The Goldilocks market scenario – and the three bears
Three types of bear are at large in volatile stock markets. For one group, at least, the tumult has brought some benefit.
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So far this year, market participants have been pricing a "Goldilocks" scenario with quiescent inflation and positive economic growth. Recent volatility has cast doubt over the likelihood of a soft landing. We would argue that market performance is being driven by three major groups of investors – let's call them the three bears.
The first group of bears is the macro hedge fund community which is being hit by the unwind of the yen carry trade. The recent shift in Bank of Japan policy, and expectations of Federal Reserve rate cuts, has undermined expectations for the rate differential between the US and Japan, leading to positions being cut across a number of carry trades.
The impact of these trades should wash out quite soon.
The second group represents the trend followers and systematic traders. This group has executed its first wave of trading, which is essentially a reaction to the rise in volatility. This first wave is typically very fast and highly correlated across systematic strategies. Right now, we are likely in the second stage where the signals start to shift, pointing to a change in trend and less correlation across strategies.
Our analysis suggests that we are not out of the woods yet for this group of investors.
The third bear is the fundamental bear. Investors in this group (and we include ourselves here) tend to be more medium-term in nature. Their focus is on gauging whether the risk of recession is appropriately priced into markets.
With markets now pricing in five to six 25 basis point rate cuts by year end for the Federal Reserve, we think that market pricing is already starting to look a bit overdone. As long as credit markets (in particular credit issuance) and labour markets hold up, we would conclude that, although valuations aren't cheap enough to justify buying assets irrespective of the cyclical outcome, this recent correction takes some of the froth out of markets and improves the outlook for returns as we head into the autumn.
- Read more about the recent volatility: What’s behind the stock market sell-off?
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