What follows is a re-print of a note we wrote back in early August following a sharp period of volatility in markets. As the US Federal Reserve became more relaxed talking about falling inflation and the likelihood of cutting interest rates in the wake of a poor jobs report, the Bank of Japan surprised with an interest rate rise to tackle rising domestic inflation. Whilst relatively small, the rate rise triggered a large unwinding in the carry trade and a spike in volatility in both Japanese equity markets and the yen. Another example of one relatively small lever being pulled in a complex financial system, that triggered a large impact elsewhere.
With summer holidays upon us and increasing numbers of market watchers getting stuck into the pages of the latest Richard Osman crime caper, rather than the financial screens on their computers, there can be years when ‘events’, combined with low summer trading volumes, can make for some uncomfortable market conditions.
The headlines are clear. Markets have started August poorly. A double-digit fall in Japanese equities during a single day is not a normal day, by any stretch, and provides an open goal for headline writers to do their worst to concern investors.
As always, there are always nuances and shades of grey, so in the interests of trying to deliver some balanced arguments…
2024 has, in comparison to the last couple of years anyway, generally been going quite well. Portfolio returns have been edging forward on the back of progress in equity markets and steady levels of interest available from fixed income funds.
In the last investment quarterly, we wrote about the damage Jerome Powell, Chair of the Federal Reserve, had caused to forward guidance back in 2022 and how this forced an over-reliance on individual data points. This is relevant today, so I’d encourage you to re-read the ‘Inflation – A bit like Play your Cards Right?’ section, that can be found here:
https://www.hfmcwealth.com/summer-where-is-the-love/
So, what’s happened?
Last week, the July US jobs data was released that was pretty weak across the board. The briefest of summaries from the July report is:
- There is weakness in several sectors when it comes to the numbers of people employed, and
- The unemployment rate nudged upwards.
There are caveats attached. First, this is one set of employment numbers. Second, the rise in unemployment is part driven by people losing their jobs (which is bad) and part by more people joining/returning to labour supply (economically, a long-term good thing assuming this labour supply gets absorbed into paid work).
Why are the markets concerned?
Rightly or wrongly, the conclusion that markets have made are:
- Central banks, particularly the Fed, are behind the curve in the interest rate cycle and should have already started cutting rates.
- That the US is bound for recession.
- The Fed will need to now go further and faster in cutting rates than anticipated.
What do we think?
The theme of our recent quarterlies highlights our consistent view that central banks are behind the curve in cutting rates. For more on this thinking see “There is nothing more deceptive than an obvious fact.” and Interest Rate Cuts – Increasingly Confident? sections from the Investment Strategy.
Following the mantra that you shouldn’t see a problem, you should see an opportunity, central banks are being given a get out of jail free card and can feed into the current market angst at upcoming meetings should they choose to do so. Whether they do so is yet to be seen and three interest rate cuts from the Fed and two more from the Bank of England by year end, looks and feels like a sensible base assumption for now. Unemployment in both the UK and the US is still low by historical standards and as long as people remain employed, they tend to be resilient in their spending patterns, which should help underpin downside risks to the economy (notwithstanding a large geopolitical shock).
In portfolios, falling bond yields are helpful for fixed income returns, but equity selections are inevitably susceptible to this bout of volatility.
Our conclusion remains:
For investors, it has been raining for so long and so hard over recent years, that in some areas we haven’t noticed some signs for optimism. The broad economic backdrop has proven to be more resilient than feared, so unless central banks refuse to start cutting policy rates, the illusion of a soft economic landing may indeed become reality. Employment remains healthy and real-terms wages are turning positive. Politics and geopolitics remain an elevated risk but should not be the driver for portfolio strategy.
Instead, we look at fixed income with renewed interest as both a source for strong income returns, but also an asset class that can deliver a solid investment return after years of ultra-low interest rates. A strong and stable income stream is an excellent starting point for future investment returns.
We look to maintain current equity weightings as this is the asset class that is going to be the foundation stone and driving force of future portfolio performance. The premise for central banks beginning to ease policy is that inflation is back under control and the economy is steady. This is not a bad backdrop for equity investors who can also source solid dividends and buybacks, that accompanied with time and patience, will allow them to capture some areas of value that are on offer.
‘Slow and steady’ may not be the most emotive rallying cry, but it remains the investment strategy of the day.
That’s all fine, but why are Japanese equities down 12% in a day!
Investors in Japan were enjoying very strong returns up to the end of July, with the Topix outperforming other major equity markets in local currency terms. Part of this equity market strength has been driven by the weakness in the yen, as companies who have overseas earnings benefit from a currency boost to their earnings. The Bank of Japan raised the policy rate last week and reduced its bond buying programme, which has sparked a strong rally in the yen, traditionally a headwind for Japanese equities.
That much we know, there is also an overlay of what our ‘sense’ is too, namely:
- A reversal in yen weakness will have triggered the closing of plenty of ‘net short yen’ positions.
- We had an interesting chat with one of our Japanese equity managers recently. They highlighted that many overseas investors focus their equity purchases in the very largest of Japanese companies, where liquidity is highest. This has helped push valuations in these largest companies to high levels and some of the move will have been triggered by focused selling by foreign investors in these largest index constituents whose share prices are most influential to index performance.
- Foreign investors own 33% of the market but account for 70% of daily trading volumes, so have an oversized influence in short term market direction.
- There’s an element of bad timing with the Bank of Japan. Raising rates when the general global market sentiment is calling for cuts and timing the rise at a point of a weakening US dollar won’t have helped sentiment either!
Dated 5th August 2024
