fed had made a mistake not cutting rates at its July FOMC meeting, and the small-cap stocks were creating a good bit of rage for recent buyers.

We have simplified things here, but the point is that there was a sea-change in sentiment in just a few days' time. That change manifested itself in broadly lower stock prices, broadly higher Treasury prices, and a weaker dollar.

What happened? Read on for context.

A Perfect Storm

In many respects it was a perfect storm for the stock market, which was already battling some valuation angst, meaning it was vulnerable to upset if "things" didn't go its way. Well, several things arguably did not go its way.

These things explained below are in no particular order, as they all fed off each other to catalyze the stock market sell-off.

• Key economic data threw off slowdown/recession signals.
  • The July ISM Manufacturing Index checked in at 46.8% versus 48.5% in June. The dividing line between expansion and contraction is 50.0%, so the July reading suggests there was a faster pace of contraction in the manufacturing sector last month. This was the fourth straight month (and 20th out of 21) that economic activity in the manufacturing sector contracted.
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  • Initial jobless claims for the week ending July 27 increased by 14,000 to 249,000. That is the highest level since August 2023. Continuing jobless claims for the week ending July 20 increased by 33,000 to 1.877 million. That is the highest level since November 27, 2021.

• Nonfarm payrolls increased by a smaller-than-expected 114,000 in July, the unemployment rate increased to 4.3% from 4.1%, the U-6 unemployment rate, which also accounts for underemployed workers, rose to 7.8% from 7.4%, and average hourly earnings growth on a year-over-year basis decelerated to 3.6% from 3.8%.

• The Bank of Japan raised its uncollateralized overnight call rate to "around 0.25%" from "around 0.0 to 0.1%" and announced a plan to reduce the JGB purchase amount by 400 billion yen each calendar quarter.
  • In straightforward terms, the Bank of Japan raised interest rates and curtailed its quantitative easing plan. That combination added more fuel for the yen, which has been strengthening quickly against the dollar, aided first by intervention support and secondly by monetary policy considerations that are expected to narrow interest-rate differentials between Japan and other developed markets.
  • Ultra-low interest rates in Japan enabled traders to borrow at low rates in Japan and invest in higher-yielding assets elsewhere. That is an advantageous trade if rates remain low and the yen remains weak, but it becomes less advantageous when those conditions reverse. Accordingly, with rates going up in Japan and the yen strengthening, so-called "carry trades," which included added leverage in some cases, became less profitable (or losing propositions), and prompted some unwinding action.
  • Since rates had been ultra-low for so long in Japan and the yen had been weakening for some time, these carry trades presumably ran deep across markets, so their unwinding had widespread impact.

• The Federal Reserve did not cut the target rate for the fed funds rate at its July meeting.
  • The decision to stand pat was all well and good... until the aforementioned data hit. When those reports were released, the market's pent-up recession fear was released. In an instant, market participants were unnerved by the thought that the economy could be headed for a hard landing while the Fed still hasn't moved to cut rates.
  • Recessions are undeniably bad for earnings prospects, so market participants were forced to consider a future of earnings disappointments that conflict with stocks currently trading with rich valuations.
  • Fear that the Fed is poised to make another policy mistake (i.e., by waiting too long this time to cut rates) triggered a risk aversion trade that benefitted Treasuries and hurt stocks.
• Israel allegedly orchestrated the killing of a top Hamas leader in Tehran. That killing prompted Iran's Ayatollah to condone a direct strike on Israel.
  
  • One could make a case that this consideration was not a major factor for the market. Falling crude oil prices would be a reasonable defense for that argument, but economic concerns ultimately outweighed this geopolitical tension as a price driver.
  • The latter point notwithstanding, there are festering worries that the Israel-Hamas war could turn into a wider regional conflict. Those worries were elevated with the Ayatollah condoning a direct attack on Israel, thereby contributing to a general risk aversion trade that undercut stocks and helped Treasuries.
• Political polls showed former President Trump and Vice President Harris in a tightening race.
  • According to RealClear Politics, former President Trump leads Vice President Harris by 1.2 points based on an average of the polls. That is within the average margin of error and down from 1.9 points a week ago.
  • The market has preconceived notions that former President Trump would be the more market-friendly candidate given his call for deregulation, lower corporate tax rates, and the extension of the 2017 tax cuts.
  • With polls showing a more uncertain outcome, one might assume that there was some recalibration for the possibility that Vice President Harris wins and there is a push to raise corporate tax rates and not to extend the 2017 tax cuts, which expire at the end of 2025.
• The mega-cap stocks didn't necessarily live up to investors' high expectations.
  • That wasn't the case for all of them. Meta Platforms (META) and Apple (AAPL), for instance, traded higher after their reports, but Tesla (TSLA), Alphabet (GOOG), Microsoft (MSFT), and Amazon.com (AMZN) all traded lower in the wake of their results.
  • A deceleration in growth rates prompted some of the selling, as did misgivings about the ultimate return on investment of heavy AI spending.
  • Until recently, there were no chinks in the armor of these stocks (Tesla being a primary exception). The notion that there could be a growth slowdown in the near term fostered an inclination to pare exposure amid heightened worries about concentration risk.
  • The indices felt the weight of their collective losses.
• Momentum cut the other way
  • There was momentum buying on the way up, and there has been momentum selling on the way down with the S&P 500, Nasdaq Composite, Dow Jones Industrial Average, and Russell 2000 all testing and/or violating support at their 50-day moving averages.
  •  The fear of further downside manifested itself in the CBOE Volatility Index, which spiked as much as 81% this week to 29.66 before pulling back.

What It All Means

The losses that piled up this week were different. They were different because they weren't a byproduct of a normal consolidation trade, where stocks simply retreat because they have run up in price too far, too fast. There was some of that, but the difference this week was that the selling activity was imbued with real growth concerns.

Some of those concerns were related to difficult comparisons for the mega-cap companies and other growth stocks stemming from a realization that, while earnings and revenue are still growing, the pace at which they are doing so isn't as fast as it used to be.

The root of the concerns, however, related to economic growth. We can make that connection looking at how the market behaved on Thursday and Friday, respectively, or after the concerning economic data were released:

• The Russell 2000, which houses small-cap companies with a mostly domestic sales orientation, was down 6.5% and was the biggest index loser.
• The worst-performing S&P 500 sectors were the consumer discretionary (-7.0%), information technology (-5.3%), energy (-5.0%), industrials (-4.1%), and financial (-4.0%) sectors.
• The best-performing S&P 500 sectors were the consumer staples (+1.7%), real estate (+1.5%), utilities (+1.5%), and health care (+0.6%) sectors.
• The fed funds futures market, according to the CME FedWatch Tool, is assigning a 70.5% probability to a 50-basis points rate cut at the September FOMC meeting versus a 22.0% probability the day before the July employment report was released. 
• The 2-yr note yield dropped 38 basis points to 3.88% and the 10-yr note yield dropped 25 basis points to 3.80%, yet stocks sold off as Treasury yields plummeted.

The latter was perhaps the most eye-opening development. The pre-existing valuation angst might have prompted some selling interest even if this week's "things" didn't happen. Lower market rates, all else equal, are valuation friendly.

The interpretation of "things" this week, though, was that these weren't friendly developments, so there wasn't valuation relief. Rather, there was more valuation angst wrapped in concerns earnings growth prospects won't measure up to expectations because the economy won't measure up to the soft landing/no landing expectations.

--Patrick J. O'Hare, Briefing.com

(Editor's Note: The next installment of The Big Picture will be published the week of August 12)