Stocks Succumb to Mounting Growth Concerns Despite Risk-on Momentum

The recent stock market rally, which seemed unstoppable, is starting to show signs of strain as it faces a growing number of challenges. Last month’s sharp downturn was an early warning of how quickly things can shift, driven largely by fears of a U.S. recession that unsettled investors who had grown accustomed to the market moving upward. Although the S&P 500 recovered after this selloff, it wasn’t able to regain all the ground it lost.

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A fresh blow came when U.S. payroll data released last Friday indicated a slowdown in job growth, reinforcing concerns that the labor market is cooling. This news sent stocks into a downward spiral. Last week, the S&P 500 dropped 4.25%, and the Nasdaq 100 experienced its steepest weekly decline since November 2022.

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U.S. economic worries are just one of the factors unnerving the market. There are also concerns about slowdowns in China and Germany, which could have negative impacts on earnings and inflation. Even as the Federal Reserve’s interest rate policy becomes clearer, the market’s future looks increasingly unpredictable. Investors are now waiting for the first interest rate cut in four years from the Fed, but the outlook remains clouded by global uncertainties.

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Adding to the list of risks are the upcoming U.S. presidential election, political instability in Europe, and the concentration of money in a few mega-cap tech stocks. These factors, which have propped up the market at times, now pose threats to the rally’s longevity.

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Another vulnerability comes from inflated valuations. Investors who bought stocks during the recent rally may panic and sell quickly if the market takes a downturn, potentially accelerating a deeper fall before the usual dip buyers reenter the market. Additionally, the growing influence of options trading and systematic investment strategies could amplify volatility, triggering large-scale selloffs when market conditions shift.

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“We were recently in a phase where markets were moving in only one direction, with everyone buying the same stocks,” says Arun Sai, a senior multi-asset strategist at Pictet Asset Management. “That’s no longer the case, and we’re unlikely to see this relentless rally continue.”

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Despite the turbulence in August, the S&P 500 is still up by 13% this year, while the MSCI World Index has gained 10%. This strong performance earlier in the year forced analysts at firms like UBS and RBC to revise their year-end targets. However, many now believe the market’s best days may be behind it. According to an average of 20 strategists tracked by Bloomberg, the S&P 500 is expected to gain only 1% more by the end of 2024.

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The market has faced challenges before, with multiple shocks in recent years temporarily halting its momentum. Whether it was the collapse of banks in the U.S. and Switzerland or escalating geopolitical tensions, the market managed to bounce back and reach new highs. The largest setback came in 2022, when inflation concerns and the Federal Reserve’s aggressive rate hikes triggered an $18 trillion global selloff. However, as inflation pressures eased, optimism returned, propelling the S&P 500 to a recovery in 2023 and a series of record highs this year.

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Nvidia Corp. has become the poster child of this year’s rally, more than doubling in value in 2024. The company’s success is emblematic of the concentration of cash in U.S. tech stocks, particularly those benefiting from the artificial intelligence boom. Nvidia alone has driven nearly a fifth of the Bloomberg World Index’s 10% rise this year, and the company’s stock has become a barometer for broader market sentiment. A selloff in Nvidia shares last week spread to other risk assets, highlighting the stakes if the company underperforms.

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“Everyone loves tech stocks because they generate a lot of free cash flow,” says Brent Schutte, chief investment officer at Northwestern Mutual Wealth Management. “But people forget about the price they’re paying for that cash flow. AI is real, and these companies are probably good businesses, but are they good stocks? We’re going to find out.”

Other risks are arising from the way investors position themselves, especially through strategies like trend-following or volatility-controlled funds, as well as the increasing dominance of short-term trading in the options market. These trading flows can exacerbate intraday market swings, as seen during the August slump.

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Since then, attention has shifted back to concerns about economic growth, with many fearing the U.S. could be heading into a recession and that the Federal Reserve may have delayed rate cuts for too long. On Friday, traders responded to the latest payroll data by increasing their bets on a 50 basis-point cut from the Fed this month. However, even if the Fed cuts rates, there’s no guarantee stocks will rally. Any rate reduction is likely to come in response to weakening economic activity, and if the outlook worsens, it could trigger further selling.

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In Europe, the focus is on Germany, where concerns about the economy deepened after Volkswagen announced it may close plants, raising questions about the future of its auto industry. Germany also faces increased political uncertainty ahead of national elections next year.

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Meanwhile, China, a key market for luxury goods, cars, and machinery, is grappling with a sluggish post-Covid recovery. A prolonged property market slump has dampened consumer spending, and growing pessimism is evident. Earlier this month, JPMorgan Chase downgraded its outlook for Chinese stocks, citing risks related to the U.S. presidential election and the possibility of new tariffs.

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In the U.S., polls suggest a tight race between Kamala Harris and Donald Trump. Trump recently pledged to cut corporate taxes to 15%, a move that Goldman Sachs estimates would boost S&P 500 earnings by about 4%. Harris, on the other hand, has proposed raising taxes on corporations and high earners.

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With so much uncertainty on the horizon, active investors like hedge funds may continue selling U.S. stocks ahead of the November 5 election to brace for potential volatility. However, despite recent months of offloading, hedge fund exposure remains high compared to previous election cycles, indicating there is still room for further unwinding.

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“The biggest risk to U.S. markets is the possibility of the economy shifting from expansion to deceleration, or even recession,” says Jens Foehrenbach, head of Public Markets at Man Group. “Valuations are somewhat inflated and don’t account for a hard landing, so any negative surprises could lead to a sharp market reaction.”

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