Jeff Meli: Welcome to The Flip Side. I'm Jeff Meli, the head of research at Barclays, and I'm joined by Ajay Rajadhyaksha, our global chairman of research. We're going to debate how to interpret the recent period of volatility that has been roiling financial markets.

Ajay Rajadhyaksha: Thank you, Jeff. And yes, have markets been moving? I mean, we are seeing multiple percentage point swings up and down. The major US stock indices and some international markets have been far more volatile. And you know it's not just stocks, Jeff. Interest rates, currencies, credit markets, they are all experiencing similar moves. This is pretty much a global event and across asset classes.

Jeff Meli: Ajay, I'm not really surprised by all this volatility. This is a period of extreme uncertainty about the direction of the US economy, and actually, by extension the global economy. Given how high asset prices have risen, we were at or near all-time highs on a bunch of these major equity indices. The consequences of any slowdown in the economy are very severe. I think investors are right to read some of the recent data that we've seen with some concern.

Ajay Rajadhyaksha: Okay. I disagree, Jeff, I think the recent market swings have been almost entirely driven by technical factors, with investors being forced out of certain leveraged positions. And unwinds of this nature can often be divorced from reality, meaning that the volatility is significantly overstating concerns about the actual economy, especially long-term investors should largely ignore these moves, which will fade as markets normalize.

Jeff Meli: Well, look, there's no denying that the catalyst, the spark, if you will, of all of this recent volatility was a fundamental one. It was the weak July payrolls report in the United States which showed that far fewer jobs were created than economists were expecting.

Ajay Rajadhyaksha: All right. So I agree that the payroll report was a spark, especially because what we call soft data. How happy or gloomy small businesses are, how fast wages are rising, how confident workers are about their ability to quit. All of these metrics had been moving down for a few months already.

Jeff Meli: Look, in this one payroll report, this upended the soft landing, quote unquote, narrative for the US economy. That's one in which the economy slows gradually, inflation approaches or reaches the 2% target set by the Federal Reserve. And that all occurs without a recession. That's like Goldilocks for financial markets. You get no major economic turmoil, so equity prices can stay high. The Federal Reserve can gradually cut interest rates that further supports asset prices. But the whole linchpin to this story is the strong labor market. As long as that continued, we could kind of stick to this soft-landing story. But that recent report showed, I think, serious cracks in the labor market, and all of a sudden, the prospect of a hard landing re-emerges.

Ajay Rajadhyaksha: I think that's an overly bearish view of one labor report. Yes, job growth was below trend, below expectations, but you have to realize Hurricane Beryl was responsible for some of that, maybe up to 25,000 to 30,000 of the missing jobs. The three-month average, which smooths through month-on-month distortions. That's still over 170,000 jobs a month. These are volatile series, but I don't think this has reached the level of questioning our overarching positive narrative on the US.

Jeff Meli: Well, Ajay, I disagree. One of the numbers that was most concerning in the payroll report was the increase in the unemployment rate. It's now at 4.3%. And in absolute terms, of course, that's low relative to history. But keep in mind that the lows in this cycle were 3.4%. So we're up almost a full percentage point. That's actually enough to cause a popular recession indicator to start flashing red. It's called the Sahm rule, and it's basically based on any increase in the unemployment rate over the trough. If it reaches a certain amount, that could actually mean that we're already in a recession.

Ajay Rajadhyaksha: So I don't think that rule of thumb applies this time, Jeff, because keep in mind, we have experienced an unprecedented wave of migration into the United States. The labor force has increased by something like an extra 3 million workers in the last couple of years. You mentioned the Sahm rule, Claudia Sahm created it, and she came out recently saying that this time the rule being breached need not indicate a recession because so much of the rise in the rate was just higher labor supply, not people actually being let go.

Jeff Meli: Well, Ajay, I want to turn to the market moves, which I think also align closely with my reading of the prospects of a hard landing. So first, look at interest rates in the Treasury market. They have fallen a lot. So the yield on the 10-year treasury, as an example, it's declined by over 90 basis points from its high. Although it has bounced a little bit higher since the yield on the two-year Treasury, which is usually more sensitive to near term economic conditions, that's fallen by even more by over 100 basis points. So investors are expecting the Federal Reserve to cut interest rates much more dramatically than was the case before that payroll report, in response to the recent weak data. I don't really see another way to interpret this.

Ajay Rajadhyaksha: From a mechanical perspective, you are right. Expectations of future cuts have increased. And you're right. Fed funds futures are now pricing 104 basis points of cuts this year, up from less than 70 bips before the payroll report. All of that is true. I just don't think you can directly link this to recession fears, because remember, investors often flock to treasuries when volatility rises. Treasury bonds are the ultimate risk-free asset, and fears of market swings usually lead to a scramble to buy treasuries. So it is very hard, Jeff, to disentangle what I think of as higher risk aversion from near term expectations for the economy.

