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The pain started in Asia, where Japan\u2019s Nikkei 225 cratered more than 12% in its worst day since 1987, while South Korea\u2019s KOSPI sank over 8%, forcing a brief mid-day trading halt. After that dismal showing, the selloff quickly turned global.<\/p>\n
Australia\u2019s S&P\/ASX 200 fell 3.7% on Monday, and Europe\u2019s STOXX 600 dropped 2.17% after recovering some of its early losses. In the U.S., all three major market indices sank more than 2.5%, with mounting recession fears taking the blame for the collapse after a less-than-stellar July jobs report<\/a> late last week.\u00a0<\/p>\n However, there were a number of root causes\u2014and reinforcing drivers\u2014that combined to create global market mayhem on Monday.<\/p>\n \u201cA confluence of events seems to have reached a head, forcing a brutal shift in risk appetite. The \u2018Wall of Worry\u2019 certainly has a broad enough foundation currently,\u201d Jack Janasiewicz, lead portfolio strategist at Natixis Investment Managers, told Fortune<\/em> in an email.<\/p>\n From lofty, and maybe unreachable earnings forecasts, to surging volatility amid brewing conflict in the Middle East that has led some popular trades to unwind, here\u2019s a look at what caused investors\u2019 dark day.<\/p>\n Of the S&P 500 constituents that reported their second-quarter earnings so far, 71% beat Wall Street\u2019s high earnings expectations, according to Bank of America\u2019s earnings tracker. The year-over-year earnings growth rate for the S&P 500 also hit an impressive 11.5%, according to FactSet data<\/a>.<\/p>\n \u201cEarnings season is way surpassing expectations,\u201d Eric Wallerstein, chief markets strategist at Yardeni Research, told Fortune<\/em>.<\/p>\n However, the average S&P 500 company is beating consensus earnings per share expectations by just 2%, according to BofA. That\u2019s the smallest beat since the fourth quarter of 2022. Additionally, although forward guidance has been strong, with 30% more companies offering above-consensus guidance than below consensus, Wall Street\u2019s expectations may be too strong for many S&P 500 companies to match.<\/p>\n \u201cStocks have an expectations problem, not a growth problem,\u201d Bob Elliott, chief investment officer at Unlimited Funds, told Fortune<\/em>. Longer-term earnings forecasts have simply become too lofty amid all the AI hype<\/a>\u2014and it\u2019s finally time to pay the piper as they come down.<\/p>\n The veteran hedge funder explained how this has led to a reassessment of the risk among investors on Wall Street, and when combined with falling stock prices, created a negative feedback loop in markets.<\/p>\n \u201cWhat functionally happens, in a lot of places, is the risk manager goes to the portfolio manager and says: \u2018We need to bring down risk, because our assessments of risk have come up.\u2019 And then the portfolio manager starts to sell, and that then reinforces the dynamic,\u201d he explained.\u00a0<\/p>\n Elliott said he believes that this feedback loop started a few weeks ago, when investors began to rotate<\/a> out of tech stocks and into small caps in anticipation of Fed rate cuts.\u00a0\u00a0\u00a0<\/p>\n The former Bridgewater Associates exec believes what we\u2019re seeing is the unwinding of a bubble in risky assets, chiefly in U.S. big tech and AI-linked stocks, after two years of solid price appreciation, along with rising earnings expectations and valuations.<\/p>\n He pointed to disappointing results from tech firms involved in AI such as Amazon<\/a>, which missed second-quarter revenue forecasts and turned in disappointing guidance, and Intel<\/a>, which slashed<\/a> its dividend and 1,800 employees last week.<\/p>\n Slowing consumer spending and a weak July jobs report have put recession fears back on the menu after most Wall Street forecasters gave up those predictions in 2023. The U.S. economy added just 114,000 jobs in July, well short of the 175,000 forecasters had expected\u2014and the 179,000 jobs added in June.\u00a0<\/p>\n Slowing job growth also led the unemployment rate to rise to 4.3% last month, from 4.1% in June. That rise triggered a key recession indicator called the Sahm Rule<\/a>, sparking fears about the U.S. economy\u2019s stability and leading some to argue Federal Reserve Chair Jerome Powell made a mistake by not cutting interest rates<\/a> last month.<\/p>\n There was certainly evidence on Monday that traders were betting on a slowing economy and more Fed rate cuts this year, with Treasury yields tumbling. Natixis Investment Managers Janasiewicz noted that the economic growth scare was widespread, too, which contributed to the global stock market rout.<\/p>\n \u201cWeaker global data is adding to the concerns with weak [purchasing manager indexes] out of Asia coupled with China stimulus hopes that are repeatedly dashed,\u201d he said.<\/p>\n However, like his mentor, the Wall Street veteran Ed Yardeni, Eric Wallerstein still remains bullish about markets\u2019 prospects, predicting a productivity boom-induced Roaring 2020s.<\/p>\n \u201cBy and large, crises have been buying opportunities. And I\u2019m not sure this is even a crisis,\u201d he said. \u201cThere\u2019s definitely a lot of things putting pressure on the equity market\u2026but the U.S. economy looks strong relative to history and vis a vis the rest of the world. So we\u2019re still bullish on U.S. stocks for the rest of the year and the rest of the decade.