Sizing Up the Sell-off

Summertime in markets tend to be lower volatility but that has certainly not been the case in the last week. The recent drawdowns and rebounds in markets are due to a number of reasons, some of which are mechanical/position related, others which are more fundamental and normal for where the economy currently is in the business cycle. 

The forefront catalyst seems to be changing policy in Japan leading to an unwind in risk position from a large number of macro investors. Years of negative and ultra-low interest rates enticed Japanese investors, including the Bank of Japan itself, to create a “carry trade” in which these investors would fund themselves with ultra low-cost deposits and invest in overseas and domestic assets of longer duration and higher yield. Many large US investors such as macro hedge funds did the same thing, funding their investments in Yen. When the Fed began hiking in 2022 this accelerated this trade as comparatively it pushed the Yen even lower - actually to its lowest relative level since 1986. This trade does not come without risk however if the investors do not hedge their foreign currency exposure, which many of them of course did not because it would dramatically lower the profitability of their trade.

Over the last few years even Japan has not been immune to rising inflation pressures which has forced the Bank of Japan to raise rates at the same time that the Federal Reserve is projected to begin lowering rates, causing the Yen to rise sharply. The Yen has recently rallied 14% which is pretty dramatic for the currency and the largest rally in 40 years. It only took the BoJ raising rates 25 basis points to trigger this move which shows how large the trade might have been and why it caused such a dramatic sell-off in global risk assets.

Another more straightforward reason for the volatility is simply that risk assets have had an incredibly strong run of performance and low-volatility over the last 18 months as we wrote about in our recent piece here. The AI-driven rally was so universal that by mid-July short interest on all large cap stocks, particularly in the technology sector, had basically disappeared. Additionally valuations began to reach or eclipse their 2022 heights which made their markets vulnerable to a short term sell-off.

The last major reason for the recent weakness in markets is anxiety over recession fears. Growth has remained strong with second quarter real GDP coming in at 2.8%. But as always, what's always important to markets is what's going to happen in the future. Third quarter GDP growth is also still predicted to come in strong around 2.4%. However the jobs market has shown signs of weakening as unemployment has ticked up off its trough to now around 4.3%. There is a commonly followed metric in economics called the Sahm rule. According to the Sahm Rule, When the three-month average unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months, the economy is in recession, or is about to be. The recent rise in unemployment off the lows has breached this level. However there are currently some structural developments in the economy that may taint the reliability of this indicator. While unemployment has been rising, job cuts have remained very low as indicated by the Challenger data. The main source of the rise in unemployment has been because of new entrants into the labor force attributable to immigration. Due to nuances in how unemployment surveys are conducted, the Sahm rule could more easily be triggered without a recession.

Overall the recession indicators remain mixed - as they have for the last two years. Coincident indicators such as economic and corporate earnings growth, consumer spending, and industrial production remain strong. Leading indicators such as the yield curve and Sahm rule still point to a future recession.  As we wrote about in this piece here this is not unusual coming out of a strong spurt of growth like we did with covid. And the unfortunate truth is that now as the economy has been expanding markets will constantly have these scares of a recession until we actually are in one.

So that is sort of a quick summation of the combination of factors that I believe have led to the recent selloff in markets. But intra-year market corrections are not uncommon, even in years when the markets rise. Even with the recent drawdown markets are still having a strong year with many benchmark indices up double digits. Earnings for the S&P 500 are still on track to be up 10% for 2024 according to consensus estimates. While some stock valuations do give us pause, the market is showing signs of broadening out with some of the more appropriately priced areas (market ex-technology) returning to growth. The recent sell-off has been a combination of mechanical and fundamental reasons which is why it has been so sharp. It could very well continue as markets do not go up in a straight line and the “Yen carry trade” could still have more room to unwind. But these developments do not cause us to deviate from our core philosophy of owning high quality securities, purchased at reasonable prices, and allowing them to compound their value over both expansions and contractions in the economy.

In addition to the points in this note, we are in the midst of a contentious political cycle however I do not think the recent market weakness is related to that. It is still too early and policy positions still too unclear. But I do look forward to writing to you in the coming months as that does begin giving markets jitters, as it surely will.