Quick Thoughts: Market dislocations—implications for investors

Originally published in Stephen Dover’s LinkedIn Newsletter, Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

Markets have been roiled in the past few trading days, marked by sharp declines in global equity indexes, bond yields and commodity prices. The Franklin Templeton Institute is following market conditions and the fundamentals closely. Across all global regions and major asset classes, our teams of strategists and analysts have gathered to assess what all this means for investors. Succinctly, here is our thinking.

Global equities

All year, we have cautioned that US equity market valuations were excessive and left little margin for disappointment. Our standing year-end S&P 500 Index target has been 5250, only slightly above where the index opened this morning (August 5). We remain cautious. Based on historical analysis of periods of economic deceleration, we believe that growth styles will outperform value, and that quality is also warranted. We are concerned about earnings disappointments—above all for smaller-capitalization stocks.

That said, we also respect that positioning, momentum and quant-style trading can be decisive when market ructions occur. While implied equity volatility has spiked (the VIX shot up to 65 this morning—the highest in four years¹), the market moves may not have yet run their course. Opportunity will eventually present itself, but we think it is too early for all but the most long-term investors to seek value.

Non-US markets have been particularly hard-hit, with Japan’s Nikkei shedding over 12% in its second-worst trading day in history. That is a reminder that it is next-to-impossible to diversify equity risk by region (or by sector or style) during major corrections or bear markets. Opportunity will arise, but in our view, it is premature to step in at this point.

Global fixed income

In recent months we have been strong proponents of extending duration, particularly in US Treasuries. However, as 10-year Treasury yields have plunged to near 3.7% (from near 4.5% earlier this year), it makes sense to us to take some profit. Corporate spreads have not (yet) widened by as much as declines in equity prices might suggest is warranted, but selective engagement into higher-grade and even higher-yield issuers should eventually make sense.

The outlook for non-US fixed income markets depends (for US investors) to a considerable extent on the outlook for the US dollar. The dollar has slumped against other major currencies in recent days, above all against the Japanese yen as carry trades² have been unwound. To a considerable extent that reflects expectations of significant Federal Reserve (Fed) easing before year-end (futures markets are now pricing in circa 100 basis points³), with an added “push” from risk aversion. We anticipate the dollar will eventually stabilize and even recover, but that could take time. Therefore, for risk-averse, income-oriented investors, we believe non-US fixed income investments offer poor risk/reward trade-offs.

Alternatives

For some time, we have been cautious about private equity, with a preference within that class for secondaries. The lack of visibility, particularly during periods of rising fundamental risk, makes us reiterate our caution.

Private credit is slated to be more interesting, particularly if banks become even more reticent to lend. Pricing should improve. Over time, long-term investors should be rewarded by attractive discounts—especially true for investors putting new money to work in this environment.

Above all, we emphasize the importance of manager selection. “Alpha dispersion” (the gap between top managers and the rest) is likely to increase significantly as a result of market dislocations.

The fundamentals

Finally, we add a few comments about how we see the fundamentals.

US recession risk is clearly on the rise, as reflected by the sharp swing in market pricing. Rising jobless claims, a poor July employment report and signs manufacturing may be contracting have changed the narrative.

That said, other indicators are less worrisome, including the latest non-manufacturing Institute for Supply Management survey, the second-quarter US gross domestic product report, and anecdotal evidence from retailers.

It is too soon, in our view, to conclude that the United States is headed toward recession. However, even a more pronounced slowdown can lead to profits disappointments, for which an overvalued equity market was not prepared.

The Fed will surely cut interest rates in September and thereafter. A 50 basis-point cut is now the market expectation for the September meeting, and an inter-meeting (“emergency”) cut cannot be ruled out. Investors will closely follow the Fed’s sessions in August in Jackson Hole, Wyoming, for clues about its policy.

Historically, equity markets have had positive returns in the year after the Fed starts cutting interest rates. This is true whether the economy has dipped into a recession or avoided one. The average return one year after the first rate cut in recessionary periods is 4.98%, versus 16.66% in non-recessionary periods. Drawdowns were magnified in recessionary periods after the first rate cut, with the average max drawdown being 20%, versus 5% in non-recessionary periods.

Globally, there are no “white knights" in the event a recession unfolds. China has shown little inclination to repeat the kind of stimulus it offered 15 years ago during the global financial crisis. Europe and Japan are similarly unwilling or unable to offer “locomotive support” to the world economy. A US election rules out quick fiscal action.

Markets, therefore, may be slower to react to good news via Fed rate cuts, when they happen, in light of those global constraints.

Footnotes

1. The CBOE Market Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Often called the “fear gauge,” lower readings suggest a perceived low-risk environment, while higher readings suggest a period of higher volatility. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges.
2.  “Carry trade” here refers to borrowing Japanese yen to invest in higher-yielding currencies.
3. Source: CME (Chicago Mercantile Exchange). As of August 5, 2024. There is no assurance that any estimate, forecast or projection will be realized.
4.  Source: NBER, Federal Reserve Bank of St. Louis, and DJII. Analysis by Franklin Templeton Institute. January 1, 1972 to July 31, 2024.Indexes are unmanaged and one cannot directly invest in them. Past performance is not an indicator or a guarantee of future results.
5. Ibid.