Throughout the summer, I have discussed how remarkable it has been to see equity market volatility fairly subdued, despite the uncertainty over the state of the economy, corporate performance and geopolitical developments. Well, the past week has certainly been less remarkable on that front. A confluence of events has taken us from a sleepy July to somewhat of a mini roller coaster and this has been the first real test of investor resolve since, well, August of last year.

 

 

It's not that July was completely friendly to equity market bulls. As the chart above shows, the S&P500 fell by 4.7% from its intraday (and record) high on July 16th to its low point on July 30th. The move was driven mainly by trepidation in the large-cap tech group.  Stocks looked like they were stabilizing on the last day of the month, but then the proverbial floor gave way starting Thursday of last week. Over the course of three sessions, the S&P had dropped by 6.1%.  This was a larger 3-day pullback than what we saw during last year’s August-October sell-off and even more pronounced than what we saw at the start of the Fed tightening cycle back in 2022, when the index dipped briefly below the 3500 level.

 

Through the last two weeks of July, we saw volatility start to creep higher as well.  This wasn’t completely a surprise as things were unusually calm to begin with. In early July, the CBOE volatility, or VIX, index was trading down in the low 12 area.  By July 25th, the index had crept back towards 18, but this was still quite low relative to the high near 20 back in April. On Monday of this week, the VIX closed at over 38 and had reached well above that level on an intraday basis. By Thursday’s close, the VIX had pulled back to the low-20s, and sentiment had improved sufficiently for the S&P to pull together a 2.5% gain from Monday. Investors are still going to be scratching their heads as to how this week of gyrations came to be in the first place.

 

 

To understand how sentiment shifted from being slightly negative in late-July to outright panicky on Monday, we start with Japan and its central bank’s decision to raise interest rates to 0.25% from a previous range of zero to 0.1%.  Back in March, the BoJ had lifted its policy rate from negative 0.1% - a target it had put in place back in 2016. Investors will look at these rates as being still ridiculously low compared to where we are in North America or Europe. Likewise, a further tightening in policy was to be expected considering that inflation in Japan has started to move higher in recent months. Only three years ago, the national inflation rate was still minus 0.1%. It reached a peak of 4.2% in January 2023, then fell back to 2% this past January. We will get July figures in a couple of weeks, but June’s inflation had risen to 2.6%. The move had reverberations in not only fixed income and equities, but FX as well.

 

 

The Japanese yen, which has been in decline for coming on 13 years, broke above 160 yen to the U.S. dollar in July – the first time it has been this weak since 1986. The depreciation in yen has been supportive of Japanese equities this year, but the abrupt strengthening down to around 144 Y/USD on Monday caused a sell-off in Japanese stocks. What is more important though is how Japan has factored in markets elsewhere around the world.

 

At the margin, the move to higher rates in Japan is coming as the Federal Reserve contemplates its first cut of the cycle. This reduces the attractiveness of what is referred to as the carry trade, where we can borrow funds in a low interest rate domain like Japan and use those funds to buy higher-yielding securities in places like the U.S., including equities. Again, the move by the BoJ and the tarnishing of the carry trade has been in the cards for months and some analysts believe that most of the unwinding of the trade has already been completed. That would have been fine, other than the fact that investors also suddenly became more concerned over the state of the U.S. economy.

 

Last Friday’s payrolls report came in well below economist expectations and the unemployment rate rose. In last Friday’s newsletter, Ally and I discussed the correlation between a rise in unemployment and the potential for the U.S. economy to slip into recession. Market participants carried that narrative through the weekend and ran headfirst into the BoJ decision on Monday. As economists have dissected last week’s jobs report, a few things come to light, such as how much immigration has played a role in the numbers over the past year. Some estimates indicate that about 0.2% of the lift in in the U.S. unemployment rate from its low of 3.4% in 2023 to 4.3% in July can be attributed to immigration. This week’s jobless claims report also showed a smaller than expected rise in jobless claims in the prior week, suggesting that the economy is not as close to the recession precipice as investors feared.

 

Which brings us back to the VIX, or what many call the “fear index”.  Any time we see market volatility spike like we did on Monday, it is going to naturally cause investors to be more concerned about their portfolios. Back last year, we saw the VIX move from below 15 to north of 20 by October, coinciding with declines in both equities and bonds. It was not a spike, but more a grind higher on the back of concern that interest rates may not be heading lower anytime soon, because of persistent inflation. As inflation gave way in the fourth quarter, that concern eased and so did volatility. It is unlikely that the VIX is going to return to the lows seen in July anytime soon given that we are less than three months from the U.S. election.

 

Even if we don’t, the more important message for investors is the extremely low volatility of early summer and record high valuations for stocks was something that was going to be hard to sustain in the first place. Having markets normalize, as we believe they have this week, actually provides a more stable environment for selecting investments based on fundamentals. If the Fed does indeed start lowering interest rates in September, this will be supportive for growth and help insulate against a recession, if indeed one is coming. In that sense, the move in the VIX these past few weeks might have provided more opportunity than fear.

 

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle

 

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Andrew Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Andrew Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

Ally Pyle is an Investment Advisor with CIBC Wood Gundy in Peterborough. The views of Ally Pyle do not necessarily reflect those of CIBC World Markets Inc.

 

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