Global financial markets have been fluctuating during the last few weeks with massive declines across different global stock markets followed by recovery in many of them. This was coupled with an evident volatility in global markets and partial exit of hot money from emerging markets.

Stocks in global markets had a strong rally earlier this year. Many stocks and indices reached all-time highs driven by strong earnings, belief in the potential of Artificial Intelligence (AI) and expectation that the US Fed will cut interest rates as inflation cooled down.

Lately, global stock markets went into a turbulent phase witnessing a sharp decline in just a few days in early August. On Black Monday – dubbed after the stock market crash of October 1987- the markets reached the trough on August 5, before recovering generally, once again.

Part A
The decline and turbulence in global markets can be attributed to a few reasons:

First, the Yen Carry Trade

After a few decades of having very low interest rates,to revive its economy and fight deflation, the Bank of Japan (Central Bank of Japan) has increased interest rates, which resulted in a quick appreciation of the Yen. For many decades, investors borrowed cheaply in Yen and invested in global markets for higher returns, which is known as the Yen Carry Trade.

Overnight, the Yen Carry Trade came to an end, as investors had to deleverage quickly by selling their global assets and turning the money back into Yen in order to pay what they had borrowed previously, at a more expensive rate. This has affected many markets, on top of which, the US market which has witnessed its worst single day since 1987 on August 5.

Second, Fears of Recession

With the US economy showing signs of a slowdown lately, many are afraid that the world’s largest economy will get into a recession and will drag the whole world along. At the same time, the US Fed has been very determined about its objective of taming down inflation, thus pushing the US economy into an inevitable recession. With recession fears, investors were concerned about the future profitability of companies and hence their unrealistically high valuations.

Third, Global Geopolitics

The last few months have witnessed heightened global geopolitical tensions whether related to the war in Gaza, Ukraine or US-China economic tensions. Such geopolitical factors had their toll on markets and increased the volatility of equities, while increasing demand for gold, which reached its all-time high in such turbulent times.

The implication of these factors has been a huge turbulence as demonstrated in increased volatility of the market, where VIX reached an extremely high level. In addition, market indices witnessed sharp drops and some companies, especially in the AI arena, have been through aggressive correction, some of which declined by more than 30% in a matter of days.

Part B
Recovery in global markets can be attributed to few reasons:

First, Bank of Japan Easing
With the huge decline in the Japanese stock market on Black Monday, authorities in Japan have softened their stance on tightening and made it clear they will not tighten quickly to avoid affecting global markets negatively. This helped contain the situation as the Yen depreciated partially and the unwinding of the Yen Carry Trade subsided.

Second, US Equities Correction
With the sharp decline in US stocks, many investors, on top of them big institutions, came to believe that the large drop in stocks present a reasonable correction and stocks will recover again through the strong earnings of big companies as well as with the expected cuts in interest rates.

Third, US Fed Easing

After months of speculation, the US Fed has sent a clear message during Jackson Hall meetings that it is time to shift policy focus as inflation is on its way to target and thus, the focus going forward would be to promote growth and employment. Thus, interest rate cuts are coming soon and may be on a scale larger than previously expected.

Such developments have sent positive signals to financial markets, where volatility subsided and indices as well as key stocks recovered a large part of their previous losses, with even bigger hopes that another big rally is coming soon. Nonetheless, some analysts are worried and believe these hopes are too good to be true and that the US economy will not be able to escape a recession, as indicated by a few indices. A US recession may drastically impact the world economy, plundering it into a decline .

The turmoil that financial markets went through has inflicted critical damage on market players. While stock markets recovered most of the losses, the opinions about the global economic outlook are divergent. Financial markets are still waiting for confirmations and clarity from earnings of big companies as well as economic indicators of major economies about the direction of the global economy.

Omar El-Shenety,
Managing partner at Zilla Capital and adjunct faculty at AUC School of Business