The Storm Before the (Relative) Calm
The second and third business days of August witnessed the sort of volatility that is rarely seen in financial markets. Initially, the blame for the two day financial market dislocation was laid at the door of August 2nd’s weak US unemployment report giving an almost instant rise in the belief that a US recession was imminent. Less than a week later, a benign jobless claims release led to a 2% plus bounce in US equities. The inaccuracies and subsequent revisions of the US unemployment data have been repeatedly signposted here in previous editions of the mid-monthly update.
However, the last day of July saw the Bank of Japan raise its key rate by 0.10% to 0.25%. Not unexpected but it provided the catalyst to push an already firming Yen to a significantly stronger level against the US currency (from a peak of 161.7 on 11 July to 142.7 on 5 August having been at 155.0 on 30 July). Consequently, those that have borrowed cheaply in Yen at close to zero interest rates and invested in higher returning assets, were minded to cover their Yen short positions by selling those higher returning investments. The following chart illustrates the fall of the Yen versus the US Dollar and the correlation to the amount of Yen short positions:
How?
Source: Bloomberg
Why?
The ‘carry’ trade has proven to be a lucrative one. For those that put the trade on in 2020, they made a higher return in Mexican Pesos than investing in the S&P 500 US equity index over the same period, as shown below:
Source: Bloomberg
Vixated
The VIX Index is the short name for Chicago Board Options Exchange (CBOE) Volatility Index, often used as a measure of the US S&P 500 Index’s expected volatility and sometimes referred to as the fear index. The VIX hit 65 intra-day on August 5th. At the time of writing, it is 16.5.
The spike in volatility has receded and some calm has returned to financial market asset classes. Japanese equities have recovered all the losses incurred by the Nikkei 225 Index on August 5th.
But actually, volatility intra-year isn’t uncommon and historically, hasn’t tended to upset annual returns too much:
Source: JP Morgan Asset Management
Rate Expectations
UK consumer price inflation (CPI) was announced for July. While the headline level of 2.2% meant a rise from 2%, the outcome was lower than expected, prompting expectations of a further rate cut from the Bank of England this year. As the graph below illustrates, the Bank will want to see services inflation continue its downward trajectory and wages continue to soften from its 5.4% rate. UK economic activity as measured by its gross domestic product (GDP) continues to improve from last year’s recession. After first quarter GDP growth of 0.7%, second quarter activity improved by 0.6% but not enough to distract the Bank of England’s Monetary Policy Committee from lowering rates again:
Source: Bloomberg
US CPI has also continued to drift lower. Following a lower than anticipated Producer Price Index the day before, yesterday’s CPI confirmed the downward momentum in US inflation:
Source: Bloomberg
Market dislocations inevitably lead to talk of help from central banks. Talk of an emergency rate cut by the US Federal Reserve quickly, and rightly, evaporated. But expectations for rate cuts in the US, UK and Europe might still appear optimistic.
Having kicked off August with a first base rate cut of 0.25% to 5.0%, the Bank of England is expected to cut again by the same margin, before year end. Like the US, wages are falling, but are still too high for the Bank’s liking but unemployment is rising.
In the US, a full 1% of cuts is expected by futures markets by year end. It’s 50/50 whether there will be a 0.25% or 0.50% cut in September but much depends upon who wins the Presidential election and what their spending plans are.
Rates will likely go higher towards 1% in Japan as inflation rises. The Bank of Japan has said it will not raise rates in difficult markets so increasing rates will take time. Prime Minister Kishida’s unpopularity due to falling living standards, has led him to not seek re-election in next month’s elections. Economic growth has picked up with GDP growing at an annualised rate of 3.1% in the first half of 2024.
While France will have benefitted from the Paris Olympics after July’s elections, Germany’s economy could do with a confidence boost:
Source: ZDM, Bloomberg
Oil
Geopolitics has not improved, yet financial markets have not reacted to Ukraine’s incursion into Russia or Israel’s killing of Hamas’s political leader on Iranian soil and the promised reprisal. However, oil was 8% higher last week despite an OPEC update indicating lower demand.
Your Money
There have been no significant changes to the funds in the first half of August. There was certainly no appetite on our part to get involved in the tumult of the beginning of the month although we are always watchful for those opportunities that arise when indiscriminate selling by forced sellers provides good entry points for investors like ourselves.
Our belief in the Yen’s cheapness has assisted performance in August while the US Dollar’s softness has aided relative performance. Bonds were a little overbought at the start of August but have settled down at higher yields supported by the macro-economic picture. Equities have rebounded helping fund performance do the same. The funds’ largest overweight versus their strategic asset allocation is in UK equities. The volatility at the start of August wasn’t helpful to UK stocks but valuations remain undemanding, political certainty has improved their appeal to international buyers and Sterling’s stability/increase in value will help equities below the FTSE 100.