What’s going on?
Despite a robust backdrop to the global economy, equity markets crashed 6% in three days last week, bringing US equities since mid-July down over 8%. The fall was led by Japanese equities, which fell 20% in yen terms. Meanwhile, bonds rallied.
Why?
When the market is ripe for a change, the catalyst can be insignificant. That said, if there is a major culprit in recent moves, it is the unwinding of the yen carry trade. Carry trading is borrowing (or selling) a currency at negligible interest rates to place into e.g. US dollars at 5% interest rates, earning ‘easy’ money. However, carry trades are exposed to foreign exchange rate risk, making them vulnerable to currency shocks, forcing them to close when exchange rates move against them. The unwind here drove a nearly 11% rally in the yen against the dollar.
The unwind was triggered by the change in interest rate outlook highlighted in dovish comments by the Fed following its monetary policy committee meeting on 31 July, explicitly flagging the chance of a rate cut as soon as September. The following day, the Bank of England strengthened the case with its first rate cut this cycle. This brought about significant weakness in the US dollar.
For context, the global equity market had been performing very well year-to-date, and indeed over longer time periods. However, US equities, led by the usual tech names, had most likely run too far and too fast (up over 37% in eight months). A small miss in US unemployment numbers and weak economic survey data on 1 August added to nervousness.
Many investors have concluded this is the start of the rate cutting cycle (typically a sign of weaker economic times ahead) and the beginning of the end-of-the-cycle rotation out of technology and growth and into defensive names. The poster child of this trade, Nvidia, is down over 25% from its peak.
What are we doing in response to it?
Generally the multi-asset team at Canada Life Asset Management proceeds with caution. Human instinct is to ‘do something’, but the automatic response is often the wrong one. In market volatility, we look for buying opportunities. Separating the noise from the signal is key and timing, as usual, is everything.
We note firstly that every correction takes both time and magnitude to complete. For example, the 2020 correction (33%) took five weeks, the 2022 correction (25%) took nine months, and the 2023 pull-back (10%) took thirteen weeks. The current retracement (8%) is only three weeks old. At times like these, we look at technical signals such as the relative strength indicator of an asset (currently flagging as an early ‘buy’ signal for US equities) and the 200-day moving average of asset’s price (for US equities, 3% below current levels) to assist our timing.
Our conclusion on equity markets is that we are entering a period of much higher volatility, driven largely by lower liquidity in summer markets. Profit taking by investors has occurred, thus far, by investors in the two equity markets that have risen the most over the past two years (i.e. the US and Japan). It is too soon for us to have enough conviction to add – so we have so far, very deliberately, done nothing.
We have more conviction within fixed income, believing that the rate cutting cycle has now quite clearly started – we have begun moving short duration bonds into medium duration as we think the risk to falling yields is now more symmetrical. We have also switched overseas corporate bond positions into more global sovereign bond positions to reduce the credit spread risk in portfolios.
How’s it likely to play out?
Longer-term risks remain, such as the indifference of developed market governments to their ever-growing deficits (which could ultimately lead to inflation) and increasing geo-political tensions. We must also acknowledge that, in the short term, both liquidity and derivatives play a much larger role today in shaping risk sentiment. These can often mask the underlying economic fundamentals, which for now, remain sound.
Our structural view remains unchanged – it is not clear to us that the tech trade, driving US equities, is over yet. Valuations for these companies may have become stretched, but their ability to grow revenue faster than other sectors should not be ignored. Away from the US and the tech trade, we consider that equities are not overbought and not expensive, and we remain optimistic.
The asset management industry has seen meaningful flows out of lower-risk funds. We think, at current yields, that investors are likely to see satisfactory outcomes from these portfolios in the years ahead. Our deep experience in fixed income allows us to adeptly navigate these markets.
Important information
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