This Monday was one of the worst days for
global stock markets in years, Stocks in the US, Europe and Japan tanked on Friday and again on
Monday before a partial rebound. Bond yields and foreign exchange rates swung around wildly
too. The VIX index, a measure of expected US stock market volatility rocketed to its highest
level since the pandemic meltdown in early 2020. The VIX essentially tracks how expensive stock
options are and can be seen as a measure of how worried investors are about large market moves in
the near future (either up or down). It had been sitting at around 12 for most of the year – which
was quite low and implied that investors expected calm - before rocketing to 65 on Monday. It
has since returned to a more moderate 22.
Japan – which we have talked about quite a lot
here over the last year was at the center of the storm. The Topix index fell 12.2% on Monday,
having hit an all-time high just three weeks earlier. The sell off wiped out its entire year
to date gains. The press described it as the worst Japanese market crash since 1987 (something
we will come back to in just a moment). The index rebounded 9 per cent the next day prompting
the FT to describe it as “Trading like a penny stock.” which is not what you want to hear
about the third largest economy in the world.
US markets, which had been strong all year
fell almost 8% from their recent highs and the tech heavy Nasdaq fell almost 13% over
the first three trading days of the month.
The Magnificent seven stocks – a term coined
by Michael Hartnett at Bank of America about a year ago to describe the hottest tech stocks
that retail investors are most focused on, lost about $1 trillion dollars in just
two days. So, what exactly is going on in markets, and how much should we worry?
Well as always in markets there is never a quick and easy explanation, but the spark that
lit the explosions in all of the YouTube finance thumbnails this week was last Friday’s US jobs
report, which showed a much sharper slowdown in hiring than Wall Street expected.
For a spark to turn into a fire, you need some fuel and there was plenty of dry
fuel lying around. The ISM survey of manufacturing businesses from the day before had shown that
industry economic activity had contracted at a faster rate than the prior month, and this
was the fourth contraction in a row. There had been a few soft earnings releases too, for
example at Microsoft, cloud services growth had slowed slightly to 29 per cent year on year,
down from 31 per cent in the previous quarter. That doesn’t sound like a big deal – except
if these stocks are priced for perfection.
Apples revenue growth appears to be stagnating
too, and its management are now pinning their hopes on AI (much like all of the others), which
investors hope will revive growth. But so far, it’s hard to know how that might work.
According to Bloomberg if AI fails to pay off, Apple starts to look more like Coca
Cola than high growth tech company.
Markets which had been pricing in a guaranteed
soft landing (meaning an end to inflation without a recession) and really no political risk as
I discussed in the recent Trump Trade video suddenly started assigning some probability
to a hard landing. Goldman Sachs said over the weekend that it now believed there was a
twenty five percent chance of the US falling into recession in the next year, compared with
its previous forecast of a 15 per cent chance.
The recent rise in the stock market has been very
much driven by the US consumer – and consumer strength is a function of the labor market.
Other evidence of a consumer slowdown can be seen in the earnings reports from Disney Airbnb
and Hilton, all of whom are seeing lower demand.
While US inflation has cooled – meaning that
prices are no longer rising – the consumer is still dealing with higher prices. According to
the San Francisco Federal Reserve – Households have now spent the excess savings that
they had accumulated during the pandemic.
As investors internalized the fact that six
of the last seven major US labor releases had been disappointments, they started
to question stock market valuations.
Because of time zone differences, The Japanese
market was closed for a big part of the US sell off on Friday. Part of the decline in the
Japanese market can be attributed to just catching up with the US market – as the US market
tends to drag other markets around with it, but Japanese investors were slowly digesting the
surprise 25 basis point interest rate hike that had been announced the prior Wednesday and they
began to panic when their market opened on Monday. A big move in one market can lead to big moves in
other markets because of interconnectedness and the way institutional risk management works.
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The 25-basis point hike in Japanese interest
rates doesn’t sound like a big move, but it was a surprise announcement, and it is
the highest interest rate seen in Japan since 2008. Policymakers also announced that they
would be halving monthly bond purchases and hinted that there would be more rate hikes
in the pipeline. This was a big change.
