An orderly return to normal

By Olivier de Berranger, Deputy Chief Executive Officer and CIO, and Enguerrand Artaz, Fund Manager, La Financière de l’Echiquier (LFDE) ǀ September 2024

Periods of summer stress are one of those unfortunate market realities that investors could do without. The one in early August was quickly forgotten. The triggers were as numerous as they were serious: a very negative surprise on US unemployment, a massive unwinding of speculative short positions on the yen following an unexpected interest rate hike by the Bank of Japan, rumours of a delay in the delivery of Nvidia’s new chip and renewed tensions in the Middle East.

But it was ultimately short-lived. A few weeks after the wave of panic, most stock market indices had fully recovered from the fall, including the Nikkei, the Tokyo Stock Exchange’s benchmark index, which lost almost 20% in a matter of days. In the United States, the S&P 500 has virtually returned to its mid-July highs and the Dow Jones has set new all-time records.

However, it would be premature to dismiss this correction as a minor event. It was actually a turning point in market psychology. For more than two years, from inflation to interest rate hikes, the markets have followed the logic that “bad news is good news”. In other words, weak or weaker-than-expected macroeconomic data was seen as good news because it suggested a less dynamic economy likely to reduce inflationary pressures, allowing central banks to stop tightening monetary policy and then start lowering interest rates.

The situation has changed radically. In the developed countries – other than Japan – interest rate cuts have already begun, in the eurozone, Canada, the United Kingdom, etc., or are in the pipeline, as in the United States, against a firmly established backdrop of disinflation. So, as bad economic data is no longer necessary for central banks to ease policy, it is back to what it basically is: bad news. The particularly negative reaction of equities to the surprise rise in US unemployment reflected this change in mindset: markets reverted to the old “bad news is bad news” mindset.

This return to normal, which is healthy in the long run, has been accompanied by another change. In recent years, the anti-correlation between equities and bonds had been shattered. In 2022 in particular, as investors became concerned about rising interest rates – and hence falling bond prices – equities fell sharply. Conversely, the sharp easing of interest rates at the end of 2023 triggered a powerful rally in markets for risky assets, with equities and bonds rising in tandem. The August correction, by contrast, saw a resumption of the opposing movements to which the two asset classes have accustomed us. Concerned about the sudden deterioration in US employment and the return of recessionary risks, equity markets fell sharply. Taking this as a signal that the Fed would accelerate its interest rate cuts, bond markets rallied sharply.

This further return to normal has one virtue: it gives investors back some room for manoeuvre in terms of allocation, with bond assets once again able to play their role as a safety cushion. At a time of growing doubts about the strength of the US labour market, this outlook is reassuring. In contrast to the annus horribilis of 2022, investors now have clearly identified safe havens – overweighting bonds, switching from cyclicals to defensives and visible growth stocks – should the markets’ central scenario of a soft landing for inflation and growth be challenged. Meanwhile, we are waiting for a return to normal in a third area: small and mid-cap valuations, which remain historically low relative to large caps.

The opinions expressed in this document are the authors’ own. LFDE shall not be held liable for these opinions in any way. The securities and sectors mentioned above are given by way of example. There is no guarantee they will remain in the portfolio over time. Final version of 4 September 2024.