The Japanese Connection
Market volatility come back with a vengeance over the past week. The VIX index[1] went up from a low of 12 to 65 for a while on Monday, August 5, before subsiding to less scary, albeit still high, levels. We have only seen such VIX levels during the LTCM debacle of 1998, the bursting of the dot-com bubble in early 2000s, the housing crisis of 2007-2008, and during the Covid scare of March 2020. Regardless whether such panic level was real or due to technicals, it’s time to take some stock.
In our view, this volatility was not caused by a single, large event, but rather by multiple data points that accumulated over the course of the past few weeks. The second quarter earnings season for the S&P 500 saw many companies report good quarterly results but provide weak guidance for the rest of the year. At the lofty valuations overall, this led to negative stock reactions. That dynamic alone should give investors a bit of a pause.
The economic data in the US is still signaling expansion but has been softening. The most recent payrolls data spooked the market and the latter started pricing in hard landing for the US economy. The bond market in particular was all but screaming “recession around the corner”. The short end of the curve was at some points pricing 100 bps of rate cuts this year alone.
Lastly, we believe we saw a case of forced deleveraging over the past few days linked to developments in Japan. Many commentators have already talked about the “Japanese connection” to the recent market moves. Over the years, Investors had borrowed in yen and invested in risky assets either in Japan or overseas (a.k.a. “carry trade”). Bank of Japan (BoJ) raised by 15 bps its benchmark overnight rate to 0.25% at the end of July and the Japanese yen has strengthened vs. the US dollar by 10-11% since July 10. This forced many investors to start repaying their yen loans by selling their collateral assets first. Our view is that it wasn’t just what happened on the Japanese side, but it was also the growth scare in the US and the pricing of massive rate cuts by the Fed that caused these moves.
So markets are wobbling and volatility is back – where do we go from here? Despite the scary volatility levels, the S&P500 index is now down just 5-6%[2] from its peak in mid-July, the 2-year Treasury which was down more than 100 basis points in two months has recovered a bit, and the market has pulled back from pricing in more than 100 bps of rate cuts by the Fed this year alone. So, have things changed? Below we explore the outlook for the economy, interest rates, earnings, and equities changed so much in such a short period of time.
First, we believe that the yen-deleveraging may have some way still to run, despite the more dovish talk by BoJ since Monday of this week. The yen carry trade had been going for a long time and it seems unlikely that it will be reversed so quickly. Not all positions will have to be liquidated, but if the yen keeps strengthening, the pain trade will be to sell assets (in the US or elsewhere) and the repay those yen loans.
Second, the development with the US economy and the data points that come out over the next few months will be crucial for the direction of interest rates and equities. If soft landing continues to be the central scenario supported by benign inflation and labor market data, we believe that this sell-off will be relatively short-lived. The earnings outlook for 2025 will be supported and equities will stabilize not far away from here (another 5-6% maybe, just to pick a number), potentially due to carry trade related selling during the traditionally weak months of September and October. At that point, the multiple on the S&P500 index will be at or below the 5-year average of 18x forward P/E. In other terms, this puts us back to around 5,000, or slightly higher than the start of the year. In this scenario, we don’t see the Fed being aggressive with the rate cuts, doing two or three 25 bps moves this year. This also means that the yield curve has room to move a bit higher from here, as it has started over the last two trading sessions.
If the economic data deteriorates sufficiently so that a recession becomes all but a certainty, we see risks to the 2025 earnings estimates and a potentially more protracted and deeper downturn for the market. We would expect then the Fed to cut rates more aggressively and the yield curve to move slightly lower from here over time. We don’t think bonds offer meaningful degree of total return potential though, as yields have moved down aggressively already. It will depend of course where the Fed Funds rate ends up this cycle. While we see lower rates, we don’t expect to see the zero-rate of yester years. Our best guess is that if we skirt a sharp slowdown, Fed Funds rate will likely bottom at 3.5%, give or take, for some 200 bps rate cuts this cycle. This seems more or less consensus currently.
How to position?
It is very difficult to know at this point which economic scenario is more likely, given how unusual this cycle has been. Structurally, we don’t find glaring red flags for the US economy the way there were some ahead of the mortgage crisis in 2007-2008 for instance. We tend to think, however, that given how pumped up the economy has been by monetary and fiscal stimuli we are bound to see a slowdown as the effects of tighter monetary policy trickle down. Further, valuations of risky assets, such as credit spreads, P/E multiples, etc. are not cheap vs. history, although equity multiples are below the levels of the dot-com bubble.
Hence, while we stay invested, we prefer to remain on the cautious side until we have more clarity about 2025. This means favoring larger cap, quality stocks and avoiding the small caps in the US. We should pay particular attention to earnings trends and balance sheets and watch for potential downgrades to earnings. In fixed income, a bond ladder in the mid-range of the curve makes sense, but we remain short duration overall, and light on the lower credit quality universe. Probably not a bad idea overall to keep some dry powder in case volatility comes back.
We don’t think it’s time to chase emerging market assets yet, despite their underperformance (India excluded). Some developed markets exposure makes sense, but the real catalyst for international equities will come when the dollar starts weakening on a global basis, potentially in a recession scenario here.
Lastly, with the elevated volatility levels, option premia have risen substantially and the potential returns from selling options could be attractive. For some investors, it may make sense to consider using options to manage risks, generate extra income, or reposition their portfolios. The exact strategy depends on one’s particular positioning and investment objectives. As always, caveat emptor! Good luck!
[1] The VIX index is the implied volatility derived from the pricing of the options on the S&P 500 index. The higher the index level, the riskier the outlook for equities.
[2] Given how volatile markets have been, the quoted market return numbers here will be only approximate, as daily changes can make them off by quite a bit.
