Fragile recovery in international markets after Monday’s hammering. Was it a market overreaction or a harbinger of more permanent, troubling developments?

A month can make a huge difference in the Stock Market. Champagne was popping in the US in July as tech companies (Apple, Microsoft, NVIDIA) and new AI players pushed stock returns to record highs. There were certainly some indications of a slowdown in economic activity, but investors preferred to ignore them.

But July US labor market data released on Friday speaks volumes: US businesses hired far fewer people than initially estimated (114,000 vs. 175,000), pushing US unemployment higher. to 4.3%, ringing the bell for a future recession. Many believe that, as a general rule, an unexpected deterioration in labor market data is a precursor to a more general deterioration in the economy, even if it manifests itself with a time lag.

Shortly before in Japan, the central bank proceeded with a new interest rate increase (it was preceded by the historic decision last March, which ended a 17-year period with zero or even negative interest rates). Double the risk for those investors who had borrowed in yen to invest in dollars. All this caused a “plunge” in the international markets, even fears of a global stock market crash.

“Let’s not be too pessimistic…”

“Markets were already at record highs anyway, so any negative news could perhaps trigger the reaction we saw on Monday and late last week,” says Antonio Fatas, professor of economics at Singapore’s INSEAD school. “However, I don’t see a solid trend (in US labor market data) that leads us to conclude that we should be particularly pessimistic…”

Fatas believes that the volatile behavior of the markets in recent days is reminiscent of the “taper tantrum” phenomenon observed in 2013, when the then head of the American Central Bank (Fed) Ben Bernanke had suddenly announced the end of the quantitative easing program in the USA, causing outflows equal to 10% of trading volume and hitting many national currencies in emerging markets. But the recovery came very quickly.

Another factor that contributed to the global sell-off in recent days is the invocation of the so-called “Sahm ​​rule”. It is a formula named after the American economist Claudia Sam and predicts that a recession is only a matter of time when the average unemployment rate for three consecutive months exceeds by at least 0.5% the low of the previous 12 months . Practically, “Sam’s Rule” has predicted every recession since the 70’s until today and is certainly taken seriously by investors.

The US economy is booming, but…

So far, however, the American economy seems to be sending encouraging messages. Growth is running at 2.8% year-on-year and inflation may remain above the Fed’s 2% target, but has slowed significantly from 9.2% in 2022. Consumer spending and the business confidence index increased in the second quarter of the year. Hopes are therefore maintained that the American economy will achieve the desired soft landing without falling into recession, even though interest rates remain at twenty-year highs.

On the other hand, the employment data, as well as those on manufacturing activity released last week, fueled concern that the Fed should have acted sooner. Today JP Morgan analysts believe that the chances of a recession now reach 50%. For Goldman Sachs, however, they do not exceed 25%. Some believe that the head of the Fed, Jerome Powell, will be forced by the developments to proceed with another rate cut by the end of August. “We’re talking about a 75-basis-point cut and another, corresponding cut in September,” economist Jeremy Siegel told CNBC.

The disappointing picture of the last few days is completed by the “low flights” of technological giants, such as Amazon, Microsoft, Tesla. Until recently, the Nasdaq high-tech index had soared thanks to the returns of the so-called “Magnificent Seven stocks” such as Apple, Nvidia and Meta, which also led the rally in Artificial Intelligence. But Nvidia stock alone, for example, fell 15% in two sessions.

The end of the carry trade?

The truth is that the rally of the technological giants was to some extent also due to the so-called carry trades. In this case, the interested party borrows in the currency of a country with low interest rates, such as Japan, to invest in the currency of a country with high interest rates, in order to benefit from the difference in interest rates. According to the Wall Street Journal, in early July speculative investors held more than 180,000 contracts, worth a total of $14 billion, betting on a weaker yen. As most rushed to close their positions, the value of these contracts was limited to 6 billion euros last week.

“Carry trade is a form of speculation, it works well until it stops working” says Antonio Fatas. At the same time, he expresses his surprise that, as things show, “some investors cannot even absorb an interest rate of 0.25%”. Otherwise, notes the INSEAD economist, “the Japanese economy seems to be strengthening and it is estimated that the growth index for the second quarter of the year is above 2%”.

Edited by: Yiannis Papadimitriou