A Comment on Recent Market Volatility

Key Points:

• Recent market volatility seems to have been driven by the unwinding of Japanese carry trades and increased pricing of a recession in the US.
• This was exacerbated by stretched investor positioning, crowding in AI related stocks and seasonal weakness.

Markets over the past few days have experienced heightened volatility. This followed a soggy period (particularly in the tech sector) as earnings, though positive, weren’t positive enough to meet lofty investor expectations. Movements have been particularly intense in Japan, with the Japanese equity market falling more than 25% from its recent peak, albeit is recovering somewhat up ~9%.

Global developed markets have seen a lower impact, the MSCI (Morgan Stanley Capital International) World Index is down ~8%, the S&P 500 ~9%, and the ASX 200 true to its historically more defensive nature only ~6%. An equity market correction is technically deemed a fall of 10% or more and is a normal occurrence in most years as the chart below shows:

While it is always difficult to identify the cause of such events, consensus seems to be pinpointing an unwinding of the JPY carry trade as the main culprit (a major deleveraging event), with a side of increased US recession concerns.

A carry trade is borrowing cheap in one currency to invest somewhere you expect a higher return. With the cash rate in Japan close to zero, borrowing there to invest elsewhere has been cheap and caused the Yen to weaken substantially against major currencies as investors sold Yen to purchase foreign assets such as US equities. However, a rate rise in Japan followed by softer US data which will likely lead to rate cuts in the US, has triggered a huge reversal, i.e. selling foreign assets to buy Yen and payback the loans. The weak Yen has boosted the Japanese equity market given large global exporters, such as Toyota, benefit from a weaker currency, so as the leveraged trades reversed the equity market sold off rapidly also.

Essentially yesterday was a large margin call on the Japanese equity and currency market which has reverberated around the world. Fortunately, our portfolios have no direct Japanese exposure, nor Asian equity funds and so the impact has been more muted with developed markets such as the US and Australia holding up much better.

Further adding to uncertainty, the rise in the US unemployment rate last Friday night triggered the so called SAHM rule. This “rule” indicates a recession has started when the three-month average of the US unemployment rate is 0.5% or more above its 12-month low. Markets reacted poorly to this, as recessions are a bad time to own equities. However, neither the Fed Chair Powell nor Claudia Sahm, who first quantified the relationship, think the US economy is in a recession. None of our macro indicators are currently pointing in that direction either.

Our Growth Barometer is relatively steady:

The Atlanta Fed nowcast of Q3 GDP growth is still positive, as are consensus forecasts. Other nowcasts of growth (Chicago Fed National Activity Index and Goldman Sachs Current Activity Indicator) are also steady. Lending conditions and credit growth are also improving which is positive. While manufacturing PMIs (Purchasing Managers Index) are weak, global services, which is a much larger share of economies, PMIs actually rose in July.

There has been weakness in the labour market, Friday’s payrolls were a continuation of that trend. However, even here there are mixed signals. Unemployment claims and layoffs in the US remain relatively muted and aren’t flashing red. This is suggestive of previously laid off workers re-entering the market than corporates having to fire people due to weak demand.

Portfolio positioning

Given most indicators of economic health continue to remain ok and there is potentially some nuance to the labour data, we continue to think this correction is more likely to resemble a moderate mid-cycle correction than be the start of a protracted bear market. However, if there are signs that economic growth is indeed slowing down or that weakness in the labour market is intensifying, we will adjust the portfolios accordingly.