Introduction
Those hoping for a typically calm summer in capital markets have been sorely disappointed. Last week was particularly eventful, punctuated by a broad, global equity market selloff on Monday, August 5th. Sixty percent of the S&P 500, by market cap, reported earnings. The central banks of the U.S., Japan and England held their regularly scheduled meetings. The monthly labor and the U.S. Manufacturing PMI reports were issued.
Although corporate earnings and the labor and manufacturing reports reveal a gently slowing economy, the market responded as if a full-blown recession was underway. The S&P 500 was down by more than 2% for several trading days. Such market volatility brings out all the Cassandras (prophetic voices) and scary headlines on popular financial market news sites. The purpose of this newsletter is to separate fact from the fiction that is unfortunately so prevalent in financial media.
Bank of Japan
The first event that got investors’ attention was the Bank of Japan increasing their short-term lending rate from essentially zero to 0.25%. This is important because the Japanese Yen has been a funding currency for large investors for decades. Simply stated, investors borrow from Japanese banks, at ultra-low rates, and use the borrowed capital to buy stocks and bonds in other currencies to earn the difference in yield or total return. This is known as the “carry trade”, and it’s been around for a long time. Although no one knows exactly how large the global carry trade is, it would be measured in the trillions.
The carry trade is a financial engineering strategy with inherent risks. Surprise economic or monetary policy data and everyone rushes for the exits, selling their most liquid foreign assets and buying Yen to repay their loans and reduce investment risk. This is exactly what happened when the Bank of Japan increased interest rates last week, and the Federal Reserve made no rate change (though it did lay the groundwork for a rate cut in September). This difference in monetary policy pushes up the Yen and pushes down the U.S. dollar, forcing anyone in the carry trade to sell U.S. assets and buy Yen as fast as possible. Weak U.S. PMI and labor market data later the same week heightened the risk to the carry trade and exacerbated the subsequent U.S. equity market selloff.
It’s not terribly important to understand the mechanics of the carry trade. The takeaway is that carry traders, in aggregate, are significant buyers of U.S. equities. This group was suddenly forced to sell U.S. equity positions due to currency movements and not due to economic fundamentals. The selling pressure from the carry trade forced other large popular investment strategies, such as volatility selling, risk parity, and momentum-following to rush for the exits as well.
Such events happen every few years and are typically violent and short-lived. Worth noting is that other asset classes are not following suit. The investment grade bond market has barely moved over the past few weeks. Risk measures like credit default swaps, a financial derivative that investors can use to bet on a recession or credit event, are largely unchanged. There simply is no follow-through to other assets that would suggest the current equity market sell-off is anything more than a technical correction.
U.S. Equity/ Bond Markets
Five of the “Magnificent Seven” recently reported better than expected earnings. Tesla disappointed. Nvidia reports earnings on August 28th. While five of six companies beat earnings expectations, lower forward guidance was troubling and suggests smaller profit margins going forward. The Magnificent 7 just produced quarterly, year-over-year income growth of 50% in the first quarter of the year and 35% in the second. Growth is expected to be 17% a year from now, still much higher than the rest of the market. But investors expect more when paying a 72% premium (as measured by forward price/ earnings) for the stock of a tech giant. Given these dynamics, it is reasonable for the market to cool its enthusiasm and turn to companies with more reasonable valuations.
Earnings of the S&P 493 (the market without the seven tech giants) have been better than expected, at 7% vs 5% year-over-year, with improving forward guidance from management. This is a healthy development and long awaited. Accordingly, we’re seeing sectors like financials and industrials outperform technology for the first time in several years.
Perhaps a sign that the economy is returning to normal is the recent behavior of the bond market, which outperformed the S&P 500 significantly over the past month (7/5 to 8/5). You can almost hear the justifiable cheers of investors with diversified portfolios.
U.S. Economy
The labor report from last Friday deserves special attention. It was weaker than expected, with just 114,000 new jobs, pushing the unemployment rate up to 4.3%. The survey period did overlap with Hurricane Debby, but the general trend towards a weaker labor market is clear. Manufacturing and overtime hours, temporary help, PMI employment survey, and job loss probabilities in the Fed household survey all point to further weakness in employment.
The bigger picture is not so daunting. Wage growth and job openings are cooling, but still very healthy. High frequency data on consumer spending does not show a rapid cooling that would justify an equity market sell-off. TSA air traveler data, box office receipts, restaurant bookings, tax withholding data, jobless claims and hotel bookings are all solid or better than normal.
Looking Forward
Bringing the current inflationary cycle to an end was always going to require a cooling economy. We’re seeing that now. But cooling and full-blown recession are very different things. Recent market activity was most likely a sharp, but short-term, technical correction related to differences between U.S. and Japanese rates and monetary policy positions.
The rare “soft landing”, defined as inflation and interest rates returning to around 2% without significant job losses and an economic recession, is tough to achieve. We do expect the economy and labor market to cool further over the course of the year, but based on what is known today, a recession does not seem likely. If Fed Chairman Powell wakes up the market’s animal spirits during his Jackson Hole speech later this month with promises of interest rate cuts, everyone will forget about the first week of August.