The stock market is entering a prolonged period of chaos – and that’s a good thing

Global markets have had an acute panic attack this week – a sudden burst of chaos in what has otherwise been a fairly placid and predictable year.

The dizziness has begun in Asia: Markets tumbled in Japan on Monday morning, with the main Nikkei index down as much as 12.4%. The tremors then spread across the globe as cryptocurrencies – supposed to be an uncorrelated store of value – experienced a temporary loss of control, falling along with everything else. By the end of the day, it was clear that US stock markets couldn’t catch their breath. Completely detached from reality, with hearts racing wildly up and down Wall Street, the Dow Jones Industrial Average closed down more than 1,000 points, down 2.6%, while the tech-heavy Nasdaq , fell 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, leading to a distinct tightness in every investor’s chest.

As with any panic attack, the reasons for its sudden onset are myriad – a combination of long-known anxieties both within and outside of our control. After the Bank of Japan raised interest rates, the Japanese yen appreciated sharply, weighing on the carry trade, a popular Wall Street strategy that has paid off for years but requires calm markets to sustain. Added to that are concerns about Big Tech, the backbone of the market in 2024. After the earnings season ended with little profit to show for AI investments, concerns that companies wasted $1 trillion on this nifty technology, but unproven, they went from whispers to open debates.

Most important, however, was the market’s painful processing of July’s jobs report, which showed the US added just 114,000 new jobs last month, well below economists’ expectations. The main reason for the market’s calmness this year has been the strong belief that America’s battle with inflation will 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 rose to 4.3% in July – has forced Wall Street to accept that its perfect economic scenario is at risk and that the Federal Reserve, which has been focused on controlling inflation, may be behind the tapering curve . interest rates to support the labor market. It was enough to send the market into a complete frenzy.

A soft landing remains Wall Street’s base case. Fed Chairman Jerome Powell is likely to step in to stimulate the economy in September. And it is likely that the recent weakness in the labor market is only a level back to a more sustainable existence. But even a little doubt can be detrimental to finance, a world ruled by probabilities. After a fairly long absence, fears that the US economy could be tipping into recession have returned to the fore, causing market people – from macro traders to stock jockeys – to panic.

The story continues

All this commotion is a warning that a new era is approaching. The post-pandemic inflationary economy is fading and something new will soon replace it. We don’t know whether that regime will reward growth or capitalize on stocks, whether it will send money flowing back to Japan or Mexico. We don’t know the makeup of this new economy – only that it will be slower than what we’re experiencing now and perhaps more “normal” than anything we’ve seen since the financial crisis of 2008. The plan is to return to a 2% inflation rate and at a benchmark interest rate of 2%. Exactly how we get there – via a soft landing or after a recession – is the question that will have markets convulsing between fresh data prints and central bank announcements until we reach our destination. It may be a turbulent ending, but at least it shows.

There are levels to this, man

Signs that the economy is slowing are neither unexpected nor unintended. They are part of our recovery from the pandemic. Faced with an economy so hot that both wages and prices have risen uncomfortably, the Fed raised interest rates from 0% to 5.25%. The explicit intent was to put the brakes on, slow consumer spending, and make companies lighten up some of their hiring. This put Wall Street in “bad news is good news” mode — so-so economic data was proof that higher rates were actually slowing things down, and over the past year, investors have had plenty of evidence . The consumer price index continued its downward trend in June, coming in at 3%, just above the Fed’s 2% target. Fewer Americans are leaving their jobs as they have become less confident that they will immediately find new ones. Wages continued to rise, but more slowly, meaning prices could stabilize.

The slower pace of growth kept the stock market on a merry-go-round. Consumers still had money to spend, and after rising prices during the pandemic, companies enjoyed record profits. On Aug. 1, the day before the jobs report was due, the S&P 500 rose 11.8 percent for the year, while the Nasdaq and Dow gained 9.1 percent and 7 percent. While there was some demand for protection against the prospect of renewed volatility, overall sentiment on Wall Street turned more bullish.

