What did you miss in financial markets during the summer holidays? A very busy period, and some significant market volatility on worries over the US labour market, while in Japan the normalisation of monetary policy caused havoc across bonds, currencies and equities. Meanwhile, some very big shifts in US politics, and it’s now Kamala Harris vs Donald Trump. The Bank of England cuts rates, and the US Federal Reserve dropped some very heavy hints at a rate cut in September. But is the economic data really bad enough to justify market expectations of 100 basis points of cuts by year end?
Hopefully this note finds you well rested after a summer break. The Willis family road trip this year took us to France and back via many EV charging points; with my usual exceptional timing, I managed to be on holiday while the markets wobbled. This is not the first time that volatility has spiked in my absence… I have managed to avoid the start of the GFC in 2007 (honeymoon), the Soc Gen derivatives blow up in 2008 (honeymoon again – long story), the US downgrade and debt crisis in 2011 (holiday), and bits of the eurozone crisis in 2015 (paternity leave). A word of warning in advance then – I am on holiday for October half term!
Investors’ experience of August will differ between those that missed the market selloff while on holiday and have returned to market levels largely as they were at the end of July and those who were at their desks during the brief, but violent, market moves in the first few trading sessions of the month. For those on holiday and with the fortitude to ignore their smartphones, FT subscription and emails, the events of early August appear to have been erased from history. Or have they? As usual trying to single out a reason for the selloff is never simple, and it is likely a combination of factors, including worries over the US economy following a weak employment report, the fallout from the Bank of Japan’s rate hike, frothy markets that were looking overbought and a lack of liquidity in thin August trading, exacerbated by the growth of systemic and options strategies that reinforce violent moves in markets. We should also consider political shifts, not least in the US, where the election outcome has moved back into uncertain territory.
Let’s start with monetary policy. We have seen interest rate cuts in the UK, rate hikes in Japan, and in the US, some very clear signals from the Federal Reserve that rate cuts are on the horizon. The rate hikes in Japan were seen as the catalyst for some of the very large moves higher for the Yen and volatility in Japanese equities that saw the Nikkei index down over 12% in a day, on the Monday after the Bank of Japan raised rates. The Bank of Japan hiked rates to 0.25% from the previous 0.0-0.1% range and announced plans to roughly halve the size of government bond purchases by the start of 2026. The Bank promised that if its outlook for economic activity and inflation is proved correct, then “the bank will continue to raise the policy interest rate”. Cue mayhem in Japanese stocks, bonds and the Yen. The subsequent volatility saw the Bank respond by playing down the potential for further hikes. As a result, having seen sharp falls, the Nikkei was back to flat for the week by the Wednesday after the collapse on the Monday morning! Longer term damage has been caused, however, to the Yen ‘carry trade’, in which investors borrow in low yielding currencies, i.e. the Yen and place it elsewhere where it will earn more. With Japanese monetary policy starting on a path towards converging with policy elsewhere, the unwind of this trade added to the market volatility.
Meanwhile, the Bank of England, with a vote of 5-4, cut interest rates by 25 basis points to 5%, though Governor Andrew Bailey noted there remained a “risk that inflation could be higher than expected if we cut interest rates too much or too quickly”. Bailey subsequently said it was “too soon to declare victory” but he was “cautiously optimistic” about inflation, expecting a steady period of falling inflation “more in keeping with a soft landing than a recession induced process”.
In the US, while the Federal Reserve meeting at the start of the month kept rates on hold, Chair Jay Powell pointed to a September rate cut, saying if the Fed does get the “data that we hope for, then a reduction in the policy rate could be on the table at the September meeting”. Last week, at the Jackson Hole policy conference, Powell was more explicit, saying the “time has come” for rate cuts, noting weaker employment data and declining inflationary pressures. Powell said the “upside risks to inflation have diminished and the downside risks to employment have increased”.
Powell’s comments on employment came in the aftermath of weaker-than-expected US jobs data for July which was seen as a factor in driving the market selloff at the start of the month. The US reported non-farm payrolls increased by 114,000, weaker than the 175,000 expected. The unemployment rate climbed to 4.3% against 4.1% expected; this is the highest level in three years. The weaker data appeared to spook markets though it is worth noting that there was a significant (and short term) impact from hurricane Beryl stopping people from working – the number of people off work due to ‘bad weather’ was a record high for July. Much was made of the pickup in the unemployment rate triggering the Sahm rule. This theory was developed by economist Claudia Sahm and is designed to identify the start of a recession; when the three-month average unemployment rate is 0.5 percentage points above the lowest point in the preceding 12 months. The average unemployment rate for May/June/July was 4.1%, 0.6 percentage points above the 12-month low of 3.5% last July. This rule has been triggered in every US recession in the past 50 years, though Sahm has questioned its validity for this cycle due to the distortions caused in the aftermath of the pandemic.
