A storm in a Japanese teacup: how it pays to be brave

Based solely on the jobs report, traders had speculated that the US was headed for a recession. It showed America's unemployment rate up to 4.3%, an added 0.5% based on the moving average over the past three months—a metric known as the Sahm Rule (after Claudia Sahm, a former Federal Reserve economist).

This rule has always been reliable in indicating that an economic recession is imminent. It states that if the average unemployment rate over three months is half a percentage point higher than its lowest level in the past 12 months, the country is in the early stages of a recession.

Reasons not to panic

According to Goldman Sachs, however, three reasons make the steady rise in the unemployment rate less concerning than in the past, despite the increase in the probability of a recession in the United States next year to 25%, up from 15% currently.

The first reason is the layoff rate remains stable and is historically low. The economy is still outside the usual 'vicious cycle' in which job losses occur. Far from weak, jobs are growing at a healthy pace that seems unlikely to decline in the near future.

The second reason for ruling out a recession is the Federal Reserve's exceptional ability to "break the silence" and intervene quickly to stimulate demand in the economy in a single meeting, should the labour market show significant weakness.

This could be achieved by dramatically cutting interest rates, which some speculate could be as much as 100 basis points (1%) in September, following the recent alarm.

Thirdly, Goldman Sachs economists believe that the rise in the unemployment rate is due to an increase in new immigrant workers, not to US citizens losing their jobs. Most immigrants struggle to gain employment shortly after arriving.

Back to reality

It is more likely that the US economy is heading towards a slowdown, not a recession, as the traditional indicators of a recession—such as negative GDP (gross domestic product) growth over two consecutive quarters—are absent.  

Data from the US Bureau of Economic Analysis indicates that the GDP grew by 2.8% during the second quarter of this year, and it is unlikely that US growth will slip into negative territory this quickly.

Regardless of the Goldman Sachs' analysis, Sahm seemed to settle the issue in an interview with CNBC, saying: "We aren't in a recession right now." Austan Goolsbee, president of the Chicago Federal Reserve Bank, was also reassuring investors during the market frenzy.

"The Federal Reserve's job is very clear; to maximise employment, stabilise prices, and maintain financial stability, and that's what we'll do," he said, as reported by The Financial Times. "If there's a deterioration in any of these parts, we'll correct it."

He pointed out that the Federal Reserve "didn't respond to one set of indicators" but kept its options open regarding monetary policy. "Should we ease restrictions? We won't tie our hands regarding what happens in the future because we'll continue to receive more information."

Missing a trick

Fears of a recession led to the "flash crash" but other factors related to US monetary policy, investors themselves, and the sectors they invest in, also impacted the markets and fuelled the negative trend in stock prices.

The Federal Reserve's decision at the end of July to keep interest rates unchanged, as expected, for the second time this year, raised concerns in stock markets about rising borrowing costs.

Meanwhile, other central banks in advanced economies, including the Bank of England, the European Central Bank, and the central banks in Canada, Switzerland, and Sweden, made slight interest rate cuts.

Even Federal Reserve Chair Jerome Powell's somewhat delayed announcement of a possible rate cut in September did not change investors' mood.

Some economists believed that the Fed erred by not cutting the interest rate at its last meeting, despite a consensus that the time had come for such action.

This was hinted at by former Federal Reserve Vice Chair Alan Blinder and Nobel laureate Paul Krugman, who said the US central bank ignored calls to cut the benchmark lending rate.

Tech stocks tank

Moreover, markets wobbled amid signs that stocks, particularly in tech, may now be inflated—a bubble driven partly by over-optimism about Artificial Intelligence.

Last week, Intel said it would lay off 15,000 staff, while rumours circulated that rival Nvidia might have to delay the release of its new chip.

The Nasdaq Index, known for its heavy technology weighting, then fell by 10% after reaching its highest level just a few weeks earlier. Were the markets correcting?

The Bloomberg Index tracks the so-called Big Seven—Alphabet (which owns Google), Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. This opened with a drop of about 9%, its sharpest single day fall since 2015.

The decline in the S&P 500 wiped $1.87tn in value in one session, equivalent to two-thirds of the entire value of the FTSE 100 Index. Nvidia, which has mesmerised markets and media in recent months, lost more than $300bn at opening.

Yen feeding frenzy

In Japan, where the storm originated, investors found themselves in a predicament, given that they had borrowed money from low-interest economies like Japan or Switzerland to finance investments in high-yield assets elsewhere.

They woke up to an 11% surge in the Japanese yen against the dollar after it had hit its lowest level in 38 years just a month earlier. This led to a yen borrowing frenzy.

The total amount of Japanese bank lending to foreign borrowers in yen reached about $1tn last March, according to data from the Bank for International Settlements. This represents a 21% increase from 2021.

Reuters reported that some of the largest hedge funds trading in stocks based on algorithmic signals began selling stocks after the sudden rate hike by the Bank of Japan, signalling the anticipation of more stringent monetary policies.

The main stock markets in the Gulf followed global markets with notable balance. On one hand, any recession in the US economy would lead to a reduction in oil demand, aside from the general decline in demand from China.

This explains the drop in crude oil prices amidst the turmoil, with oil a major driver for financial markets in the Gulf region.

Buy when others sell

Another factor that contributed to investors' selloffs and exits was psychological. When the veteran investor, boss of Berkshire Hathaway, and 'Sage of Omaha' Warren Buffett unusually chose to shed stocks, others noticed.

It sparked concern among traders, given that Buffett is famous for staying calm when everyone else is not. He often says that market downturns—when stocks fall by 20% from their peak—are the best times to buy.

So, when he sold half of his shares in Apple, it triggered a new wave of panic on Wall Street. Tech billionaires, including Jeff Bezos, Mark Zuckerberg, and Elon Musk, were also hit hard, collectively losing $68bn overnight, according to Bloomberg.

The Fear Index, also known as the Volatility Index (VIX), is important as a measure of future expectations about market volatility, but it is also used as a contrarian indicator when it is abnormally high.

When the market is in a state of extreme selling, that can also be an opportunity to buy. So, congratulations to those who bought last Monday at the peak of the fear. Congratulations, in other words, to those with brave hearts.