Possible US recession and concerns about AI bubble as a trigger

“Risk happens fast,” this old stock market insight came true again on Monday. Starting from a veritable crash on the Japanese stock market, share prices worldwide have fallen sharply. The coming weeks will now show whether this was a short-term panic reaction to sobering economic news or whether the financial markets have begun to reassess the economic opportunities and risks. There is currently some evidence to suggest that certain tipping points have been passed in the short term and that investors are seeing the world through a different lens for the time being.

Black Monday on the Japanese stock market

In the USA and Europe, the leading indices have fallen significantly. At the close of trading, the American Dow Jones was down 2.6 percent, the DAX was down 1.8 percent and the Swiss SMI was down 2.8 percent. In Japan, the Nikkei had previously fallen by a whopping 12.4 percent, which was one of the biggest setbacks in history.

Together with the losses on the previous two trading days, the Japanese leading barometer has fallen by a peak of 20 percent. The Nikkei only reached a record high of around 42,400 points on July 10th. Since then, however, things have gone downhill significantly and quickly.

The stock market boom in the two years after the pandemic has now turned into a correction. It remains to be seen whether this will become a bear market, which is what we would call a price loss of 20 percent from the last high. The end of the bull market is accompanied by a change in mood from euphoria to fear. The deeper cause is that investors are now less worried about excessive and sluggish inflation, which is preventing central banks from cutting interest rates, than they are about fear of an economic downturn.

The stock market earthquake with Black Monday in Japan has various specific reasons. From the perspective of many market participants, a recession in the USA has become more likely in recent days. The disappointing labor market data in the USA from last Friday played a particularly important role. The unemployment rate rose from 4.1 to 4.3 percent. Although this is still low, it is well above the low of 3.4 percent that was reached in May 2023. At the same time, the number of newly created jobs outside of agriculture clearly missed market participants’ expectations on Friday.

AI boom driven by Nvidia

There are also concerns that the artificial intelligence (AI) boom is weakening or coming to an end. The sharp rise in technology stocks in recent quarters was very much driven by AI stocks such as those from chip manufacturer Nvidia. The shares of this company had temporarily risen by around 700 percent since the beginning of 2023. The rally also included tech heavyweights such as the “magnificent seven” (Alphabet/Google, Amazon, Apple, Meta, Microsoft, Nvidia and to some extent Tesla) and also drove up the overall market.

In the meantime, there are more and more voices warning of an AI bubble on the American stock market, for example from the investment bank Goldman Sachs or the hedge fund Elliott. Some observers now believe that the billions invested in AI by companies like Amazon, Google or Microsoft will not pay off for the time being, which will ultimately also put a strain on demand for semiconductors.

The temporary end of carry trades

In addition, the unwinding of so-called carry trades is likely to have had a major impact on market activity in the past few days. With carry trades, investors take on debt in a currency with very low interest rates, such as Japan.

The funds are exchanged into other currencies of countries with high interest rates, such as the USA. There, the funds either remain on the foreign exchange market or are invested in riskier investments such as stocks or crypto tokens such as Bitcoin, Ethereum or Solana. This trade works excellently as long as the interest rate difference between the relevant currency areas widens or at least remains constant.

However, the Bank of Japan recently increased the upper limit of its monetary policy target range from 0.1 to 0.25 percent. At the same time, due to the weakening economy in the USA and the disappointing labor market data, investors are expecting faster interest rate cuts by the US Federal Reserve Bank.

As a result, the interest rate difference between Japan and the USA is likely to narrow significantly in the coming quarters. Accordingly, the yen has already strengthened significantly against the dollar. In mid-July a dollar cost 162 yen, now it is only 144 yen. The rise in the yen is causing profits for Japanese companies with strong international operations to fall, which is weighing on their share prices.

At the same time, the strong yen makes carry trades less attractive or even leads to losses for their investors, which is why they liquidate them. However, this also requires selling the assets in which the money was invested, such as stocks and crypto tokens. However, no one knows exactly where investors have invested the money.

Economic weakness in China, stagflation in Germany

This situation is accompanied by increasing geopolitical tensions in the Middle East. If the conflict between Israel and its neighboring states, especially Iran, develops into a full-scale war, investors’ eyes would focus primarily on the oil market. Around a third of the global oil supply still comes from the Middle East.

A sharp rise in oil prices would have an impact on the already tepid global economy. In China, national debt is rising, the economy is only growing moderately by local standards, and the problems in the real estate market have still not been resolved. In Europe, Germany, the largest economy, has been in stagflation for two years, in which a stagnating economy meets high inflation. Observers do not expect the German economy to pick up in the second half of the year either. In the other large euro countries France, Italy and Spain the economy is doing better, but some of these countries are heavily indebted, which has been giving investors latent headaches for years.

An inverted yield curve has proven to be a very good recession indicator for the USA in recent decades. This is inverse if bonds with a short term yield higher than bonds with a long term of ten years. This is exactly what has been the case over the past two years or so. If a recession were to materialize, which is still up in the air, American stocks would probably need further adjustment in the medium term. The Dow Jones and the technology barometer Nasdaq 100 have so far only corrected around 6 percent and 14 percent from their recent record highs.