On Monday, Wall Street was hit by a bout of severe tumult and suffered its worst day in almost two years. Global equity markets have since recovered some ground, but what drove the sell-off? Our Chief Investment Officer Bernard Swords shares his views on what’s driving the recent weakness, and what it all means for equity investors looking ahead.
In short, the recent weakness in equity markets has come from two sources: economic news flow from the US and the rapid unwinding of yen carry-trades.
1. Economic news flow from the US
Last week, one of the leading business sentiment indices in the US, the ISM Manufacturing index, dropped to 46.8, which is well into contractionary territory. This was followed by a weaker-than-expected jobs report (non-Farm Payrolls). And so, to see equity markets lower last week was hardly a surprise. However, we would advise caution about reading too much into a couple of data releases.
Firstly, sentiment surveys in the US have been consistently weaker than actual data. So, the manufacturing sector may not be as weak as this sentiment survey is suggesting. Secondly, not all the data has been weak. The ISM non-Manufacturing survey (covering a much larger part of the US economy) was released on Monday and it jumped to 51.4 – back into expansion territory. Other data points, such as second quarter GDP and Retail Sales, were stronger than expected. The fact that the data is mixed suggests that there is a slowing in growth in the US but that it is not alarming.
2. The rapid unwinding of yen carry-trades
Last week, the Bank of Japan raised its main interest rate to 0.25% - the highest level since the global financial crisis in late 2008. This was the catalyst that caused an unwinding of “carry trades” in world markets.
Padraig Rourke, Head of Active Trading Desk at Goodbody, explained: “A “carry trade” occurs when investors borrow relatively cheap money (Yen in this case) as there are low interest rates and little cost. This money is moved to higher yielding currencies or assets. The profit from this is the “carry”. Theoretically, investors can just move the money into other currencies and benefit from a higher deposit rate. As always, in markets some look for higher returns. A lot of the money has therefore ended up in other markets, and the tech market in particular.
“Following the rate increase in Japan, the yen rallied 12%. This firming reduces the attractiveness of the trade. A lot of the gains were wiped out and investors had to deleverage. The weakening currency had also helped the local market – the Nikkei. The strengthening currency caused a very significant correction. The index retraced by nearly a quarter in less than three weeks. The 12% drop alone on Monday was very significant. It has calmed somewhat since then but clearly a lot of the fall was technical with forced selling, stop losses and so on.”
Will these corrections cause economic dislocations?
It’s unlikely that these corrections will cause economic dislocations. Indeed, for France and Germany, and hence the euro area, it will be a relief that a competitor’s (Japan) currency is appreciating. Hence, we regard this as a market event rather than an economic event and, consequently, it is unlikely to have any material impact on the global economy and thus have any lasting impact on global equity markets.
Were you surprised by these developments?
These developments have not come as a complete surprise to us. We thought that equity markets would have to face a more challenging economic environment (see Chart of the week: a challenge). We were nervous that the ‘magnificent seven’ may have gotten ahead of themselves (see Chart of the week: Extended? Yes. A ‘bubble’? We do not think so). Lastly, we felt the Japanese market faced the risk of an appreciating currency (see Chart of the week: Japanese equities – all that glistens is not gold).
We are seeing that the ‘magnificent seven’ are correcting and the economic data still suggests a ‘soft landing’ to ‘no landing’. Hence, we are looking at any further falls in equity markets as a potential buying opportunity.
And have there been any positive developments?
There have been two pleasant developments in recent weeks. Firstly, bond prices have risen, so in a mixed portfolio they have given some relief. Secondly, interest rates will probably come down quicker in the developed world than we thought a couple of weeks ago. Central Banks will be more nervous about keeping interest rates higher for too long.
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