Japanese stocks had hit new highs over the summer,
and the Yen had been in a long term downtrend, which was starting to cause problems. By July, the
Yen was the weakest it had been against the dollar in 34 years. This wasn’t a strong dollar issue
either, it was weak against every other developed market currency too. While Japanese policymakers
wanted inflation – they were worrying that the weak yen was causing the wrong sort of inflation
– where imported goods were getting expensive, rather than Japanese goods and services. This
meant that money would just leave Japan and do nothing to boost the local economy. The
policy makers are aiming to spur inflation, which would be good for Japanese businesses who
would then be forced to increase wages leading to a virtuous cycle where Japanese workers earn
more and spend more – kickstarting the economy.
Japan’s core inflation rate had been above the
Bank’s 2% target for 27 months and there was concern that the decline in the yen was
just hurting consumer spending. The FT reports that Japanese government officials
had put pressure on the Bank of Japan to hike rates and arrest the yen’s decline.
The interest rate hike on the 31st of July did have an impact. The Yen strengthened quickly
and on Thursday and Friday the stock market sold off - with Toyota, Panasonic and Japan’s
biggest banks being the biggest losers.
Toyota had just reported record profits, boosted
by a favorable exchange rate and increased consumer interest in hybrid vehicles rather than
pure electric vehicles. The weak yen, which boosts the value of overseas profits for Japanese
exporters, also helped. It’s price decline added two and a half billion dollars in operating
profit to the firm over the quarter. The problem with that is that if the yen were to strengthen
– like it did - the opposite would happen.
Over the last three years, the yen carry trade —
which involves borrowing at a low interest rate in Japan to fund investment in assets elsewhere
that offer higher returns — has exploded because of Japan’s ultra-low rates which contrast with
higher interest rates around the world. With the carry trade you can buy foreign bonds
to earn the interest rate differential, or you can buy other risk assets. This is
a trade that works as long as the foreign exchange rate doesn’t move and wipe out all
of your profits, or even cause you losses.
Low rates in Japan combined with higher
rates around the world - especially in recent years - as central banks have been hiking rates
to fight inflation caused this trade to explode in popularity. It’s not just forex speculators
who do this either, big Japanese companies often keep their foreign earned income abroad to
reap the higher interest rates available.
The low-return environment in Japan over the
last thirty five years led the Japanese into being amongst the biggest capital exporters in
the world: they own over a trillion dollars of US Treasuries and half a trillion Euro bonds.
Commerzbank estimates that Japanese international investments come to around four
trillion dollars in total.
The rapid appreciation of the yen brought about
by the rate hike forced hedge funds and other leveraged investors to rapidly unwind their carry
trades. This was a big contributor to the extreme volatility in global markets over the last ten
days or so as investors rushed to dump assets, they had purchased by borrowing in yen.
The way risk management often works at big financial institutions is that when a big
loss occurs in one investment strategy, the risk management team often walk around the trading
floor telling traders who are running completely different strategies to cut their position
sizes. As these traders cut their position sizes, the spreads that they are trading widen, causing
further losses, and further cuts in risk. This can lead to contagion, and experienced traders
who hear about a loss on a different trading desk often cut their positions right away – as it
is better to get out quickly before the spreads start widening due to industrywide deleveraging.
We saw a huge spike in stock market correlation on Monday – correlation being a measure of
the degree to which stocks move up or down together - as shares across the market
fell in lockstep. This was a big change as in July correlation had hit a record low,
helping to dampen overall market volatility.
I’ve made a few videos about Japanese
markets over the last year or two and still feel that the Japanese market might be the most
interesting thing going on in markets right now.
My first video on the rise and fall of Japan
was made after finding a 1988 article George Soros had written in the wake of the 1987 crash.
In it he argued that the crash had signaled a transfer of financial and economic power in the
world economy from the United States to Japan.
In the crash, Japanese stocks fell around 15%,
which was much less than the 23 percent decline in the United States. On top of that, the
Japanese market recovered to its pre-crash levels in just five months. While the US,
UK and Germany all needed more than a year to achieve the same level of recovery.
The Japanese market appeared to do better as the ministry of finance pushed the nations four
largest securities firms to start buying stocks to keep the market afloat. Japan was able to keep all
of their balls in the air for a few years longer, but since 1990 the nation has been in decline.
In 1989, 32 of the 50 largest companies in the world were Japanese and Japan’s stock market was
worth 45% of the whole global market, while the US was at 33%. Today, Japanese stocks are 5.4% of
the global market and only one Japanese company (Toyota) is in the global top 100.
