Black Monday

Here are some of the biggest stories from last week:

• Global markets fell sharply on Monday and volatility surged.
• A time-tested indicator suggests that the US economy is in recession.
• The US earnings season has been a bit of a mixed bag so far.
• And tech firms failed to convince investors that their AI investments are paying off.

Dig deeper into these stories in this week’s review.

Markets

A broad sell-off that has roiled markets since the beginning of the month intensified at the start of the week, with global stocks, crypto, and other risk assets slumping on Monday. The declines came amid fears that the Fed has been too slow to respond to signs that the US economy is cooling, especially after data the previous Friday showed job growth slowed by much more than expected in July and the unemployment rate hit its highest level in almost three years.

The global rout caused the Nasdaq to drop by 3.4% on Monday, which was further driven by an investor exodus from expensive tech stocks in response to growing concerns over whether their heavy investments into AI will eventually pay off (more on that later). Not helping matters was news over the weekend that Warren Buffett’s Berkshire Hathaway had virtually halved its massive position in Apple during the second quarter. As US stocks slumped, the VIX – a volatility index popularly known as Wall Street’s “fear gauge” – registered its biggest single-day jump in more than three decades, surging to its highest level since the early days of the pandemic.

Over in Japan, the Nikkei 225 slumped by 12.4% on Monday – its worst day since the 1987 Black Monday crash. The move was partly driven by the US’s worse-than-expected jobs report (the data was released on Friday afternoon, meaning Asian markets had their first chance to react on Monday). But another big factor contributing to the slump in Japan is the surging yen, which negatively impacts the country's exporter-heavy stock benchmarks. The currency is shooting higher after the Bank of Japan unexpectedly hiked interest rates last week, forcing many traders to unwind their yen-funded carry trades.

Cryptocurrencies also reeled from the bout of risk aversion in global markets on Monday, at one point sending bitcoin down more than 16% and saddling second-ranked ether with the steepest fall since 2021. That came just a few days after US bitcoin ETFs suffered their biggest investor outflows in about three months last Friday (August 2). Not helping overall sentiment is the potential sale of bitcoins that governments have seized as well as those that are being returned to creditors through bankruptcy proceedings, since the increase in supply could further drag down prices.

Macro

One of the reasons why last Friday’s US labor market report was so worrying was because the rise in the unemployment rate triggered the “Sahm Rule”. The indicator – devised by a former Fed economist – says that when the rate’s three-month average rises by half a percentage point from its lowest level in the past year, we’re in the early stages of a recession. It makes sense: a swift uptick in unemployment, especially from lower levels, clearly indicates a challenging economic environment. It also influences future conditions because, as more people lose their jobs, they spend less money, resulting in reduced sales of goods and services. That could force businesses to cut more jobs in response, creating a vicious cycle that quickly deteriorates the economy.

Quite worryingly for investors, the Sahm Rule’s track record is remarkably accurate: it correctly identified every previous US recession and generated only one false positive signal (and, in this case, “false” means it was six months too early). That said, like all backtested indicators, an important caveat applies: it was developed retrospectively, after observing previous recessions – except for 2020, when it demonstrated its effectiveness in real-time.

Now, it’s worth mentioning that the rule’s inventor has been on the record saying that the indicator may give a false positive this time due to the distorted conditions created by the pandemic. In other words, she doesn’t think that the US is currently in recession. But she does believe that the momentum is heading in that direction. And considering that most investors had all but ruled out a US downturn, you can understand why they were seriously caught off guard when the Sahm Rule was triggered last Friday…

Earnings Season

As US markets experience a surge in volatility, it’s worth taking a step back and assessing stock fundamentals. And this is an opportune time to do just that, since we're in the middle of the second-quarter earnings season. This one is particularly crucial, with investors closely monitoring how Corporate America is performing amid growing recession fears and high valuation levels in the US.

As of the end of last week, three-quarters of the companies in the S&P 500 have provided their latest updates. And the results so far have been a bit of a mixed bag. On one hand, 59% of them have reported actual revenues above estimates, which is below the 10-year average of 64%, according to FactSet. On the other, 78% have reported a positive earnings-per-share (EPS) surprise, which is above the 10-year average of 74%. But the market’s reaction to these positive surprises has been lukewarm this season, while investors have been punishing negative results by more than normal.

What’s more, firms performing better on earnings than revenue suggests that profit margins are improving, which indeed is the case. In fact, FactSet’s “blended” S&P 500 profit margin for the second quarter, which combines actual results for companies that have reported with estimated numbers for those that have yet to report, is 12.3%. That’s higher than the same period last year and the first quarter of 2024.

In terms of growth, the S&P 500’s blended year-over-year EPS growth rate for the second quarter is 11.5%. If that turns out to be the case after the reporting season is done, then it would mark the fastest pace of earnings expansion since the end of 2021 and the fourth consecutive quarter of positive growth. But whether that’s enough to convince investors that the S&P 500’s rally over the past two years still has some momentum remains to be seen…

Big Tech

The AI frenzy has forced tech companies to replace their post-pandemic cost-cutting programs with huge investments in data centers. And Big Tech’s one job heading into this earnings season was to show that the billions of dollars being funneled into AI is translating into actual sales. But they disappointed in the eyes of investors, with shares in Alphabet, Microsoft, and Amazon all falling after they provided their latest updates.

Alphabet’s outlook for AI growth was short on specifics. And investors’ concerns about capital expenditures, which are forecast to increase by more than 50% this year from the one before, overshadowed the firm’s slightly better-than-forecast earnings. Microsoft let investors down by reporting an unexpected growth slowdown at its key cloud division – the most obvious business to benefit from AI given the technology’s huge need for computational resources. The firm’s capital expenditures, meanwhile, have ballooned. That’s not entirely surprising when you consider that it’s opening a new data center every three days. Finally, Amazon’s revenue last quarter came in below expectations, and its outlook for the current quarter also disappointed investors.

One company that bucked the trend is Meta: it unexpectedly raised its forecast for capital expenditures, citing AI investments, but its second-quarter revenue beat expectations. Crucially, the firm’s CEO credited spending on AI for helping it sell more targeted ads and improving content recommendations. More specifically, the company is using algorithms to better determine when and where to show ads. It’s also starting to roll out generative AI features so that marketers with small budgets can create more interesting promotions.

However, taken altogether, Big Tech’s latest updates did little to alleviate concerns about whether heavy investments into AI will eventually pay off. So impatient investors are starting to take their money elsewhere, and are increasingly opting to put it in utilities. These firms are already financially benefiting from rising electricity demand from data centers, and their shares offer a cheaper way for investors to gain exposure to the AI boom compared to buying more expensive tech stocks. Case in point: investors poured more than $1.7 billion into US utilities funds in May and June, their best showing in nearly two years, with another $1.1 billion estimated in July.

Next week

• Monday: Nothing major.
• Tuesday: UK labor market report (June). Earnings: Home Depot.
• Wednesday: China foreign direct investment (July), UK inflation (July), eurozone industrial production (June), US inflation (July). Earnings: Cisco.
• Thursday: Japan GDP (Q2), China retail sales and industrial production (July), UK GDP (Q2), US retail sales (July), US industrial production (July). Earnings: Walmart, Applied Materials, Deere.
• Friday: UK retail sales (July), eurozone trade balance (June), US consumer sentiment (August).