Finance
The stock market is entering an extended period of chaos – and that’s a good thing
Global markets suffered an acute panic attack this week – sudden chaos in what has otherwise been a fairly calm and predictable year.
The dizziness started in Asia: The markets in Japan crashed early Mondaywith the main Nikkei index falling as much as 12.4%. The tremor then spread around the world as cryptocurrencies – supposedly an uncorrelated store of value – experienced a temporary loss of control and plummeted along with everything else. At the end of the day, it was clear that the US stock markets could not catch their breath. Completely detached from reality, with hearts beating wildly up and down on Wall Street, the Dow Jones Industrial Average closed more than 1,000 points, a decline of 2.6%, while the technology stock exchange Nasdaq fell by 3.4% and the S&P 500 fell 3%. In the days that followed, the market jumped or fell with each new piece of information, creating a palpable tension in the chest of every investor.
As with any panic attack, there are countless reasons for its sudden onset: a combination of long-known fears that are both within and beyond our control. After the Bank of Japan raised interest rates, the Japanese yen suddenly rose in value. mixing up the carry tradeA popular Wall Street strategy This has been paying off for years, but requires calm markets to sustain themselves. On top of that came concerns about Big Tech, the backbone of the vibrant market of 2024. After closing out the earnings season with little to gain from investing in AI, concerns about companies wasting $1 trillion on this useful but unproven technology went from whispers to open debate.
Most important, however, was the market’s painful digestion of the July jobs report, which showed that the U.S. created just 114,000 new jobs last month, well below economists’ expectations. The main reason for the market’s calm this year was the strong belief that America’s fight against inflation would end with a soft landing, an ideal scenario in which prices come back under control without a wave of job losses. The recent rise in unemployment – which reached 4.3% in July – forced Wall Street to accept that its perfect economic scenario is in jeopardy and that the Federal Reserve, which has focused on controlling inflation, may be lagging behind when cutting costs. interest rates to support the labor market. It was enough to send the market into a frenzy.
A soft landing remains Wall Street’s base case. Fed Chairman Jerome Powell is likely to intervene in September to boost the economy. And it is likely that the recent weakness in the labor market is just a step back towards a more sustainable existence. But even a little doubt can be detrimental to the financial world, a world ruled by probabilities. After quite a long hiatus, fears that the US economy could enter a recession resurfaced, sending people in the markets – from macro traders to stock jockeys – into panic.
All this chaos is a warning that a new era is approaching. The inflationary post-pandemic economy is fading, and something new will soon take its place. We don’t know if that regime will reward growth or appreciate stocks, or send the money back to Japan to Mexico. We don’t know the structure of this new economy – only that it will be slower than what we are experiencing now and perhaps more ‘normal’ than anything we have seen since the 2008 financial crisis. The plan is to return to an inflation rate of 2% and a reference interest rate of 2%. How exactly we get there – via a soft landing or post-recession – is the question that will keep markets convulsing between new data prints and central bank announcements until we reach our destination. It may be a turbulent end, but at least it is in sight.
There are levels, man
The signs that the economy is slowing are neither unexpected nor unintentional. They are part of our recovery from the pandemic. In the face of an economy so hot that both wages and prices were skyrocketing uncomfortably, the Fed raised interest rates from 0% to 5.25%. The explicit intention was to pump the brakes, slow consumer spending and get companies to relax some of their hiring practices. This put Wall Street into ‘bad news is good news’ mode – lackluster economic data was evidence that higher interest rates were actually slowing things down, and over the past year investors got plenty of proof. The consumer price index continued its downward trend in June, amounts to 3%just above the Fed’s 2% target. Less and less Americans have quit their jobs because they became less confident that they would immediately find new ones. Wages continued to risebut slower, meaning prices can stabilize.
The slower pace of growth kept the stock market rolling happily. Consumers still had money to spend, and after price increases during the pandemic companies enjoyed record profits. On August 1, the day before the jobs report dropped, the S&P 500 was up 11.8% this year, while the Nasdaq and Dow Jones were up 9.1% and 7%, respectively. While there was some demand for protection against the prospect of a return of volatility, overall sentiment on Wall Street had turned more positive.
