In recent weeks, markets have experienced a significant correction that has hit the major US indices. The S&P 500 has fallen by 6.5%, the NASDAQ by 11% and the Dow Jones by around 4%. This correction, which we have been waiting for for quite a long time, is due, among other things, to interest rate rises in Japan. This move has led to a strengthening of the Japanese yen and an outflow of capital from the US, as the strong rise in US equities was largely driven by the so-called Carry Trade, whereby institutions borrowed at 'zero' in Japan. Read more here.
Markets have also begun to factor in recession risk, as reflected in the poor economic data over the past week. The market finally seems to be returning to normal where - bad news is bad news. On the other hand, the market seems to have forgotten the Federal Reserve's (Fed) strong position of having the ability to cut interest rates, which is almost certainly expected in September. The question remains, however, by how much the Fed will cut rates.
Technical analysis also does not look favorable. The S&P 500 index has drawn a head and shoulders formation, which is a negative signal. In part, the market has already made its reaction and may now reverse its trend back up. In addition, we have experienced the worst days in the markets since Covid and the VIX volatility index has reached 30 points, a 100% increase. Often in the wake of these moves, corrections have reached their bottom.
Therefore, it should not surprise us if the markets regain their upward direction in the next 3-4 months and reach new all-time highs. The main reason for this is the potential for capital movements following interest rate cuts. There is approximately USD 20 trillion in the market waiting to be tapped and another USD 6 trillion immediately available for use. These funds are likely to head into dividend, defensive and low-cost titles once the Fed starts to cut interest rates.
For this reason, we have increased our positions in ETFs with long-term U.S. government bonds such as TLT and GOVZ, which have rallied over the past two days and are helping to temper these corrections, but especially government bonds in a declining U.S. interest rate environment, which are embedded in these ETFs are showing strong gains. The popular small caps may have taken a hit, but they remain technically and valuationally attractive. In a declining rate environment and if the markets come out of risk-off mode, these smaller companies could outperform the major indices again.
The market is now going through a short-term storm, but new opportunities are on the horizon. We are ready to react because the best may be yet to come.