Fin-X Pulse - Reaction to the Recent Market Volatility
- nav719
- 4 days ago
- 5 min read
Equity markets have stabilised in today's trading session. But we believe that this might be a short-term technical reprieve in the absence of any clear fundamental improvements. In this note, we outline our thoughts on what's driving the market volatility and some possible future scenarios.
What has prompted the sell-off?
Last Wednesday’s US tariff announcements were substantially larger than the market imagined. This has been compounded by retaliation by China, talk of EU retaliation and threats by President Trump to add another 50% to Chinese imports.
However, so far, it’s driven more by a sudden shock to liquidity than fundamentals. The sudden drop in the equity market on Thursday spread to other asset classes on Friday as investors looked to raise cash. The sudden switch from weakness to strength in the US dollar is indicative of a scramble for cash.
Why has liquidity come under pressure?
The Federal Reserve created more than $2 trillion in excess liquidity during the pandemic. As this liquidity needed to flow into assets, high growth stocks and cryptocurrencies were bid, while special purpose acquisition companies (SPACS) and other speculative investments soared.
Heading into 2025, the excess liquidity created during the pandemic was close to being exhausted. So, the evolving backdrop was already making it more difficult for asset prices to trade on elevated valuations.
Following the tariff announcements last week, the sell-off in equities tightened financial conditions. Credit spreads then widened, reducing the value of bonds.
Bonds are high quality collateral that can be used to raise cash in the repo market. As the collateral value falls, less liquidity can be generated to invest in other assets and positions need to be trimmed.
Rising market volatility also increases modelled expected losses (e.g. value at risk), prompting hedge funds to trim positions.
Not only had the VIX index climbed and remained above 40, the MOVE index measure of treasury volatility also remained above 100, further reducing collateral values.
Last night, the MOVE index spiked to an unusually high level of 137 and bond yields soared. The US 10yr Treasury yield spiked +0.19% higher after the Senate narrowly passed a tax bill, including the extension of the 2017 tax cuts and allowing the process of reconciliation to move forward without the threat of filibuster. Normally a positive development, the Senate bill adds a potential $ +5.8 trillion in new government debt to the current $29 trillion over the next 9yrs, according to the non-partisan Committee for a Responsible Federal Budget.
The bond market is further concerned that American inflation could hit an annual rate of +5% by year-end, beginning with some upside risks to CPI and PPI on Thursday and Friday night.
Has the selling ended?
Despite JP Morgan raising their recession probability 60% and Larry Fink saying overnight that the recession was already here, a recession is not yet priced into equity markets.
For example, the forward earnings multiple on the S&P 500 was 18.8x at last night's close, +7.4% above the long-term average, according to Bloomberg.
If earnings remain flat instead of increasing the forecast +10%, then the index is still trading +18% above the long-term average. If a recession does become more likely, the forward PE usually falls below the average.
Nevertheless, the sell-off has been so rapid that the S&P 500 and several other indices are outside the daily Bollinger Bands. This is a technical measure indicating that the short-term potential for mean reversion is high, and many hedge fund momentum models won't resume selling until the prices move back within the bands.
In other words, even in the absence of fundamental change, a short-term bounce wouldn't be unusual.
How likely is a US recession?
The National Bureau of Economic Research (NBER) defines a recession as "a significant decline in economic activity spread across the economy, lasting more than a few months". The NBER looks at several measures. So, a substantial period of sub 1% GDP growth can meet the definition.
Unfortunately, the US economy was already slowing at the beginning of the year. The Chair of the Federal Reserve had already described the labour market as a “low hiring environment”, meaning that the economy was vulnerable to a drop in growth.
The combination of downsizing government departments, increasing policy uncertainty, and raising short-term inflation would be more than capable of tipping the economy into recession.
The falling equity and credit markets also play a role. The tightening in financial conditions Is likely to delay growth projects and may lead to job losses.
Unfortunately, since tariffs could lead to higher inflation expectations, the Federal Reserve is constrained and how much it can do to offset the tightening.
The bottom line is that the longer the current tariff plans remain in place, the more likely a recession becomes.
What would improve the economic outcome?
Various scenarios are possible. President Trump could abandon plans to go ahead with tariffs in the next few days or members of his administration could say that the requirements for “emergency” tariffs are not met. This seems unlikely.
There is also scope for Congress to remove the power of the president to apply tariffs. But a sufficient number of Republicans would have to join Democrats in opposing tariffs and Speaker Johnson would have to allow the vote. This is only marginally more likely.
There may be some scope for negotiation. Based on conversations with Israel, this might need to result in wiping out the trade deficit which for some countries would be impossible and might only pare the tariff back to 10%, which would still be damaging to global trade although not as bad as the current rates.
What could indicate that the market is bottoming?
We will be watching carefully for signs of an improvement in liquidity, even in the absence of an improvement in fundamentals.
This could be a result of monetary easing. Central banks outside the US will have more scope to cut rates and could eventually provide quantitative easing. The Federal Reserve may also slow the pace of quantitative tightening again before cutting interest rates.
As liquidity conditions improve, we would expect the US dollar to weaken and the Australian dollar to rise more durably above US$0.60.
Credit spreads and bond yields would likely stabilise, and equity market volatility would be two-way rather than skewed to the downside.
What action can investors take?
The large daily swings make trading very difficult. Switching between funds could lead to missing out on an overnight rebound, for example.
But taking a medium- to long-term view, increasing exposure to Australian dollars at this attractive entry point would seem appropriate.
When central banks show a willingness to cut rates, we would also expect bonds to perform relatively well as the short end could pull down the entire yield curve. However, this could take some time in the US, and yields could remain volatile for several months as deficit concerns persist.
On the other side, we would be wary of increasing equity exposures too hastily, at least until we see a more determined stimulus effort from policymakers. In particular, we remain underweight riskier small caps and private markets (both credit and equity).
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