Assessing equity volatility and recession risk: Is now the time to take action?

As we assess equity volatility and recession risks during these turbulent financial times, it’s crucial to be vigilant and adjust our investment strategies accordingly. As of August 5, 2024, the S&P 500 Index has lost over 8% since July 16, with significant selloffs particularly following the onset of August. By staying nimble while maintaining a neutral position in our cross-asset strategy, we navigate these rapid changes more effectively.

Earlier this year, the US stock market celebrated record highs, largely fueled by enthusiasm for artificial intelligence (AI) stocks. This narrow rally, while notable, wasn’t indicative of a robust market as it relied heavily on just a few sectors. As a result, we observed a rotation into smaller companies that were able to benefit from the favorable lower interest rate environment in July.

The primary drivers of the recent volatility have been softer US labor market data, which emerged on August 2. There are growing signs of macroeconomic deceleration that have contributed to the correction we’re witnessing in equity markets. Yet, our outlook on global economic prospects remains relatively steady despite these fluctuations.

Notably, on August 5, Japan’s equity market, illustrated by the Nikkei 225 Index, experienced a staggering one-day drop exceeding 12%. This significant decline followed an earlier drop of 5.8%, marking the largest two-day downturn in its history. The sharp increase in both realized and implied market volatility signals what could be referred to as a crisis moment, characterized by capitulation among leveraged investors such as hedge funds.

It is critical to differentiate between economic conditions and stock market reactions. The US economy, while showing signs of slowing, continues to grow close to its trend level. Although the increase in reported unemployment rates draws parallels to earlier recessionary stages, the current labor market conditions appear more stable than they may seem at first glance. Indicators like hours worked and jobless claims are returning to pre-COVID levels, suggesting a more normalized landscape.

Our recession probability calculations, based on current equity market dynamics, estimate a 25%-30% likelihood of a recession occurring within the next 12 months. While this aligns with a view of rising recession risks, it still indicates that a recession isn’t a foregone conclusion.

In analyzing the current economic landscape, we employ a range of leading economic indicators to assess trends more accurately. While global leading indicators show some moderation, they still suggest reasonable growth prospects. Therefore, we hold a cautious perspective that indicates “growth is constructive but slowing.”

In the realm of labor market indicators triggered by recent downturns, we are monitoring various metrics beyond nonfarm payroll growth. Key indicators such as hours worked and jobless claims have softened but remain near historical averages, offering a level of comfort. Corporate earnings can also signal labor market trends, so tracking earnings breadth is vital. Despite a concentrated earnings drive from major tech companies known as the “Magnificent Seven,” which represent over 50% of earnings since January 2022, broader labor market metrics continue to underscore stability.

We continue to watch inflation trends closely. Recent positive inflation readings in the US indicate potential shifts in macroeconomic conditions. While we anticipate gradual inflation normalization, any unexpected spikes in inflation could complicate this landscape further.

Turning our focus back to equities, the recent drawdown provides us with insights into recession probability and market behavior. Several indicators point to “oversold” territory, including the elevated levels of the VIX index and relative strength index (RSI) readings. These suggest that market conditions may present buying opportunities—but caution is warranted as some long-term indicators continue to highlight overstretched valuations.

To navigate this drawdown effectively, increasing commitment to market breadth and momentum signals will be crucial. Observing advance/decline breadth and moving average configurations can guide us in identifying favorable entry points for longer positions when the market conditions align.

Certain sectors are particularly vulnerable in the event of a downturn. US large-cap growth stocks, which significantly outperformed their value counterparts earlier this year, are showing signs of wear. Although they recently faced a correction, their performance prior reflects an elevated valuation that may not hold under prolonged economic scrutiny.

As we consider investment strategies resilient to recession risks, the fixed income market offers a glimmer of hope. With government bond yields declining and high-quality bond prices rising sharply, bonds appear well-positioned amidst ongoing market turbulence, providing a potentially stable investment avenue.

Geopolitical tensions and trade conflicts add another layer of complexity to market dynamics. Volatility often responds differently to these external pressures; for example, oil prices have dropped even amidst Middle Eastern tensions due to fears surrounding decreasing demand rather than supply disruptions.

Moreover, the role of central banks, particularly the US Federal Reserve, is a pivotal factor in mitigating or exacerbating recession uncertainties. While emergency rate cuts may hold allure for some, it’s vital to recognize that such actions could enhance panic rather than soothing market concerns. The overarching goal should be to normalize monetary conditions and facilitate sustainable growth.

As we examine the risks involved, it’s crucial to underscore that all investments carry inherent risks, including potential loss of principal. Equities are subject to price fluctuation, while fixed income securities face their own unique risks concerning interest and credit. Thus, thorough analysis and clear communication will remain paramount.

In conclusion, as we navigate these uncertain waters of equity volatility and recession risk, our focus should remain steady. By leveraging robust data analysis and a clear understanding of market movements, we can adjust our positioning to optimize our investment strategies in the face of evolving challenges. With vigilance and strategic foresight, we may find opportunities even in uncertain times.

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