“We’re not seeing a lot of demand for downside protection,” Mandy Xu, the Cboe’s head of derivatives market intelligence, told me late last month. She added that, for the most part, people on Wall Street were making a lot of bets that the market would go up. When everyone starts betting in the same direction, it gets skewed.

The sudden revaluation after the jobs report not only caught many investors off guard on Wall Street, but changed the tenor of the entire market – bad news is now bad news. A slowing economy is what policymakers and investors wanted to see, but not so slow that it could hurt the labor market or, at worst, send the economy into a full-blown recession. The question is whether we are in the first kind of slowdown and not the second.

If you dig deeper into the recent economic data, there is a strong case for the US being in a milder and more accommodating slowdown. July’s jobs report showed wages rose 3.6 percent year-over-year, meaning people are still getting raises even when adjusted for inflation. At Apollo Global Management, Torsten Slok, chief economist, argued to clients that “the source of the increase in the unemployment rate is not job cuts, but an increase in labor supply due to increased immigration.” In other words, there is no sudden increase in layoffs, just more demand for jobs. In another note to clients on Tuesday, Slok noted that the rate of borrowers defaulting on subprime loans has fallen over the past year — not what you’d expect to see before a recession.

Until Americans lose their jobs, consumers will continue to spend. As long as consumers continue to spend, the US economy can stay on track. The problem is uncertainty. Until Wall Street can be sure that the consumer will hold out (or not), conviction is slightly shaken. And when the conviction is slightly shaken, there is an increased risk of flight. It takes a lot of data points to arrive at clarity, and the process of examining them to see the new shape of the market is in its infancy.

Not all companies will come out on top in this new environment. Corporations have been able to raise prices over the past three years to reap record profits, but consumers are becoming more discerning about what they spend their money on, sometimes switching to cheaper products. This causes problems for some brands that have pushed their prices too far. Starbucks, which raised prices during the pandemic, missed second-quarter earnings. McDonald’s, which has raised prices by 40% since 2019, has also felt it. Meanwhile, Shake Shack, which raised prices by only about 8% during the pandemic, beat earnings estimates over the same period. That dispersion in winners and losers means investors will have to be more selective about the stocks they pick, Kevin Gordon, director and senior investment strategist at Charles Schwab, told me. Traveling an index will no longer reduce it.

“Those that do well in terms of pricing power do well. Those that don’t get crushed for missing estimates,” he told me. “Companies that benefited from the wave of inflation are no longer benefiting.”

In recent years, some of Wall Street’s leading 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 these have been replaced by quant trading and embracing indices. Maybe it will find its place in the future market, or maybe it’s just a stop on the way to the next trend. Part of the chaos of this moment is that no one knows.

Known known and known unknown

Investors have spent most of the past four years trying to figure out one unknown after another. Since 2020, they have gone from pandemic-driven emergency interest rate cuts to historically rapid inflation-fighting interest rate hikes. The economy was essentially put into sleep mode, the deficit pushed prices up, and corporations laid off workers only to bring them back. If it felt like a wild ride, that’s because it was. After all this strangeness and uncertainty, returning to a normal state of affairs can be a shock of its own. If all goes according to plan, that’s the kind of market we’ll be entering: normality. A “normal” economy with inflation close to 2%, steady job gains scattered across various industries, and a Fed that can fade into the background for a while. Be boring.

The Fed may cut interest rates in September, but if the deterioration of the economy accelerates, the likelihood of a recession increases, and these cuts may not be enough to stop it. A recession is also a “normal” event, but not a particularly fun one. After years of strange times and huge gains, Wall Street is dancing on a knife’s edge. The trades that worked in our strange post-pandemic market will not work in a more standard economic regime of low inflation and lower interest rates. As we saw with the carry-trade explosion, changing these positions generally means violence. What happened Monday was a sudden realization that the new structure may assert itself before Wall Street imagined it would. Expect more chaos as the market digests each new piece of information, grasping at something solid, moving with whatever data eases or generates recession fears. This is the song the market is dancing to right now. It’s kind of chaos, but think of it as positive chaos.

Lynette Lopez is a senior correspondent at Business Insider.

Read the original article on Business Insider