Heading into the end of July, global equity markets had enjoyed a relatively calm year, maintaining the positive trend established through 2023. With second-quarter earnings just getting underway, North American markets have remained strong despite growing doubts about whether the strong performance of US technology leaders would continue and whether signals of a weakening consumer would persist.
Boy, how quickly things change. Entering August, an increasing number of investors were optimistic about the first possible interest rate cut from the US Federal Reserve, driven by cooling inflation, weakening employment, and slowing consumer spending. By Wednesday, we learned that the Fed had stuck to their September plans, and markets rallied hard. In a conversation with the team, I asked, “would it last?” understanding that to achieve the desired economic soft-landing, now was the time to ready the landing gear. Fast forward two days, and as expected, those easy gains began to reverse as new economic data continued to show softening US growth, causing investors to worry that the Fed might now be late to the rate-cut party, endangering a soft-landing scenario.
While the Fed's decision captured most of the attention last week, at the same time the Bank of Japan (BOJ) quietly made a significant policy move that likely went unnoticed by many North American investors. Unlike their Western counterparts, the BOJ raised interest rates to support the Yen and combat inflation caused by its weakness. This move might have remained under the radar if it hadn't sparked a considerable sell-off in Japanese markets, leading to the Nikkei’s largest two-day percentage decline in history and pushing it into bear market territory.
Unsurprisingly, this drew the attention of global equity markets, triggering further declines to start the week and marking the second peak-to-trough drop of over 5% in US markets this year, just shy of a technical correction:
You might wonder why an increase in Japanese rates would impact your North American-focused portfolio. The answer lies in something called the Yen carry trade.
For most of my lifetime, the Japanese economy has experienced minimal growth. To combat stagnation and stimulate growth, Japan, like many Western nations, kept interest rates very low for decades. This low-growth/low-rate environment gave rise to the Yen carry trade, where low-interest Yen loans were used to purchase higher-interest, higher-return investments overseas—a strategy that has thrived for many years. However, the BOJ's rate increase on Wednesday has begun to change the outcome for many investors using this strategy. Higher rates and a strengthening currency have made these loans more expensive and less profitable. As Japanese investors sell global investments to buy back Yen and pay off these loans, the Yen strengthens further, worsening the problem—a bit of a vicious cycle.
With this context in mind, let's discuss our take on the markets given these events and our positive commentary this year. As we have discussed in past communications, we believe the direction of interest rates in Western economies is lower—a reflection of slowing economic growth and inflation. Many central banks, including ours, have already begun this shift, and we think the US central bank is now slightly behind (though not beyond recovery). The recent events in Japan underscore their significant influence in the global economy and the intricate ties between the US and other major economies. We suspect that both the Fed and BOJ are closely monitoring their markets' reactions and reassessing their policy stances, much like we saw during previous periods of rate-induced market stress, such as in 2018. Whether they wait for a scheduled meeting or act sooner to ease the pressures of the Yen carry trade remains to be seen. However, we anticipate there's good chance they will, which we believe will be a net positive tailwind for equities.
In terms of the current market drawdown, our regular readers will already know that most years can see multiple 5% drawdowns. While the reasons may vary, they are a healthy feature of a normal market, despite unfolding quickly and causing investor unease.
We recognize that unlike previous drawdowns, this bout resembles a large margin call happening on the other side of the world and is not a reflection on the fundamentals of the companies in our portfolios. For those unfamiliar, a margin call is when investors need to sell their assets to repay borrowed funds, which in turn can disrupt the market. The unfortunate aspect of this sort of event is that high-quality companies, which are otherwise robust investments, can become collateral damage as investors are forced to free up capital. However, as we have observed through many past corrections, this too will pass, and the inherent quality of these investments will shine through once again.
- Jack
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