The Big Crash: Unravelling the Market’s Turmoil

Monday’s trading screen numbers were shocking, even for the most experienced market professionals.

In Tokyo, the Nikkei plunged 12%. In Seoul, the Kospi tumbled 9%. As the market opened in New York, the Nasdaq nosedived 6% within seconds. Cryptocurrencies also took a hit, the VIX—an indicator of stock market volatility—soared, and investors sought refuge in Treasury bonds, considered the safest assets.

It’s uncertain whether Monday’s dramatic market swings signal the end of a global selloff that started last week or the beginning of a prolonged downturn. What is clear, however, is that the fundamental beliefs that have underpinned financial market gains for years have been shattered. These once-optimistic assumptions—that the US economy is unbreakable, that artificial intelligence will rapidly revolutionise businesses globally, and that Japan will not significantly raise interest rates—now appear overly confident.

Recent weeks have brought swift evidence that undermines these assumptions. The US July jobs report was lacklustre, Big Tech’s AI-driven quarterly earnings fell short of expectations, and the Bank of Japan increased interest rates for the second time this year.

Speculation about looming US recession

Let’s start by examining the recent speculations about an impending US recession that have been a topic of concern over the past year. Since the COVID-19 pandemic, the US has comfortably been the fastest-growing economy among the G7 leading industrial nations. Historically, unemployment rates have been low, and America’s self-sufficiency in energy has shielded it from the severe inflation shocks experienced in Europe following Russia’s invasion of Ukraine.

However, the situation is changing swiftly. The latest US job figures, released last week, indicate a significant cooling of the labour market. Payroll growth in July slowed to 114,000—about half the average of 215,000 over the past 12 months and well below economists’ expectations. The unemployment rate rose from 4.1% to 4.3%.

This has raised concerns. Financial markets have been heavily betting on the US economy’s ability to withstand higher interest rates. The latest GDP figures, showing annual growth close to 3%, supported this optimistic view.

The Federal Reserve uses a rule of thumb, known as the Sahm rule, to gauge whether the US economy is in recession. Named after economist Claudia Sahm, it states that when the three-month moving average of the US unemployment rate is 0.5 percentage points or more above its low over the prior 12 months, the economy is in the early stages of a recession.

Last week’s jobless report from the Bureau of Labour Statistics indicated that the Sahm rule was close to being triggered. According to consultancy Capital Economics, the rule will be met next month unless the unemployment rate decreases.

Historically, the Sahm rule has been a reliable predictor of looming US recessions and has been cited frequently in recent days by those arguing that the Federal Reserve has delayed cutting interest rates for too long. Speculation has arisen that the Fed, having fallen “behind the curve,” may announce an emergency rate cut before its next scheduled meeting next month.

Some economists caution against overreliance on the Sahm rule, pointing out that a decoupling between robust economic growth and steadily rising unemployment is unprecedented in recent history. Over the past 60 years, whenever the US unemployment rate has inc reased by 0.5% in a year, GDP growth has also been on the verge of recession—until now.

Unemployment was rising not due to widespread layoffs but because labour supply had been increasing faster than labour demand. The stock market, especially tech stocks exposed to the artificial intelligence boom, appeared more vulnerable to a recession than the real economy.

The key concern is determining what type of recession we should fear. Similar to the 2000–01 period, the greatest risk may lie in a severe downturn within the more speculative segments of the stock market.

But rising unemployment is not the only warning sign. Vice President Kamala Harris faces additional challenges in defending the current administration’s economic record against attacks from Donald Trump.

The performance of UPS, often seen as a gauge of the US economy’s health, has also been concerning. Last month, the company failed to meet analysts’ estimates and revised its growth forecasts for the rest of 2024 downward.

With the presidential election only three months away, an immediate recession is unlikely. However, signs that households are cutting back on spending are troubling news for the Democratic presidential hopeful. To top it off, Monday’s global rout wiped out billions across markets from New York to London, and this has probably served to threaten the Democratic presidential campaign even further.

