Market Essentials | August 9, 2024 Edition

If you do go off the grid, take a satellite phone …

Well, it’s summer, and we’re supposed to be relaxing, but I’m afraid there’s a lot to unpack (I know, just when you’d rather be packing!). So, broadly speaking, I’d say the economy is softening a bit, and corporate earnings have been good, but not a lot better than expected. If you’re a regular reader you’ll know I expected some spells of soft markets ahead of the election, and this is what we have just witnessed. I am not expecting the S&P 500 to slip much below the 5000 level (in fact I’d probably see that as a buying opportunity), but nor do I see a lot of upside to my year-end target of 5,300. To drive forward from here we’d probably need an election result that preserves the low corporate tax rate.

 

Over the last week or so we’ve seen a softening in tech stocks. They continue to have good earnings growth, but they have only met, rather than beaten, expectations. I don’t think we’re going to see the same acceleration in growth that we have witnessed going forward, and, if we’re to stave off cold feet and jitters, we’ll need to see a healthy return on investment to some of the extraordinary capital expenditure (capex) spending we have seen. The argument that companies have needed to spend either to avoid being leapfrogged, or to stay dominant, won’t cut it forever.

 

The elephant in the room – the unwinding of the yen carry trade

Now let’s address the elephant in the room – the unwinding of the yen carry trade. As a reminder, the mechanism here is that a weak and stable yen, that is cheap to borrow because of low interest rates in Japan, has been a funding mechanism for other higher yielding currencies and assets. This was all working very well for participants until the Bank of Japan threw a wrench into the works with an unexpected rate hike (albeit a small one), and some more hawkish rhetoric. The result was a sharp appreciation in the yen which likely triggered an unwind in the carry trade (remember carry traders have effectively shorted the yen, so its shooting higher is a problem). That led to a historic sell off in Japanese equities, the market was down around -20% at one point, led by some of the big banks which were down around -30%. So, just huge moves, not seen since the crash of 1987. But here’s the thing, I don’t fully equate what happened in Japan with the weakness in the U.S. and Europe. Why? Well, carry traders usually seek their higher yields in shorter dated fixed income paper, not stocks. So, it’s not clear to me that the tech weakness and the yen situation are as closely linked as some believe. Add to that the fact that most of weakness was concentrated in Japanese stocks (which, given their export-oriented nature, are more directly hit by a stronger yen). Frankly put, the Bank of Japan’s timing and messaging was strange. I think they got their fingers burnt, and I expect they’ll stand pat for a while now.

 

How about the Fed?

Well, the most recent payrolls report was that 114,000 jobs were created in July. That implies around 0.8% annual growth in the labor force, which is more than the normal 0.5% or so. But, just because that was weaker than expected, and, yes, the unemployment rate crept up (to 4.3%, from 4.1% before), that doesn’t mean, in my view, that the Fed either needs to hold an interim meeting, or to cut by 50 basis points (bps) in September. Indeed, I still think September is fifty-fifty in terms of a cut, and I am talking 25bps only. Furthermore, I think if they do move, it’s more likely to be because of the gyrations of the bond market, and less because of the labor market. Certainly there’s been a lot of volatility and hoopla this week, and that may foreshadow more to come, with the election and geopolitics still front and center known unknowns, but, if the yen stabilizes, as I hope it now has, I don’t think the Bank of Japan is on its way to a 1% rate, nor the Fed to cut to 4% as the market seemed to expect just recently. My view is still just a few cuts from the Fed, and I think they’ll be gradual.

 

Macro data does not warrant any panic

Keep in mind that, although the markets have been volatile, the macro data does not warrant any panic. Growth is slowing, but not falling off a cliff, and, although inflation is normalizing, it’s still above the Fed’s target level of 2%. Chairman Powell put plenty of caveats into even a 25bps cut in September in his last press release, and, to be quite frank, I think that cutting by 50bps so soon ahead of an election that could provide so much clarity on fiscal policy, and on tariffs (both of which have the capacity to reignite inflation) would be a mistake, one that could damage the credibility of the Fed and its policymakers. The wheels are simply not coming off this economy.

 

So, I know August is a time for the beach, and I do hope you get plenty of time to relax. But maybe take your laptop with you, and at least keep one eye on what’s going on.

 

Enjoy the rest of the summer… 

     

– David