August Update

A Tale of Two Halves

August 2024 was marked by significant volatility, particularly during the first week, which saw major U.S. indices suffer sharp declines. However, by mid-month, the markets began to stabilize, and both the Nasdaq 100 and S&P 500 recovered, closing the month on a positive note.

Market Performance: Volatile Beginnings and Positive Finish

In the first week of August, major indices saw significant declines:

• The S&P 500 dropped to a low of 5,119, reflecting an 8.5% decline from its July highs.

• The Nasdaq 100 fell to a low of 17,435, representing a 13.6% drop from its previous peak.

These declines were largely driven by the unwinding of the USD-JPY carry trade, which contributed to market-wide turbulence. Despite the early volatility, both indices managed to recover and finish August on a positive note:

• The S&P 500 ended the month at 5,648, posting a positive performance for August.

• The Nasdaq 100 closed at 19,574, also finishing up for the month.

The recovery was supported by several factors, including improved investor sentiment, better-than-expected corporate earnings from key sectors, and bond market rallies fueled by speculation of Federal Reserve rate cuts in September.

The USD-JPY Carry Trade: A Key Factor in Early Volatility

The early-month volatility was driven by the unwinding of the USD-JPY carry trade. This strategy involves borrowing in low-interest yen to invest in higher-yielding U.S. dollar assets. With the Bank of Japan raising rates and the Federal Reserve discussing potential rate cuts, the narrowing interest rate differential led to the reversal of these trades, contributing to an estimated $500 billion in unwinding. This caused significant currency swings that impacted equity markets.

Source: UBS, Refintiv, Royce Advisory

Corporate buybacks likely to peak soon

Over the past four years, the percentage of excess cash held by S&P 500 companies has decreased significantly, falling by four percentage points from near multi-decade highs and approaching the 8.0% low seen during the 2008 Financial Crisis. This decline suggests that companies have been using up their excess cash, which could limit their ability to pay future dividends and conduct share buybacks. As a result, firms may now prioritize rebuilding their cash reserves, potentially reducing the capital returned to shareholders. Given this environment, we focus on companies with strong business models, robust free cash flow, and substantial capital reserves, as these attributes provide a competitive edge and stability in uncertain times.

Source: BofA US Equity & Quant Strategy

Monetary Policy: Gradual Rate-Cutting Expected

On the monetary policy front, the Federal Reserve is expected to start a gradual rate-cutting cycle. While inflation is moderating, it remains above the Fed’s long-term target, and unemployment has ticked up slightly. The Fed is anticipated to implement 25 basis point reductions over the coming months, providing a cautious easing of the monetary brake.

Source: Edward Jones

Yield Curve Developments

In the bond market, the yield curve between two-year and 10-year Treasury notes briefly turned positive in August for the second time since 2022. This shift, driven by weaker-than-expected job openings data, fueled expectations for more aggressive Fed rate cuts. However, the yield curve inversion, a common recession indicator, has persisted longer than in previous cycles, signaling continued economic uncertainty. The spread between 10-year and 2-year Treasury yields closed in positive territory after 565 consecutive sessions of inversion, surpassing the previous record set in the late 1970s when the curve remained inverted for around 410 trading days. Historically, most recessions have begun after the yield curve turns positive again. The inversion, where short-term yields are higher than long-term yields, is typically viewed as a warning of recession within 18 months to two years. Yet, the current inversion has persisted longer than in prior episodes. The recent "disinversion" temporarily restored the normal relationship between two- and 10-year yields, where longer-term yields reflect expectations for future economic growth and inflation. Yield curve inversions have traditionally been reliable indicators of impending recessions.

Source: Bloomberg

Conclusion

August was characterized by a sharp decline early in the month followed by a strong recovery. The unwinding of the USD-JPY carry trade, combined with evolving expectations for Fed policy and broader economic trends, contributed to the month’s volatility. Despite the turbulent start, both the S&P 500 and Nasdaq 100 ended August positively, reflecting improved market sentiment and expectations for gradual monetary easing as we move into the fall.