“We don’t see much demand for downside protection,” Mandy Xu, head of Cboe’s derivatives market intelligence unit, told me late last month. She added that Wall Streeters were largely betting that the market would rise. When everyone starts betting in the same direction, things get lopsided.
The sudden revaluation following the jobs report has not only sidelined many Wall Street investors, but has also changed the entire tenor of the market: bad news is now bad news. A slowing economy is what policymakers and investors wanted to see, but not one so slow that it could hurt the labor market or, in the worst case, plunge the economy into a full-blown recession. The question is whether we are in the former form of slowdown and not the latter.
If you dig deeper into recent economic data, there is a strong case that the US is in a kinder, more forgiving slowdown. The July jobs report showed wage growth of 3.6% year-on-year, meaning people are still getting raises even when adjusted for inflation. At Apollo Global Management, Torsten Slok, the chief economist, argued to clients that the “source of the rise in unemployment is not job losses, but an increase in labor supply due to increasing immigration.” In other words, there is no sudden increase in layoffs, just increased demand for jobs. In another note to clients on Tuesday, Slok noted that the number of borrowers defaulting on risky loans has fallen over the past year – not what you would expect in the run-up to a recession.
Until Americans lose their jobs, consumers will continue to spend. As long as consumers keep spending, the U.S. economy can stay on track. The problem is uncertainty. Until Wall Street can be confident that consumers will hold out (or not), its beliefs are easily shaken. And if the belief is easily shaken, there is an increased risk of stampede. There are many data points needed to get clarity, and the process of sifting through them to see the new shape of the market is still in its early stages.
Not all companies will come out on top in this new environment. Companies have managed to jack up prices to achieve record profits over the past three years, but consumers are becoming increasingly choosy about what they spend their money on, sometimes switching to cheaper products. This is causing problems for some brands who have pushed their prices too far. Starbucks, which raised prices because of the pandemic, missed profits in the second quarter. McDonald’s, which has that increased prices by as much as 40% since 2019, also smelled. Meanwhile, Shake Shack raised prices by only about 8% due to the pandemic, beat earnings expectations during the same period. This spread in winners and losers means that (gasp!) investors will have to be more picky about the stocks they pick, Kevin Gordon, director and senior investment strategist at Charles Schwab, told me. Driving on an index is no longer sufficient.
“Those that do well on pricing power are doing well. Those that don’t are getting crushed because of missing estimates,” he told me. “Companies that benefited from the inflation wave are no longer benefiting.”
In recent years a number of Wall Street’s most prominent investors have complained that the art of fundamental financial analysis has been lost. Searching for cheap stocks, reading balance sheets, listening to investor calls – some of that has been replaced by quantitative trading and index-hugging. Maybe it will find its place in the coming market, or maybe it’s just a stopover on the way to the next trend. Part of the chaos right now is that no one knows.
Known known and unknown known
Investors have spent the better part of the past four years trying to make sense of one unknown after another. Since 2020, they have gone from pandemic-induced emergency rate cuts to historically rapid, inflation-fighting rate hikes. The economy was essentially put into sleep mode, shortages drove up prices and companies laid off workers to bring them back. If this felt like a wild ride, that’s because it was. After all the strangeness and uncertainty, returning to normal can feel like a shock in itself. If all goes according to plan, that’s the kind of market we’ll be entering: normality. A ‘normal’ economy with inflation near 2%, steady job growth across sectors, and a Fed that may fade into the background for a while. Be boring.
The Fed will likely cut rates in September, but if the economy’s deterioration accelerates, the chances of a recession increase, and those cuts may not be enough to stop it. A recession is also a ‘normal’ event, but not exactly a pleasant one. After years of strange times and excessive profits, Wall Street is dancing on a razor’s edge. Trades that worked in our strange post-pandemic market will not work under a more standard economic regime of low inflation and lower interest rates. As we saw with the carry-trade boom, changing those positions generally means violence. What happened Monday was the sudden realization that the new structure could sustain itself before Wall Street could imagine it. Expect more chaos as the market analyzes every new piece of information, looks for something solid and moves with the data that facilitates or causes the recession scare. This is the tune the market is dancing to now. It’s kind of chaos, but think of it as positive chaos.
Linette Lopez is a senior correspondent at Business Insider.
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