MARKET UPDATE 14/08/2024

Market sentiment: Improved. The recent volatility on global stock markets appears to be over, for now. The VIX index of implied volatility on the S&P500 (‘the fear index’) spiked at 66 last Monday, but it has since fallen back to 19. Last Monday’s sharp sell-off was followed by a global stock market recovery and investors are sitting on good year-to-date gains. The Japanese TOPIX is still up around 7% this year despite a 12% fall on 5th August, while the NASDAQ is up around 14% since January, back to its May high of 16,780.

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But the old fear of ‘what happens when the yen carry trade ends?’ has re-emerged, having been hiding amid the weak yen of recent years, and it should not be ignored. Investors need to consider it along with other risks, whether it be fear of a U.S recession, the oversupply of U.S government debt, decelerating global growth, or geopolitics. The solution, as with all types of risk, is portfolio diversification. Investors are helped in this by having somas good yields available on bonds, with the prospect of capital gain as global inflation slowly but surely weakens.

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What caused the recent volatility?? Three explanations have been offered for the sharp sell-off that we saw on Monday 5th August. Probably it was the combination of all three, accentuated by the simple desire to crystalise profits after strong year-to-date performances by U.S tech and Japanese stocks.

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First, recession fears. Weak U.S inflation and jobs data the previous week led to a revived fear that the Fed is ‘behind the curve’. ie, that the Fed should have cut interest rates a fortnight ago. By not doing so, the argument went, ?it has increased the risk of recession. July’s non-farm payroll report showed 117,000 new jobs created last month, against expectations of 175,000. There has been mounting evidence of more cautious consumer spending, and an increase in households struggling to repay debt.

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We have also seen some traditional indicators of recession stat to flash. The Sahm Rule has been triggered (whereby recession follows a 0.5% rise in unemployment from its 12-month low). And we are seeing an unwinding of the inverted U.S Treasury yield curve (longer dated bond yields are now only slightly lower than those of short dated bonds), which has often preceded a recession. ?

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Second, a partial unwinding of the yen carry trade. Japanese investors, as well as many U.S hedge funds and other overseas investors, have accumulated around $500bn worth of borrowing in yen (according to a study by UBS) since 2014. This has been used to buy Japanese and overseas financial assets, notably U.S bonds and global tech stocks. This trade relies on a stable, or a weakening, yen and for yen borrowing rates to remain very low relative to central bank rates elsewhere. The trade has ballooned over the last twenty years, as very low interest rates in Japan have contributed to a weak yen. The $500bn estimate cited above is a conservative one, ignoring as it does pre-2014 yen borrowing by investors.

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The most recent phase of the yen carry trade dates back to early 2022, as monetary policy began tightening throughout the G7, except Japan, to combat inflation. As a result, the yen fell from 114/$ in December 2021 to 160/$ last month. Anyone who borrowed in yen to invest in, say, the Magnificent Seven U.S tech stocks did very well, benefiting from the share price gain and -if unhedged- a currency gain too. As interest rates rose elsewhere, the yen became the last source of cheap funding for leveraged investors.

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But on 31st July the Bank of Japan (BoJ) announced a surprise interest rate hike, of 15bp, taking the key policy rate to 0.25%. Investors wondered if this was the start of a new, aggressive policy by the BoJ and the yen rallied to 142/$. This, in turn, led to margin calls from the banks that had lent yen, triggering asset sales by the investors as they raised funds to meet those calls. This explanation accounts for the why the focus of the sell-off last Monday was Japan and global tech.

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Third, an exaggerated response to economic data. This argument holds that investors are putting too much weight on individual pieces of data, and not seeing the wood for the trees. This is accentuated by computer-based trading models, that are all trained to look at the same data, and to respond in a similar way. As some economists have observed, July’s new jobs data was not the worse this year - only 108,000 new jobs were created in April. But in April traders were at their desk, not at The Hamptons, and this meant more trading of diverse positions, and so more market liquidity, which diluted the negative effect of a weak jobs report.

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Furthermore, the argument goes, ‘rules’ such as the Sahm Rule and the inverted yield curve (mentioned above), tend to predict more recessions than actually occur. And when economists at Goldman Sachs and JP Morgan raised their recession predictions, to 25% and 35% respectively, we should remember that this means a 75% and 65% confidence measure that recession will not occur.

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The outlook for the yen carry trade. The immediate pressure on the yen carry trade has eased. Governor Ueda of the BoJ, perhaps surprised by the reaction to the rate hike, has talked down the likelihood of another hike this year. Meanwhile, the Fed’s delay in cutting its interest rates last month, and its refusal to cut following the stock market sell-off, has helped weaken the yen. It is back to 147/$. We do not know how much of the $500bn yen carry trade has been unwound over the last fortnight, or whether there are any large investors still needing to sell assets in order to meet margin calls from last week. But the risk seems much lower today than it did ten days ago.

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What, though, might happen should investors one day turn their back on the yen carry trade, en-mass?

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Some analysts paint a grim picture. Starting with the BoJ perhaps deciding to pursue a ‘strong yen’ policy, should inflation become uncomfortable high for the central bank. Japanese institutional and retail investors would first sell their large holdings of U.S Treasuries, and global tech stocks, and other overseas assets. Global investors, who have borrowed in yen to finance all sorts of trades, would follow suit. Some will be eager to crystalise gains, while some will be forced to sell assets to meet margin calls from the banks they borrowed from.

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This would depress global bond and stock market prices, and lead to further yen strengthening as the proceeds are converted into yen prior to the yen borrowing being repaid. A spiral of spiral of distressed selling and an ever-strong yen may set in, until the Bank of Japan intervenes. Meanwhile, falling Treasury prices lead to higher yields and U.S borrowing costs– with a chilling effect on the global economy, as well as on financial markets. It is a grim scenario, and is a risk investors need to be conscious of. But we should not exaggerated the risk, a sudden ‘strong yen’ policy from the BoJ is unlikely (equally, a weak dollar is unlikely over the coming years, given both Republican and Democrats love of trade tariffs).

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U.S and U.K inflation data this week. Today (Wednesday) sees the release of CPI inflation for July, in both the U.S and the U.K. In the U.S, if headline CPI comes in at or just below 0.2% month-on-month, markets will be relieved. In the U.K, headline CPI is expected to come in at 2.3% year-on-year, above the 2% seen in May and June. The increase has been so well flagged, even by the Bank of England, when they cut rates for the first time in the current cycle, that the increase should not move markets.

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In both countries service sector inflation remains high, and it is this that is making it hard to bring the headline rate down -and to keep it down- at the 2% target. Services inflation is itself driven by wage growth, which is growing in real terms. The job of central banks is to curb wage growth, so curbing services inflation. This means keeping monetary policy tight enough to create slack in the labour market (ie, unemployment), without inducing recession. A delicate job and one that, so far, both central banks appear to be doing successfully.

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The lessons for portfolio construction is…diversify. During the recent period of volatility, investors piled into bonds, pushing up prices and forcing yields down. This cushioned the impact of the stock market sell-off on multi-asset portfolios.

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The return to negative correlations between core government bonds, and stock markets, is welcome and is likely to persist. It is supported by the generous positive real yields now available to investors, with yields on U.S and U.K 10yr government bonds, for example, well above domestic inflation rates.

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The relative stability of the FTSE100 in recent weeks (down by less than 1% so far this month) also shows the value of diversity within the equity portion of a portfolio. The NASDAQ, down 4% over the same period, has produced far superior long-term returns over the last decade, but in times of market stress the defensive bias of the FTSE100 makes it a valuable component in a portfolio. Quality value stocks compliment growth stocks, it is not an either/or question.