This week in the markets - the storm passes

Things feel calmer than they did a week ago. An investor in the world’s biggest stock market ended last week pretty much where they started. The storm blew through almost as quickly as it arrived.

What happened?

Hindsight brings clarity. It now seems clear that there were three main drivers of last week’s market volatility.

First, investors worried that the Federal Reserve has left it too late to cut interest rates. Weak jobs data suggested that a soft landing for the economy is less likely and the odds on a recession have shortened.

Second, rising interest rates in Japan, while the rest of the world is loosening policy, have pulled the rug from a popular trade that has seen investors borrow cheaply in yen to invest in higher yielding places like Mexico. The unwinding of that trade has pushed the yen higher, bad news for an export-focused market like Japan.

Finally, concerns linger about the sustainability of the AI-focused technology trade that has driven the US market to a historically punchy valuation. Warren Buffett didn’t help matters by cutting his holding in Apple by half during the second quarter.

How all of this showed up was in a big drop and bounce back in Japan with more muted moves in other markets. By the end of the week much of the damage had been repaired. More of a summer squall than a proper storm.

What next?

The focus shifts this week to inflation, with announcements on both sides of the Atlantic. In the US, this week’s data will help determine whether the next move by the Fed is a quarter point cut (most likely), another hold or a bigger reduction in rates.

Here in the UK, the rate cutting cycle has already begun but how far it goes will be shaped by what’s going on beneath the surface with inflation. Service sector inflation and wage growth remains a concern for the Bank of England.

Reasons to worry

The market is very momentum driven at the moment, not least because of the growing importance of passive money which is agnostic about fundamentals such as valuation. As such, volatility is likely to be greater for a while.

The length and magnitude of the current bullish phase of the market is approaching levels at which bulls have run out of steam in the past. Another concern, although not a reliable indicator, is that we are approaching the most volatile time of the year. Some of the biggest market moves have occurred between August and October.

Finally, we are heading into the sharp end of what is likely to be an acrimonious and closely fought US Presidential election. As well as the likely volatility this could trigger, there is the Presidential cycle to consider. The best years for investors are the third and fourth of the four-year cycle. Perhaps the best is behind us from this perspective.

Stay calm and carry on

But the rapid stabilisation of the market last week is a reminder of the need for perspective at times like these. Around half of the time, markets are 10% or more below their most recent peak. Corrections are part and parcel of normal market performance.

The relative weakness of the dollar last week is a positive too. Normally at times of market stress, investors seek out safe havens like the dollar. That they did not is encouraging.

The correction has also had the effect of reducing the market’s overall valuation. On the basis of expected earnings, the US market is now on a multiple of less than 20. The equal weighted S&P 500 is cheaper still, on around 18 times earnings.

Another reason to be positive is that the second quarter earnings season, now concluding, has been strong. Growth in earnings rose from 9% to 13% over the course of the results round, also helping push valuations lower over time.

And finally, it’s worth noting that big market falls, such as we experienced last week, have typically been the precursor of strong returns over subsequent years. As my colleague Andrew Oxlade discovered last week, the 10 biggest market falls for the FTSE 100 since 2000 led to three year returns of between 6% and nearly 60%. Seven of the 10 had three year returns of over 40%.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Please be aware that past performance is not a reliable guide indicator of future returns. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.