\u201d<\/p>\n The seemingly ever-increasing potential of a broadening of the conflict in the Middle East also weighed on investors Monday, leading to some fear-based selling.\u00a0<\/p>\n Markets have largely brushed off Israel\u2019s campaign in Gaza. But now Iran, a key oil producer, may be on the verge of expanding the war. Israel\u2019s foreign minister said his Iranian counterpart informed him that Iran now \u201cintends to attack Israel\u201d in response to the assassination of one senior Hamas leader and one senior Hezbollah leader last week, the Jerusalem Post<\/em> reported<\/a> Monday.<\/p>\n \u201cIf there\u2019s a real war between Iran and Israel, that\u2019s a huge risk, which looks like it\u2019s increasing,\u201d Yardeni Research\u2019s Wallerstein warned.<\/p>\n For years, while most Western nations raised interest rates to fight inflation, the Bank of Japan held rates near zero. The country has long dealt with painful deflation, so a bout of inflationary pressure wasn\u2019t seen as something worth fighting.\u00a0<\/p>\n The unintended consequence of this policy was a large interest rate differential between Western nations and Japan, however, and that drew foreign investors into something called the \u201ccarry trade.\u201d<\/p>\n This is where investors will borrow money in one currency with low interest rates and then invest that money into other assets abroad, often U.S. Treasuries or stocks. But the Japanese carry trade was a bit more complex, with many traders opting to short, or bet against, the yen as its central bank kept rates steady, putting pressure on the currency.<\/p>\n \u201cIt was quite literally the most popular and easiest carry trade. And carry trades work until they don\u2019t. So everyone was in it,\u201d Wallerstein said. \u201cIt was super, super crowded. Everyone was overextended. And plenty of people were catching up to the trade using leverage just to get quick exposure, because they didn\u2019t want to miss out on those gains.\u201d<\/p>\n Now though, with Japan\u2019s central bank raising rates this year while the U.S. Federal Reserve is looking to cut rates, the carry trade is unwinding. That means traders will either need to put up margin, or close out their positions pretty quickly to take profits\u2014and that\u2019s leading to selling pressure in U.S. markets, where investors often park their cash during this carry trade.\u00a0<\/p>\n Hedge funds and other investors had $14 billion worth of options contracts betting against the yen as of July 1, according to CFTC data, but by last week, those positions had been cut to around $6 billion.\u00a0<\/p>\n Still, Unlimited Funds\u2019 Elliott noted that the carry trade only exacerbated the global selloff in stocks, but didn\u2019t start it. \u201cI don\u2019t think the carry trade in Japan is the driver of what\u2019s going on. It is reflective of the fact that levered asset managers, like hedge funds, crowded into a lot of positions, the most extreme of which was actually long growth and tech stocks, as they were trying to keep up with or catch the market returns,\u201d he said.<\/p>\n Yardeni Research\u2019s Wallerstein also emphasized Monday\u2019s selloff was merely boosted by the unwinding carry trade, and it wasn\u2019t the only trade that helped do so. \u201cEvery trade that was crowded into\u2014the Nikkei, long tech, long Mag 7, and then also the Aussie dollar, the Brazilian real\u2014all that stuff got hit at the same time,\u201d he said.<\/p>\n Rising risks of an ongoing tech selloff, a wider war in the Middle East, and an economic slowdown also led Wall Street\u2019s fear gauge<\/a>, the CBOE<\/a> Volatility Index (VIX), to surge on Monday.<\/p>\n Wallerstein noted that there are several types of funds, including quant funds, Commodity Trading Advisors (CTAs), volatility control funds, and risk parity funds, that were caught offside when the VIX briefly touched a four-year high to start the week, forcing them to sell stocks.<\/p>\n \u201cYou\u2019re definitely getting a lot of volatility-induced selling. These guys have triggers to sell when volatility hits certain levels. So the VIX above 30 is one of those. It\u2019s a big one,\u201d he explained. \u201cI think that\u2019s a big reason why [the selloff] was so extreme. It doesn\u2019t make the sell-off, but it definitely makes it worse.\u201d<\/p>\n The good news is Wallerstein believes this volatility-induced selling pressure will likely end soon.<\/p>\n \u201cWe definitely expect this to subside and fade,\u201d he said, noting that these funds tend to sell quickly, while the U.S. economy, the key driver of stocks\u2019 long-term performance, still looks \u201cOK.\u201d<\/p>\n However, for investors looking to buy the dip, Unlimited Funds\u2019 Elliott had a warning to share.<\/p>\n \u201cThe short story is, when you\u2019re on the backside of a bubble dynamic and asset managers are deleveraging, it\u2019s not a time to be trying to catch the falling knife,\u201d he said.<\/p>\n<\/div>\n1. Earnings have been strong, but maybe not strong enough<\/h2>\n
2. Recession fears are back in vogue<\/h2>\n
3. Conflict in the Middle East is testing investors\u2019 nerves<\/h2>\n
4. The \u2018carry trade\u2019 is unwinding<\/h2>\n
5. Volatility-induced selling is making it all worse<\/h2>\n