Mike O’Sullivan is Moonfare’s Chief Economist and Senior Advisor. You can meet Mike at many of our community events and investor calls or follow his monthly commentary published on Moonfare's blog. Also, don't miss Mike's latest interview to learn more about his views on a range of topics — from interest rate cuts to opportunities in artificial intelligence.

2024 has up until very recently been a strange year in stocks in that the distribution of market returns has been compressed – there have been relatively few ‘big’ days to the upside, and even more remarkably, not a single two percent drop in the S&P 500 index for over four hundred days. Such periods of calm typically end with extreme volatility, as markets reassert a more normal distribution of returns.

In that regard the recent sell-off in equities is overdue, and helps to make valuations and the risk outlook more ‘normal’. Yet, the fact that the VIX volatility index hit levels (on Monday) that have only been exceeded in the global financial and COVID sell-offs¹ will worry investors and has triggered some commentators to herald a recession and call for emergency interest rate cuts. Our view is that this episode is much more of a portfolio crisis than an economic crisis in the sense that it is motivated by the de-risking of portfolios, rather than a reaction to a worsening macroeconomic outlook.

Notably, in recent months the performance of AI centric large cap stocks have markedly outstripped that of the broad market, to the extent that market concentration became extreme (the top 10 stocks in the S&P 500 made up 75% of its value)², and in some cases valuations became extended. At the same time low interest rates in Japan have encouraged a carry trade (borrowing in yen to ‘invest’ elsewhere), which we believe will prove detrimental, possibly fatal, to some hedge funds.

Both of these ‘trades’ have become overcrowded in the sense that many investors are exposed to them, and the extreme market unwind can be partly explained by this. In this sense, the market volatility is more characteristic of a portfolio crisis, than a real economy one. That will not stop talk of a recession, though.

In this respect, with an eye on private markets, there are two important considerations – interest rates and the business cycle.

On the latter, we view that we are in the midst of a mild slowdown in the US economy. Here, unemployment is rising, lead indicators are pointing downwards (notably manufacturing indicators are weaker than services ones) and some segments of the housing market are weak. The corporate sector is relatively strong, however. In this context, the upside is that a good number of the factors that have spurred inflation are now in retreat. In Europe, where economies have been much weaker in the past year, there are signs of a mild rebound, and indeed, scope for an upturn in the credit cycle.

In general, this macro climate, together with the anxiety caused by market volatility, gives us reason to think that there is scope for interest rates to fall, but not dramatically so. We do not agree with the view that the Federal Reserve should make an emergency rate cut, and from a moral hazard point of view it would be very unwise to do so. That said, the emphasis in coming meetings will change to a more dovish tone. Additionally, within the coming days we expect that the Bank of Japan will publicly address the volatility in the yen, and try to curb its fall.

The key variable we are watching is credit spreads. The credit market is the transmission mechanism from financial markets to the real economy. Broadly, there are two paths ahead.

Scenario #1 – Credit spreads remain muted in the US, Europe and Asia, and market volatility  begins to ebb, with a small number of rate cuts priced into markets. The overall macro impact and effect on private markets is low (and indeed we may see large private equity investors use the lower rate environment to invest cash).

Scenario #2 – Credit spreads widen, market volatility persists and passes to other sectors like financials. This would be more damaging for the real economy, and would ultimately necessitate a bigger policy response.

In summary, our sense is that volatility (and risk taking) will reset to a level commensurate with a disorderly world, and in the context of lower rates, investors will be more judicious in seeking out opportunities. This ‘selectiveness’ has already been a feature of private asset markets in the past two years, and institutional cash levels are very high.

In private markets, any macroeconomic dislocation will certainly produce opportunities, and we do not rule out that private equity firms look to buy more public firms. They will also focus more intently (as our Deal Talk on AI noted) on the ‘what's next after AI’ companies, by which we mean firms that are much more applied in terms of their use of AI. Defense, healthcare and logistics are interesting sectors here. 

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