Elsewhere, we saw plenty of data to counter concerns over the US employment numbers. Consumers are still consuming, as highlighted by robust retail sales in July. Worries about a sudden slowdown in the labour market were somewhat calmed by the weekly jobless claims releases, which have shown a marked drop since recording an increase at the end of last month on hurricane-related disruption. We also saw US inflation at its slowest pace since March 2021, with CPI up 2.9% year on year. The bank lending survey showed increasing normalisation in bank lending conditions, consistent with a soft landing and far more accommodative than we saw last year in the aftermath of the (brief) banking crisis. US GDP was also considerably stronger than expected in Q2, with annualised growth of 2.8% against 2.0% expected, accelerating from 1.4% in Q1.
Moving on to politics, and the focus has been on the US, where there have been some very significant shifts since my last update. The fallout from the weak performance by Joe Biden in the US Presidential television debate with Donald Trump, at the end of June, saw Biden under increasing pressure from senior Democrats to step back from the campaign. In late July Biden announced he would not contest the election, and gave his backing to current Vice President, Kamala Harris. The President said, “while it has been my intention to seek re-election, I believe it is in the best interest of my party and the country for me to stand down and focus solely on fulfilling my duties as president for the remainder of my term”. Democrats, including potential rivals and ex-Presidents, swiftly gave Harris their backing. The Vice President promised to offer Americans a “brighter future” compared to the “chaos, fear and hate” proposed by Donald Trump. The Democratic National Convention in Chicago, which could have been contested if any candidates had chosen to stand against Harris, became a coronation. Kamala Harris addressed the convention and vowed to “strengthen, not abdicate” America’s global leadership. Harris called on US voters to reject “unserious” Donald Trump and said that as President she would ensure “America, not China, wins the competition for the 21st Century” and promised to “stand strong with Ukraine and our NATO allies”.
Harris has enjoyed a significant ‘bump’ in the opinion polls, overtaking Donald Trump at the national level, and in some key swing states. This is a huge shift for markets to digest; at the time of the Republican convention in July, when Joe Biden was the presumptive Democratic candidate, the prevailing view in markets was that Donald Trump was highly likely to win the election. A month on, with Biden stepping back, the contest looks wide open once again. Markets have shifted from presumed certainty around a Trump victory back to the unknowns of a tight contest. Such uncertainty will likely weigh on markets in the coming months, as investors contemplate the potential outcomes of either candidate winning. One area we do have some clarity is on corporate taxes, with Harris planning to stick with a proposal put forward by President Biden to increase the corporate tax rate from 21% to 28%. By contrast, Trump is proposing a cut in the tax rate to 15%.
Elsewhere in politics, we have seen escalating tensions in the Middle East causing some volatility in oil prices. While there is a ceasefire agreement proposal on the table for Israel and Hamas, Israel and Hezbollah in Lebanon continue to exchange rocket attacks, while Iran warned it was their “duty to seek vengeance” for the Israeli assassination of Hamas political leader Ismael Haniyeh in Tehran. The US warned that an Iranian attack on Israel was “highly likely.”
Closer to home, UK Prime Minister Keir Starmer warned the budget, on 30 October, will be “painful”, asking the nation to accept “short term pain for long term good”. Starmer laid the ground for tax rises, saying “things are worse than we ever imagined”, blaming the need to rebuild the UK’s public finances on the previous, Conservative, government. The Prime Minister said the new government’s election plans did not cater for a £22 billion “black hole” that Chancellor Rachel Reeves claimed to have discovered in the public finances. Parliament will return from its summer recess next week.
In the near term, financial markets will be very sensitive to the expected future path of interest rates and any signs of the US deviating from a soft landing. Futures markets are still pricing around 100 basis points of rate cuts from the Federal Reserve between now and the end of the year. With only three meetings to go, this implies at some point the Fed will feel the need to cut rates by 50 basis points in one of their meetings. But is the economic data bad enough to justify a larger rate cut rather than a more gradual rate trajectory? With fewer concerns over inflation, the employment data is likely to be the driver of Federal Reserve decisions over the coming months. The selloff in early August was driven by a number of factors but we are mindful that September can often be a tough month in markets, and against a backdrop of political and economic uncertainty and with some decent returns for the year so far, it would be understandable for investors to choose to take some risk off. We are watching closely for economic signals, and the impact these have on expectations for earnings, monetary policy and risk appetite as we move into the autumn and a very busy period of newsflow.
Kind regards,
Anthony.