Jeff Meli: Well, then look at the equity market where evaluations have also taken a big hit. So the S&P 500, for example, it's down about 6% from its highs. And the tech heavy Nasdaq is down even more than that.

Ajay Rajadhyaksha: Yeah. But the move is not uniform. The bulk of the move was in stocks which had run up in price because of the promise of AI. What you and I call the Magnificent Seven. Other sectors that have hurt included banks as earnings there are closely tied to the level of interest rates, interest rates, fall banks, net interest margins, or NIMs go down on their lending books. And so, those stocks purely reflect that dynamic. In fact, all through July, if you remember, the big move was not a uniform fall, simply a rotation out of the Mag. Seven into small caps, smaller companies. I mean, look at homebuilders. They went up 25% in July.

Jeff Meli: Well, I think you're making a good point on the bank side. That is probably just a pure rates play. Of course, those same bank stocks went up a lot when interest rates were rising. So that's probably more linked mechanically to interest rates, but the AI trend and the so-called Magnificent Seven, I think of that a little bit differently. I think really those are growth plays. The companies that we're talking about are trading at unbelievably high multiples.

Ajay Rajadhyaksha: That part is fair. Nvidia is at 61 times, AMD is at 153 times earnings. So yes, they are still massively richer than the broader S&P, which trades at more like 21 to 22 times right now.

Jeff Meli: Right now, in order for a company to trade at 60 or 100 times its current earnings, that must mean that the expectations are for earnings to grow a lot and to grow fast. So they need to grow now to grow into that kind of a valuation. Now, look, maybe in the super long run, AI is like an inevitable force. And we're all going to bow down to our robot masters. But if any slowdown in the US economy reduces the appetite for investment today in AI, such that the growth required to justify these multiples never actually materializes, then those companies are at serious risk. They are an ultimate growth play.

Ajay Rajadhyaksha: Well, first of all, I want to put the selloff in perspective. Yes, these stocks have come down a fair bit, but they are still massively higher than even one year ago. Take Nvidia. From the start of this year, Jeff Nvidia is still up 100% even after falling third since the payroll report.

Jeff Meli: Sure, they are still up a lot. And of course, everyone does expect AI to be this inevitable force in the long run. But I think there is a real question being asked about timing and the sustainability of the near-term investment.

Ajay Rajadhyaksha: That's true. But the narrowness of the selloff, especially the selloff in these seven names and other stocks that benefited from the AI boom. That actually is in keeping with my story, which is that the volatilities are driven by an unwind of leveraged and concentrated positions rather than some change in fundamentals. You called the Mag. Seven the ultimate growth play, but everyone also owns them. So I think of it as the ultimate momentum play.

Jeff Meli: Well, look, it is true that the rally in equities this year has been incredibly concentrated around that AI theme. I mean, the market cap of some of these names is so big that it's actually reducing the diversification that you get by investing in some of the broad indices, because their weight in those indices is so high.

Ajay Rajadhyaksha: Exactly. And look at how volatile these stocks have been, and then take a look at Japanese equity markets which have done much worse. At one point, the Nikkei had sold off 26% from its high in less than a month, including a shocking 12%. It's been swinging massively since some days up huge, like 10 to 11% in a day. You made a good effort to connect the US payroll report to the US economy, but honestly, why would one jobs number cause such crazy reactions in Japan?

Jeff Meli: I guess I could argue that when the US sneezes, the world catches a cold, right? That's the phrase you hear. But I acknowledge that the moves in the Japanese equity market are clearly well beyond anything that could be linked directly to the US labor market.

Ajay Rajadhyaksha: And the thing is, there was a surprise in Japan at the same time as the US jobs number. The Bank of Japan surprised markets with an interest rate hike.

Jeff Meli: Yeah, that's news of course, because rates in Japan have been low, even negative, for a really long time as Japan struggled to avoid deflation. So while the rest of the developed world has been worried about prices rising too fast, Japan is worried about trying to get them moving in the opposite direction.

Ajay Rajadhyaksha: And investors have been taking advantage of this stability to put on what is called a carry trade. That's where they borrow at a low interest rate, invest in a high returning asset in another currency and pocket the difference. In this case, they borrowed in yen the Japanese currency. Because rates in Japan were both low and stable. And then some of them invested in high flying equities like the Mag. Seven.

Jeff Meli: Yeah. The key to this trade obviously, is that the difference in interest rates stays really large and that the currency market doesn't undo the gains that you might make by buying them higher returning asset. That doesn't really seem like a risk either, or at least it didn't. Because for most of the period since 2013, the Bank of Japan has preferred a weaker yen to help create inflation. And that obviously benefits you if you're borrowing in that currency.

