Monday Digest
Posted 12 August 2024
Market correction turns into pothole
Last week started with some of the worst stock market losses in nearly two years – prompted by recession fears and Japanese liquidity problems – but ended with most of those losses recovered. Volatility spiked across most regions and almost all asset classes. The sell-off proper started in Japan (where stocks were routed last Monday) after higher interest rates unwound the ‘carry trade’ (borrowing where rates are cheap and investing where yields are higher) but US liquidity has also been under pressure for a while, which suddenly became apparent. We suspect the growth of high-frequency trading amplified volatility, since it shortens the timeline between trades and increases market sensitivity.
US recession fears are arguably overdone, considering that corporate credit remained relatively stable – and in fact corporate cost of finance fell thanks to sharply lower ‘risk free’ government yields. Recession risks are certainly higher than a few months ago, but our base case is still a ‘soft landing’. Business sentiment in the services sector continues to be strong, for example, counteracting weakness in manufacturing unemployment. Even Bitcoin (a fairly reliable risk indicator) recovered strongly into the end of the week.
There is still much to be positive about. Lower yields should help US mortgage rates, for example. The gap between mortgage rates and long-term treasury yields has come in from the highs of 2023, but it still has a way to come down in terms of historical averages. That should support growth.
The market shakeout was brewing for weeks, judging by the positioning activity of some hedge funds. This need not threaten stability (volatility settled down pretty quickly) but we seem to be in a different phase, in terms of medium-term outlook. Equity valuations have fallen but still look pretty optimistic in terms of expected earnings growth. Falling yields will help those valuations – but probably at the expense of the expected earnings growth they are based on. That could mean higher valuations but slightly soggier profits. Decent returns perhaps, but with a different set of winners.
Japan’s carry-trade catharsis
The Bank of Japan’s rate rise has unwound the yen ‘carry trade’ (borrowing cheaply in Japan and investing in high-yield assets like US stocks) and knocked markets everywhere in the process. Japanese stocks had their worst day since 1987 last Monday, erasing all of the TOPIX’s year-to-date gains. It regained ground in the following days, after dovish comments from the BoJ. This volatility is bad for confidence: Japanese risk appetite is slow to build and quick to collapse, and there is little economic momentum to fall back on.
The BoJ felt it had to dial back rate rise talk, but it will be wary of staying too easy. The problem for policymakers is that international hedge funds have been much more willing to take advantage of cheap Japanese rates than domestic investors. The carry trade grew massively this year, with money flowing out of Japan and into the US and Mexico – sinking the value of the yen. The BoJ probably turned hawkish because it saw the small impact its easy policy was having on the domestic economy, compared to the huge impact it was having on the yen. This hurt hedge funds involved in the carry trade, amplifying volatility across global stocks.
Domestically, volatility could spook Japanese investors, but the long-term case for Japan remains strong. Recent corporate reforms are a positive for profitability – one of the reasons Japanese stocks broke all-time highs earlier this year. And the yen is extremely cheap on a purchasing power parity basis (even with the currency’s sharp recent gains) making Japanese exports extremely competitive. The ingredients are all there for profit growth over the long-term – exemplified by Honda’s strong Q2 earnings against a difficult backdrop for carmakers. If that comes through, Japanese stocks will start to look very cheap. Hopefully, the carry-trade shakeout is a much needed catharsis.
Interest rate expectations
Interest rate expectations have moved down sharply after capital market turbulence. The US Federal Reserve has a rate cut pencilled in for September, which the Fed all but confirmed in its July meeting. Recent job market data was disappointing, and the acceleration in unemployment has now triggered an historic recession indicator (the ‘Sahm rule’). Markets now expect the Fed funds rate to be 4.5% by January (down from current 5.25-5.5%). The Fed will have to do something extraordinary to meet current market expectations – but we doubt it will. Recession fears are arguably overplayed, and Jerome Powell has proven his willingness to stick to the plan, even if markets don’t like it.
The Bank of England cut rates in July, but cautioned against further cuts. The sell-off since has moved down markets’ rate expectations – but not as sharply in the UK as elsewhere. Bond traders see the BoE settling on 3.5% rates in 2026, much later than the US and Europe. This is partly cyclical: the UK economy is improving, unlike most developed countries. But it is also structural: the BoE’s 2% inflation target is written in law, unlike its peers who have more discretion. With talk about changing targets globally, we think that makes the BoE structurally more hawkish.
The ECB cut in June and is expected to do so again in September. Markets now put Eurozone rates at 3% by January and close to 2% by the end of 2025. Even though growth and inflation recently beat expectations, forward looking economic indicators are weak and Europe faces many headwinds. If the ECB cuts in line with market expectations, it would mean a rate-lowering cycle almost as aggressive as the pace of hiking before. Europe’s ailing economy might need it.