On Monday, financial markets faced significant downturns as last week's sell-offs accelerated. In Europe, France's CAC 40 plummeted by 2.78%, Germany's DAX fell by 2.84%, and the FTSE 100 opened 2.19% lower. Despite a slight calming since then, the question remains: what triggered this turmoil?
US Economic Woes
First, there was fear of a harder-than-excepted recession in the United States, the world’s biggest economy. Last week, several indicators contributed to this fear:
Thursday: a key manufacturing index indicated that the sector was contracting.
Friday: the unemployment rate rose, reaching 4.3%; and
Ongoing trend: rising delinquencies with credit card debt.
Worsening this, the US Federal Reserve decided against lowering interest rates. The Fed's decision on July 31st, perceived as a failure to address worsening economic conditions, highlighted their persistent focus on inflation. Here is the Fed’s Press Release:
Recent indicators suggest that economic activity has continued to expand at a solid pace. Job gains have moderated, and the unemployment rate has moved up but remains low. Inflation has eased over the past year but remains somewhat elevated. In recent months, there has been some further progress toward the Committee's 2 percent inflation objective.
With inflation nearing the Fed's target, there is speculation that rates might be cut in the next meeting in September, if not sooner.
Japan’s Market Meltdown
On the far side of the world, in Japan, things were far more grim. Long suffering ongoing economic pressure, Japan’s Nikkei index saw its biggest daily sell-off since the infamous 1987 Black Monday crash. Below, you can see how Japan’s two major stock indexes performed on Monday (For partial relief, notice the recent bump).
Japan's central bank has been trying to keep up the yen's value by raising interest rates and discontinuing its bond-buying program. While these moves strengthened the yen, they also had adverse effects.
The yen's appreciation forced many investors to unwind carry trades, where low-interest yen are borrowed to invest in higher-yield assets in dollars or euros. This unwinding, combined with fears of rising interest rates, sparked widespread sell-offs in Japan and across other Asian markets (including the ASX20).
The Fear Gauge
People’s hearts really palpitated in reference to S&P500 volatility index, dramatically dubbed the ‘fear gauge’. This index, which reflects the volatility implied by options derivatives, surged to levels reminiscent of the COVID-19 crisis and the Global Financial Crisis (GFC).Such a spike underscores the heightened uncertainty and apprehension about future economic stability.
Implications for Europe
A potential U.S. recession poses significant risks to European markets. Additionally, Japan's economic instability cannot be overlooked. As one of the largest cross-border lenders globally, Japan's foreign direct investment (FDI) into the European Union amounted to approximately $34.3 billion in 2022.
Despite these global tremors, Europe's underlying economic conditions have not changed dramatically. European shares even experienced a rebound on Tuesday, mirroring recoveries in other global markets. Positive corporate earnings announcements provided some respite.
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