Some thoughts on recent market turmoil

This week has seen investment markets in the news and we felt it would be useful to share our thoughts.

Let’s have quick recap on what the news flow has been:

US Economic Data – Some weaker economic data, notably employment data for July, released last Friday was in absolute terms not bad but importantly below market expectations. This along with some other data releases has pointed to an increase in the risk of a more pronounced economic slowdown in the US. Expectations at the end of last year have evolved from a “soft economic landing” in 2024 to “no landing” by March to a “Hard Landing” e.g. recession, today. It is important to put this in context, Goldman Sachs is still putting the chance of a hard landing at no more than 25%.

Interest Rates – We have now seen rate cuts from both the European Central Bank (ECB) and Bank of England (BoE). Meanwhile the Bank of Japan (BoJ) increased interest rates to 0.25% from 0.1% on the 31st July. Whilst the timing may have been a surprise the direction was not. Japanese interest rates had remained unchanged whilst other central banks raised rates in response to inflation and a rate rise now indicates that the Japanese economy is actually doing well and that the BoJ no longer needs to pursue extraordinary measures in order to support the economy. However, the US Federal Reserve (Fed) left interest rates unchanged at its 31st July meeting and coupled with the weaker data this has led investors to worry whether the Fed has left it too late to cut interest rates – and if its inaction risks causing a recession.

Corporate Earnings – Corporate earnings for Q2 have shown robust earnings growth across major markets and 14% in the US. This is above market consensus expectations going into this earnings season. However, the recent gains in equity markets create their own narrative and it seems (perversely) that the market has been disappointed that the scale of positive earnings surprises has been more muted compared to previous quarters.

The Japanese Yen – The Yen has been extraordinarily weak against other major currencies. This has largely been driven by interest rate differentials…it is possible for institutions to borrow money in Yen for practically nothing and then sell (short) the Yen on the foreign exchange markets and invest the money in higher yielding assets such as Emerging Markets (one can get c. 11% on Mexican Pesos) or US equities. This is a form of leverage called the Yen carry trade and works extraordinarily well until the day the Yen strengthens sharply. Then the Yen carry trade can be extremely painful.

So what happened? A significant change in the expected future interest rate differential between Japan and the US led to a sharp rebound in the Yen which has strengthened by c. 12% since its low on 11th July. It is rare to see these types of moves in a G7 currency outside of a global crisis. The speed and magnitude of the move (7% since 31st July) is probably exacerbated by thin liquidity in the summer holiday season and has led to a forced unwinding of the Yen carry trade as computer driven “stop loss” trades get activated.

We also saw a 2 day decline in Japanese equities of c. 16% (partially reversed this morning). We suspect that this may be due to domestic institutions (probably Japanese Life Insurance Companies) getting margin calls on their short Yen positions and needing to raise cash immediately.

This volatility has spread to other equity markets but has not developed into a self-fulfilling “doom loop”. Despite the lurid headlines the scale of these moves is entirely within the ranges of a normal equity market correction. Certain parts of the US market, notably the Magnificent 7 Tech stocks¹ that we have commented upon before were overdue a reality check, but the speed of the change in sentiment will have caught many investors off guard. This is where most of the largest market gains had been made in recent months and it is where some of the bigger market declines are currently being seen.

Experience tells us that taking a calm approach during periods of heightened market volatility is generally the better option rather than reacting before all the salient facts can be assessed properly. The interconnectivity of markets, levels of automated trading and currently a degree of general nervousness around market valuations means things tend to get very volatile very quickly. Nevertheless, we are keeping a very close eye on how the situation is evolving and if we see things changing, including the risk of US recession increasing in future data, we will make further changes to the portfolio once this volatility has settled a little. What is difficult to tell yet is whether this may represent a good buying opportunity or a need to take risk off the table. We will keep you posted.

August 2024

1. Alphabet (formerly Google), Amazon, Apple, Meta (formerly Facebook), Netflix, Nvidia, Tesla ↩︎