Ajay Rajadhyaksha: That's exactly correct. But when the Bank of Japan raised rates, and they did it just as US interest rates were falling, the difference in interest rates compressed quite a bit. And at the same time, Japanese officials also decided, well, the yen is now too weak, and we are no longer comfortable with it. We are selling dollars to strengthen our currency, meaning both legs of this carry trade moved against investors and once that started happening, investors had to unwind their positions. These unwinds caused even more reaction because they were selling stocks into a market rout.

Jeff Meli: Yeah, the so-called falling knife.

Ajay Rajadhyaksha: And that falling knife exacerbated the moves across all asset classes. So look, take US equities, particularly tech. They did overreact. But it's because investors had been nervous already about how fast these stocks had gone up. They didn't want to see their profits disappeared. So they sold. And sure enough, everyone rushed into the safety of US rates. Look at the currency moves also, Jeff, when investors get nervous, remember they usually buy the US dollar. The Chinese currency strengthened against the dollar. If nothing else, that shows you that this was a technical correction and unwind of this so-called carry trade.

Jeff Meli: Yeah, but Ajay, you know what else moved the Japanese stock market? Like you just said, it cratered. Down what, 26%? At one point, down double digits in one day alone. That's not some high-flying asset where investors could capture carry. So why does that drop if it's just an unwind of the carry trade?

Ajay Rajadhyaksha: I think because that's exactly how panic selling works. Investors sell what they can and that's usually the most liquid stocks. Selling is indiscriminate. So for example Japanese banks like US banks benefit from higher interest rates. And you said it yourself. The Bank of Japan unexpectedly hiked rates. Japan's bank stock index fell 17% in one day because in bouts of deleveraging, investors always sell what they can first.

Jeff Meli: Okay. So one comment here is that even if it's the case that the unwind of some highly leveraged trades worsened the volatility that we experienced, it can still also be true that the underlying economic narrative is changing. I'd actually say that it's kind of common that a change in fundamentals, even a slight one, is the spark that forces these kind of leveraged, sophisticated trades out of the market. Think about the global financial crisis in house prices. There was plenty of panic selling that banks and other investors were doing of those like highly structured products that were linked to housing. But in the end, the cause of all the volatility was an actual, real and true deterioration in the fundamentals of the US housing market.

Ajay Rajadhyaksha: I do agree with that point. In general, there is some reflexivity in the economy. I just don't agree. In this instance, the underpinnings of the rally remain in effect. Six large firms just told us that they were going to spend 600 to $700 billion this year alone on their machine learning buildup. Now, I know it's just six names, but $600 billion is still a massive amount. I will grant you that. Small business surveys in the US are gloomy, but they have been for all of 2024, and in the first half of this year, the economy has still grown over 2%.

Jeff Meli: Okay. Well, a second comment that I would make about your narrative is that the volatility of the nature we've just experienced can take its own toll. It could actually become a self-fulfilling prophecy in a way. For example, take wealth effects. Wealth effects means how consumers respond to the increase in their home prices or their equity portfolios. They are wealthier as those go up, and then they turn that into more consumer spending, and it becomes like this virtuous cycle.

Now if you turn it the other direction, it becomes a vicious cycle. Prices start to go down. They cut back on spending that causes economic slowdown, et cetera. We've wiped out something like $7 trillion of assets just within a few days. Globally, that's got to have an effect on consumer behavior. The speed that that occurred, I think, matters too. It happened in just a few days, maybe even hours, really, if you were to look down at the intraday trading, that must raise concerns that the foundation of the rally, the foundation of all this wealth that got created, is crumbling or somehow suspect. It's a precarious time for markets if prices can fall that far that fast.

Ajay Rajadhyaksha: All right. Well, I do just like you believe in the wealth effect, but aggregate numbers matter. At the start of 2024, US household wealth had gone up $42 trillion from three and a half years ago when Covid started. Even now, Jeff, US stocks are still up 10 to 11% this year. The wealth effect is still very, very positive. And look, I agree volatility creates its own issues. The recent episode even with that comes with a few silver linings. The first one is that mortgage rates have dropped so houses just got more affordable. Another is that the dollar has weakened meaning US exports got more attractive. I think these balance the negatives in my view.

Jeff Meli: Well, you are remarkably sanguine, Ajay, your belief that this was a technical event in markets and that it will blow over and it's not linked to a weaker economy, is quite rosy.

Ajay Rajadhyaksha: I mean, look, I am nervous. I'm trying hard not to be needlessly upbeat, but honestly, I genuinely struggle to see a US recession in the near future.

Jeff Meli: Well, Ajay, I hope you're right for all our sakes. Listeners who are interested in more on this topic can read our latest global rates weekly entitled the Sky Is Not Falling, as well as our latest global macro thoughts on Barclays Live.