Unwinding of artificial intelligence euphoria

Another potential factor contributing to the sudden market downturn is the deflation of the AI bubble. The New York Stock Exchange has experienced an almost two-year surge, fueled by anticipation that artificial intelligence is on the verge of significantly transforming our lives – the artificial intelligence euphoria.

The recent Wall Street boom, driven largely by advancements in technology and artificial intelligence, saw a remarkable 39 percent rise over the past nine months. However, this surge was heavily concentrated in just seven companies—Nvidia, Amazon, Microsoft, Google, Meta, Apple, and Tesla—accounting for more than 60 percent of the gains, while the other 493 companies in the S&P 500 lagged behind. And this implies a monopoly problem within the AI sector.

In 2021, it was observed that modern AI advancements are primarily driven by concentrated data and computing resources controlled by a few major tech corporations. This growing reliance on AI grants disproportionate power over our lives and institutions to a handful of tech firms.

The so-called Magnificent Seven companies have fuelled AI enthusiasm and stock market gains over the past year, pushing the concentration of the S&P 500 to unprecedented levels. However, a recent report from Morgan Stanley Wealth Management indicates that such index concentration typically corrects itself over time due to various factors, including regulatory, market, and competitive forces, as well as business cycle dynamics. The report also notes that equity returns have historically struggled following peaks in concentration, foreboding the market crash we experienced this week.

We are often told that AI will “change the world.” It is expected to significantly boost productivity, although it may disrupt millions of jobs in the process. This technological advancement is anticipated to create substantial new wealth for global distribution. According to an enthusiastic report by ARK Invest, AI could add $40 trillion to the global GDP by 2030, transforming every sector, impacting all businesses, and driving innovation across various platforms.

The euphoria and perceived inevitability surrounding this straightforward narrative are concerning. Even if one believes that artificial intelligence (AI) will be as transformative as electricity or the internet, we are at the nascent stages of a complex, multi-decade transformation that is far from guaranteed. Yet, current valuations seem to have already priced in this entire transformation. A February report by Currency Research Associates highlighted that it would take 4,500 years for Nvidia’s future dividends to justify its current price. This underscores the long-term uncertainties involved.

Even though Nvidia generates tangible revenues from selling real products, the broader AI narrative is fraught with numerous uncertain assumptions. For instance, AI requires substantial amounts of water and energy. Both the US and EU are pushing for companies to disclose their resource usage, and it is highly probable that these input costs will rise significantly in the future, either through carbon pricing or resource usage taxes.

In addition, even for more routine mid-level tasks, there are numerous questions about how to effectively integrate AI into workflows and whether it will be more productive than the humans it might replace. Resistance is already emerging, evidenced by the Hollywood writers’ strikes, which fundamentally revolve around control of AI, and unions are increasingly addressing the broader issue of technology regulation.

Simultaneously, copyright disputes related to AI are intensifying. Last week, French regulators fined Google €250 million for failing to inform news publishers that their articles were used to train its AI algorithms and for not securing fair licencing agreements. Similar lawsuits have been filed against OpenAI and Microsoft by the New York Times. As AI becomes more embedded in proprietary corporate data sets, we can expect an increase in copyright litigation, potentially intersecting with worker concerns about corporate surveillance.

Currently, AI developers are not required to own the copyright to the content used for training their models. Immediate profits from AI are not necessary; mere speculation about future gains is enough to sustain current market exuberance. This relentless techno-optimism has created significant paper wealth in Silicon Valley. It is worth noting that many advocates of “AI everywhere” were recently championing Web3, cryptocurrency, the metaverse, and the gig economy.

A major distinction, however, is that AI has received endorsements from large, cash-rich, market-leading companies such as Microsoft, Google, and Amazon. Yet, even within these corporations, there are internal doubts. A senior staff member at a leading AI firm recently admitted that profit assumptions surrounding AI are “more speculative than substantive” and acknowledged many unresolved issues.

