The Global Stock Market: From Euphoria to Fear
Until July, the leading stock market indices globally were breaking records one after another. There were already doubts about the sustainability of the boom at that time, but many investors remained unfazed. Now, the sentiment has shifted from euphoria to fear.
“Risk happens fast,” this old stock market adage proved true again on Monday. Following a major crash in the Japanese market, stock prices plummeted worldwide. The coming weeks will reveal whether it was a temporary panic reaction to disappointing economic news or if there is a reevaluation of economic opportunities and risks in the financial markets. Currently, there is evidence that certain tipping points have been crossed in the short term, and investors are viewing the world through a different lens for now.
Black Monday at the Japanese Stock Exchange
In the US and Europe, the leading indices saw significant declines. The American Dow Jones closed 2.6 percent lower, the DAX dropped by 1.8 percent, and the Swiss SMI was down by 2.8 percent. Prior to this, the Nikkei in Japan had plummeted by a staggering 12.4 percent, marking one of the biggest setbacks in history.
Combined with losses from the previous two trading days, the Japanese benchmark index had plunged by up to 20 percent. The Nikkei had reached a record high of around 42,400 points on July 10th, but has since experienced a rapid and significant decline.
The stock market boom in the two years following the pandemic has now transitioned into a correction. Whether this will lead to a bear market, defined by a 20 percent decline from the previous peak, remains to be seen. The end of the bull market is accompanied by a shift in sentiment from euphoria to fear. The underlying cause is that investors are now less concerned about high and persistent inflation, which prevents central banks from reducing interest rates, and more fearful of an economic downturn.
The recent stock market turmoil, with Black Monday in Japan, has various concrete reasons. Many market participants believe that a recession in the US has become more likely in recent days. The disappointing US job market data from last Friday played a crucial role in this. The unemployment rate rose from 4.1 to 4.3 percent, still relatively low but significantly higher than the low of 3.4 percent reached in May 2023. Additionally, the number of new non-farm payroll jobs fell well below market expectations on Friday.
The Nvidia-Driven AI Boom
Concerns are also mounting about a potential slowdown or end to the artificial intelligence (AI) boom. The significant rise in technology stocks in recent quarters was heavily driven by AI companies like the chipmaker Nvidia. Nvidia’s shares had surged by around 700 percent since the beginning of 2023. This rally also impacted tech giants like the “big seven” (Alphabet/Google, Amazon, Apple, Meta, Microsoft, Nvidia, and partly Tesla), lifting the entire market.
However, there are now warnings of an AI bubble in the US stock market from entities like investment bank Goldman Sachs and hedge fund Elliott. Some observers believe that the billions invested in AI by companies such as Amazon, Google, or Microsoft may not yield immediate returns, potentially weighing on semiconductor demand.
The Temporary End of Carry Trades
In recent days, the unwinding of so-called carry trades likely had a significant impact on market dynamics. In carry trades, investors borrow in a currency with very low interest rates, such as Japan, and exchange the funds into currencies of countries with higher interest rates, like the US. These funds either stay in the foreign exchange market or are invested in riskier assets like stocks or crypto tokens such as Bitcoin, Ethereum, or Solana. This trade works well as long as the interest rate differential between the currency areas widens or remains constant.
However, the Bank of Japan recently raised the upper limit of its monetary policy target range from 0.1 to 0.25 percent. Additionally, investors anticipate faster interest rate cuts by the US Federal Reserve due to a weakening US economy and disappointing job market data.
As a result, the interest rate differential between Japan and the US is expected to significantly narrow in the coming quarters. Consequently, the yen has strengthened significantly against the dollar. In mid-July, one dollar was worth 162 yen, but now it’s only 144 yen. The yen’s surge tends to reduce the profits of highly internationally active Japanese companies, putting pressure on their stock prices.
The strong yen also makes carry trades less attractive or even leads to losses for their investors, prompting them to unwind these trades. This requires selling the assets in which the money was invested, such as stocks and crypto tokens. However, no one knows exactly where investors have allocated these funds.
Economic Weakness in China, Stagflation in Germany
Adding to this mix are escalating geopolitical tensions in the Middle East. If the conflict between Israel and its neighboring states, especially Iran, escalates into a full-blown war, investors would focus primarily on the oil market. Around one-third of the global oil supply still comes from the Middle East.
A sharp rise in oil prices would have implications for the already tepid global economy. In China, state debt is rising, the economy is growing moderately by local standards, and problems in the real estate market have yet to be resolved. In Europe, Germany, the largest economy, has been experiencing stagflation for two years, where a stagnant economy meets high inflation. Expectations for a revival of the German economy in the second half of the year are low. While the economies of other major Eurozone countries like France, Italy, and Spain are performing relatively better, they are also burdened with high levels of debt, causing long-standing concerns for investors.
One reliable indicator for a recession in the US in recent decades has been an inverted yield curve. This occurs when short-term bonds yield higher than long-term bonds with a maturity of ten years. This has been the case over the past two years. If a recession materializes, which is still uncertain, American stocks would likely require further adjustment in the medium term. The Dow Jones and the technology benchmark Nasdaq 100 have corrected by only around 6 percent and 14 percent from their recent record highs.
Follow Frankfurt economic correspondent Michael Rasch on Twitter, LinkedIn, and Xing.