The pain started in Asia, where Japan’s Nikkei 225 cratered more than 12% in its worst day since 1987, while South Korea’s KOSPI sank over 8%, forcing a brief mid-day trading halt. After that dismal showing, the selloff quickly turned global.
Australia’s S&P/ASX 200 fell 3.7% on Monday, and Europe’s 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 late last week.
However, there were a number of root causes—and reinforcing drivers—that combined to create global market mayhem on Monday.
“A confluence of events seems to have reached a head, forcing a brutal shift in risk appetite. The ‘Wall of Worry’ certainly has a broad enough foundation currently,” Jack Janasiewicz, lead portfolio strategist at Natixis Investment Managers, told Fortune in an email.
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’s a look at what caused investors’ dark day.
1. Earnings have been strong, but maybe not strong enough
Of the S&P 500 constituents that reported their second-quarter earnings so far, 71% beat Wall Street’s high earnings expectations, according to Bank of America’s earnings tracker. The year-over-year earnings growth rate for the S&P 500 also hit an impressive 11.5%, according to FactSet data.
“Earnings season is way surpassing expectations,” Eric Wallerstein, chief markets strategist at Yardeni Research, told Fortune.
However, the average S&P 500 company is beating consensus earnings per share expectations by just 2%, according to BofA. That’s 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’s expectations may be too strong for many S&P 500 companies to match.
“Stocks have an expectations problem, not a growth problem,” Bob Elliott, chief investment officer at Unlimited Funds, told Fortune. Longer-term earnings forecasts have simply become too lofty amid all the AI hype—and it’s finally time to pay the piper as they come down.
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.
“What functionally happens, in a lot of places, is the risk manager goes to the portfolio manager and says: ‘We need to bring down risk, because our assessments of risk have come up.’ And then the portfolio manager starts to sell, and that then reinforces the dynamic,” he explained.
Elliott said he believes that this feedback loop started a few weeks ago, when investors began to rotate out of tech stocks and into small caps in anticipation of Fed rate cuts.
The former Bridgewater Associates exec believes what we’re 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.
He pointed to disappointing results from tech firms involved in AI such as Amazon, which missed second-quarter revenue forecasts and turned in disappointing guidance, and Intel, which slashed its dividend and 1,800 employees last week.
2. Recession fears are back in vogue
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—and the 179,000 jobs added in June.
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, sparking fears about the U.S. economy’s stability and leading some to argue Federal Reserve Chair Jerome Powell made a mistake by not cutting interest rates last month.
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.
“Weaker global data is adding to the concerns with weak [purchasing manager indexes] out of Asia coupled with China stimulus hopes that are repeatedly dashed,” he said.
However, like his mentor, the Wall Street veteran Ed Yardeni, Eric Wallerstein still remains bullish about markets’ prospects, predicting a productivity boom-induced Roaring 2020s.
“By and large, crises have been buying opportunities. And I’m not sure this is even a crisis,” he said. “There’s definitely a lot of things putting pressure on the equity market…but the U.S. economy looks strong relative to history and vis a vis the rest of the world. So we’re still bullish on U.S. stocks for the rest of the year and the rest of the decade.”
3. Conflict in the Middle East is testing investors’ nerves
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.
Markets have largely brushed off Israel’s campaign in Gaza. But now Iran, a key oil producer, may be on the verge of expanding the war. Israel’s foreign minister said his Iranian counterpart informed him that Iran now “intends to attack Israel” in response to the assassination of one senior Hamas leader and one senior Hezbollah leader last week, the Jerusalem Post reported Monday.
“If there’s a real war between Iran and Israel, that’s a huge risk, which looks like it’s increasing,” Yardeni Research’s Wallerstein warned.
4. The ‘carry trade’ is unwinding
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’t seen as something worth fighting.
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 “carry trade.”
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.
“It was quite literally the most popular and easiest carry trade. And carry trades work until they don’t. So everyone was in it,” Wallerstein said. “It 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’t want to miss out on those gains.”
Now though, with Japan’s 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—and that’s leading to selling pressure in U.S. markets, where investors often park their cash during this carry trade.
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.
Still, Unlimited Funds’ Elliott noted that the carry trade only exacerbated the global selloff in stocks, but didn’t start it. “I don’t think the carry trade in Japan is the driver of what’s 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,” he said.
Yardeni Research’s Wallerstein also emphasized Monday’s selloff was merely boosted by the unwinding carry trade, and it wasn’t the only trade that helped do so. “Every trade that was crowded into—the Nikkei, long tech, long Mag 7, and then also the Aussie dollar, the Brazilian real—all that stuff got hit at the same time,” he said.
5. Volatility-induced selling is making it all worse
Rising risks of an ongoing tech selloff, a wider war in the Middle East, and an economic slowdown also led Wall Street’s fear gauge, the CBOE Volatility Index (VIX), to surge on Monday.
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.
“You’re 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’s a big one,” he explained. “I think that’s a big reason why [the selloff] was so extreme. It doesn’t make the sell-off, but it definitely makes it worse.”
The good news is Wallerstein believes this volatility-induced selling pressure will likely end soon.
“We definitely expect this to subside and fade,” he said, noting that these funds tend to sell quickly, while the U.S. economy, the key driver of stocks’ long-term performance, still looks “OK.”
However, for investors looking to buy the dip, Unlimited Funds’ Elliott had a warning to share.
“The short story is, when you’re on the backside of a bubble dynamic and asset managers are deleveraging, it’s not a time to be trying to catch the falling knife,” he said.