All these factors were tell-tale signs of the AI euphoria unwinding, and it was simply a matter of when. And it appears that the time has indeed come. In fact, the situation of AI today is also reminiscent of previous technology investment bubbles, where only a few companies typically survive the inevitable bust, and initial movers often do not reap the long-term rewards. A notable difference this time is the smaller number of corporations involved and their substantial profitability. Unlike the 2000 tech bubble, driven by many loss-making ventures reliant on continuous investor funding, the current race for AI dominance involves financially robust companies.

However, the significant imbalance in share valuations is becoming a disadvantage for those in the AI race. Any major earnings slip or unfulfilled promises are likely to trigger heavy selling. Additionally, the anticipation of upcoming US interest rate cuts could make other, less tech-focused stocks more attractive, prompting major investors to shift their portfolios away from tech giants to achieve better balance.

Surging yen and the issue of carry trade

Finally, the rising yen caused issues with carry trades.

The recent strength of the yen—up more than 10% against the U.S. dollar in just weeks—has caused a classic “carry trade” to unwind, creating significant issues. A carry trade involves borrowing and selling one asset to use the cash to buy another, hoping to earn more from the asset purchase than the borrowing cost. This strategy works well if currency values remain stable, but the surging yen has eroded potential profits.

This surge began with officials from the Bank of Japan discussing raising interest rates, leading to the central bank increasing rates into positive territory for the first time in 17 years. Higher rates typically support currencies as investors buy local currencies to purchase bonds with attractive yields. Meanwhile, the U.S. Federal Reserve’s talk of cutting rates and recent weak economic reports have pressured the U.S. dollar.

It is suspected that the Bank of Japan has been buying yen to support its value, another factor that can boost currency values. The issue with carry trades is that the targeted spreads are usually small, often just two to four percentage points. To make these returns attractive, some investors use borrowed money to increase exposure, which increases risk. Rapid moves in asset values and borrowed money can lead to large, unexpected losses.

The main risk with heavily leveraged trades is that investors might lose so much that they can’t repay their lenders. In such scenarios, the lenders also face significant problems. There are signs of margin calls, indicating someone may be facing significant losses. The risk of hedge funds blowing up due to the carry trade unwind is hard to gauge, but this uncertainty forces investors to be cautious and reduce exposure, leading to volatile days like Monday.

The Fed’s move?

The market panic witnessed this week introduces a variety of risks, both significant and minor. The most critical concern is that if the selloff remains unchecked, it could destabilise the financial system, impede lending, and potentially serve as the catalyst that plunges the global economy into the long-feared recession.

This turmoil has prompted calls for the Federal Reserve to lower interest rates, possibly even before the next scheduled policy meeting in September. In the bond market, a rush into shorter-term Treasuries briefly caused yields on two-year notes to dip below those on ten-year bonds for the first time in over two years. This disinversion, which returned the yield curve to its typical shape, is often seen as a harbinger of an imminent recession.

Consequently, markets are now anticipating approximately 125 basis points of U.S. rate cuts this year, up from around 90 basis points last Friday and 50 basis points at the start of last week. According to derivative market pricing, traders now view a 50 basis point cut in September as almost certain. The closely monitored U.S. 2-year-to-10-year yield curve has also narrowed its inversion to 2 basis points, the smallest gap since July 2022, signalling expectations for a sharp reduction in short-term yields.

A Trader’s View

Let’s take a look at the weekly timeframe of the USD/JPY chart. As we can see, there has been a very sharp drop within the last few weeks due to the intervention and raising of the interest rate by the Bank of Japan.
There is a high chance that it may continue to drop to the strong support region of 137.3 to 140.15.
Overall, the trend is still an up-trend and there is a chance the drop may slow down in the support region. Once the support zone is broken, it may continue to drop further into the 128 region.

As long as the support level holds, it will be better to stay on the long side. 

Aaron Kuan