Markets are well on their way to recovering from the August sell-off but investors should not write this event off as “a toddler throwing a tantrum” as there are important lessons to learn from it, experts have warned.
While stock markets had been falling since mid-July, there was a global plunge on Monday 5 August when investors apparently panicked at the combination of weak US economic data, an interest rate hike in Japan and signs of overvaluation in tech stocks.
The two weeks since, however, have largely seen markets recover, with the MSCI AC World index up more than 5% since the sell-off.
Performance of MSCI AC World over 2024
Source: FE Analytics. Total return in sterling between 1 Jan and 19 Aug 2024
Stephen Dover, chief market strategist and head of the Franklin Templeton Institute, said: “We believe it would be wrong to dismiss the early August market turbulence as akin to a toddler throwing a tantrum – much ado about nothing. As in almost all aspects of markets, price moves convey important information.”
He argued that the sell-off came at a time when the source of worry among investors was shifting from inflation to economic growth and its implications for corporate profits.
One sign of this is that the sell-off for companies reporting earnings disappointments is becoming more pronounced. FactSet said companies that reported a negative earnings surprise in 2024’s second quarter had an average share price decrease of 3.8% two days before the earnings release through two days after; this compares with a five-year average of 2.3%.
Dover said: “The key insight we have gleaned from the turmoil is that excessive market positioning created vulnerabilities, which were exposed as perceptions about global growth shifted. Accordingly, we believe investors must now be mindful that perceptions of economic activity, not inflation, will likely drive the coming phase of equity, fixed income, currency and commodity performance.
“The pace of growth should dictate how soon and how fast the US Federal Reserve, the European Central Bank and the Bank of England can cut interest rates, and whether the Bank of Japan will continue to tighten. It may also determine whether China finds the wherewithal to boost its flagging economy.
“But mostly, perceptions about growth could direct what investors can expect in terms of future corporate profits, which would contribute to what valuations they are prepared to pay for those earnings.”
However, Invesco chief global market strategist Kristina Hooper believes the 5 August sell-off was “an overreaction” and expects that stocks have likely stabilised since.
Among her reasons for confidence are the Bank of Japan saying it will be cautious about hiking rates again in the near term, expectations of “measured” rate cuts from the Federal Reserve, a key technical indicator signalling stocks may be oversold and projections for strong earnings growth in 2025.
That said, Hooper conceded that it might not be all plain sailing from here.
“While stocks seem to have stabilised, I do believe there is nervousness in the air, which is likely to lead to higher volatility and the potential for outsized reactions to data and developments,” she added.
“I believe investors with long time horizons would benefit from viewing their investment journey as a marathon rather than a sprint.”
Anthony Rayner, multi-asset manager at Premier Miton, encouraged investors to take a step back from the prevailing narrative that the August sell-off was down to the strong yen and weak US economic data.
“When financial markets are exposed to some sort of shock, as they were at the beginning of August, investors tend to look for the most obvious, reasonable-sounding explanation. Then they try to back-fill events with that story, providing a degree of comfort,” he said.
“This is understandable, as [the Japanese carry trade] was the scene of a lot of the stress, and it makes a good story. However, this encourages investors to focus on that same dynamic, rather than the broader picture.”
Rayner argued that the broader picture shows an important change in the dynamic of the global economy as, after the synchronised shutting of economies in lockdown, they are “dancing to their own drumbeats again”.
The consequence of this is that as policy-making becomes less synchronised – like the fact that interest rates are moving in different directions in the US and Japan – then new market dynamics will emerge, creating opportunities for investors.
“This is not to say that that’s the end of market instability in the short term but just that investors shouldn’t expect stress to show up just via the carry trade, as many lessons should already have been learnt there,” Rayner said.
Over at Hawksmoor, chief investment officer Ben Conway is another encouraging investors to pay less attention to the short-term noise around the recent volatility and more attention to the bigger picture.
He said the rapid spread of information combined with shorter attention spans leads to events being blown out of proportion quickly. This makes it difficult to accurately assess the significance of market events.
Added to this, today’s financial markets are increasingly difficult to analyse because their structure has evolved dramatically over the past 20 years. The rise of speculators, high-frequency trading and passive investing have shifted market dynamics away from fundamentals like company performance and valuations.
He also pointed out that these market participants often use complex strategies, including high leverage and algorithmic trading, which can amplify market movements and mean there are fewer active investors as a proportion of the whole who trade on fundamentals.
“The truth is that no one knows exactly why the days in the first week of August saw a spike in volatility only beaten twice in history (the great financial crisis and Covid being the two others),” he said.
“Yes, the Bank of Japan inched up its interest rate. Yes, the US had seen surprisingly poor economic data. Yes, there were some disappointing earnings from the largest companies in the world. But no one knows why it was Japanese equities that reacted the worst to this, why UK mid-caps fell, why US equities have since recovered and Japanese equities have not.”
He recommended that investors instead act in two ways: staying disciplined in focusing on the “controllables” (such as what they pay for investments and the work they put into research) and accepting that volatility is an unavoidable part of investing.