A premature recovery

The period from late July to early August is typically quieter, as many enjoy their vacations somewhere by the sea or in the mountains. Ideally, this summer break could be used to take a little digital break, during which we no longer frantically consult our favourite online financial media. Those of us who have managed to disconnect, in the truest sense of the word, may feel that nothing has happened since we left in July. After the lightning correction that saw the Japanese yen rise from 162 to 142 against the dollar between mid-July to early August, triggering a mini-crash of the Japanese market during which the Nikkei index lost 26%, the least we can say is that the recovery and the VIX index’s spike in volatility to over 65% has been as rapid as the fall that preceded it. 

This episode of market volatility has no fundamental cause. It was triggered by technical factors, notably overly extreme positioning by investors using leverage financed in Japanese yen. Even if there is no fundamental problem, this correction, which is beneficial for the continuation of the primary bull market in force since October 2022, cannot and must not be so brief. 

Credit spreads provide a valuable insight

During the recent correction, credit provided us with an important confirmation of the state of the economy in the US and Europe. Indeed, the widening of credit spreads has been very limited and has already reversed. During this phase, riskier bonds outperformed less risky ones. On the other hand, corporate issuers were able to take advantage of falling interest rates to issue new bonds, which were met with healthy demand. The primary bond market therefore performed perfectly. Anecdotal evidence thus points to confirmation of the overall health of private balance sheets on both sides of the Atlantic, as well as the technical nature of the recent turbulence.

Expectations of a rapid rate cut could be disappointed

The summer market correction has triggered a wave of optimism for rate cuts by the Fed and the European Central Bank. Chair Powell’s dovish tone at this year’s much anticipated Jackson Hole conference reinforced it. For our part, we are circumspect on the subject. In the US, the labour market has indeed cooled, but given that private balance sheets are in good financial health, we believe the Fed will be keen to gauge the risks of excessive or premature easing in the cost of credit at a time when demand for bank credit has recently re-accelerated. On the other hand, with the US equity market close to its all-time high and credit spreads compressed, we can imagine that the central bank will be anxious not to fuel a possible speculative asset bubble. The central bank has every incentive to proceed in an orderly and measured manner. In our view, the case for lower rates is stronger in Europe, where final demand is sluggish and underlying inflation has already fallen back below 2%. We reiterate that, at this stage, the equity bull market does not need multiple rate cuts to continue in a context of moderate recession risk.

Good earnings season in the United States

In the meantime, the investment cycle in infrastructure for AI services is continuing, but any disappointment in the upcoming earnings report of the leading chipmaker could be sanctioned by a new phase of stock market correction led by the technology sector. In the coming quarters, we’ll also be keeping a close eye on the free cash flow of the major technology platforms, which between them account for 50% of the sales of the world leader in microprocessors. It’s worth noting in passing that these mega-cap technology companies passed the quarterly results test unscathed, despite relatively high expectations. On the positive side, the rest of the market returned to profit growth, beating analyst expectations.

Gold rises discreetly

Meanwhile, the yellow metal belongs to the select club of asset classes that are trading at all-time highs. The ounce of gold is trading around USD 2500. Its year-to-date performance is +20%. We also note that, despite this strong advance, the main instruments enabling Western investors to build up a position are not benefiting from any net buyer flows. Gold is silently rising and trading at record levels, typical behaviour in the initial phases of a structural bull market. 

What does this mean for investors?

Fundamentals are sound and the market remains in a primary uptrend. From a technical perspective, the cleansing of extreme positions is healthy and provides investors with a significantly improved risk-reward outlook for the second half of the year. However, the rapid recovery since the recent lows suggests these lows could be re-tested and that the correction phase is not over, warranting patience.