Japan has been struggling to recover from the malinvestment brought about by excessive
government interference in markets for thirty-five years. Today, western politicians look to Chinas
economic miracle driven (once again) by government interference and wonder if they should mimic
the industrial policies that appear to be generating all of this growth.
Japan’s public debt reached $9.2 trillion dollars as of March 2023 and at 263
percent of GDP is the highest debt to GDP ratio in the developed world - more than twice
the debt to GDP ratio of the United States. Servicing this debt is already a struggle and
will become more difficult if rates rise and the yield-curve control program is abandoned.
Japanese stocks broke a number of records last week — their combined 20 per cent fall over the
three sessions from last Thursday to Monday was the biggest drop ever, wiping $1.1trillion dollars
off the value of the stock market. On Tuesday, the stock market bounced back by almost 10 per
cent in the steepest rally in almost 16 years.
The Yen did seem very cheap at its lows,
but the Japanese economy did contract in the first quarter of this year – so while the
rate hike may have helped the yen, the Bank of Japan is hiking rates into a weak economy.
The severity of the market reaction is likely to have surprised the central bankers, but even
after the decline the Topix is still up 4.4% year to date and up 65% over the last five years.
Pressure on the Yen can be expected to wane if the US starts cutting rates as the market
now expects. interest rate differential will become less extreme under that scenario.
The reason the Japanese market is so interesting is that Japan is on a completely different
economic cycle to the rest of the world, trying to spur inflation when the rest
of the world was fighting inflation, and now hiking rates when the rest of the world
is either cutting rates or thinking about it.
For the last year, Japan has looked like it might
finally return to economic growth. But, over the past 30 years Japan has seen many false dawns,
and the country is facing some big structural problems that won’t go away – their ageing
population, low growth and high public debt.
Over the last few days, the S&P500 all but erased
the losses suffered by investors in a week that included some of the worst and best days for
US stocks in almost two years. The jobs report, added to fears that higher interest rates
were finally having an impact and slowing the economy reducing companies hiring and consumers
willingness to spend. This is only so much of a surprise, as that is the mechanism through
which higher interest rates reduce inflation, and it is not a bad thing for investors to
be considering the risks when investing.
Blaming the carry trade unwind on the declines
in the US stock market might be unreasonable, as the carry trade was by no means
what was driving the rise in the US stock market over the last few years.
The worry with US stocks is that the magnificent seven - which have been driving stock
market returns for quite some time - are failing to deliver on the sky high expectations that
investors have for them. The magnificent seven had contributed 52% of the Year-to-Date return
of the S&P 500 through to the end of July. If you excluded Tesla from that group – as it
has been falling for close to three years – the contribution of the remaining six stocks
to US investors returns has been even higher.
As I mentioned in last week’s video, the big
tech firms have been laying off staff for quite some time and more worryingly – insiders
have been selling their stock. Indicating that they are possibly less excited about the
AI future than the rest of the market is.
Leadership at Amazon, Meta, Alphabet, Nvidia
Apple Microsoft and Tesla have all been selling.
Last weekend we learned that Warren Buffets
Berkshire Hathaway had sold 390 million shares of Apple – which was about half of its
stake. Buffet started paring his position last year but really stepped up his sales in 2024.
The antitrust judgement against Google – finding that they have a monopoly in search came out on
Monday, this wasn’t just bad for Alphabet – but also for Apple as court documents showed
that Google paid Apple $20bn in 2022 alone, a huge chunk of Apple’s services business,
which includes its App Store and Apple Pay.
If Alphabet is no longer allowed to pay apple to
be the default search engine on their devices, Apple might leave the choice to customers –
like they do in Europe – where most customers pick google – but Apple will receive no payment.
Earnings for the big US tech firms have not been bad at all. For example, if you look at Alphabets
core businesses they have been doing just fine. But Alphabet (just like the others) is spending a
fortune on AI which is not yet making money – and there is no obvious path towards profitability
either. This is the case for all of the big tech firms other than Tesla who have just been having a
bad year as demand for their cars has dried up.
It is not yet obvious how the big tech firms plan
to make back the money they are spending on AI and interestingly, a recent study from Washington
State University found that including the term "artificial intelligence" in a product description
made consumers significantly less likely to buy a product. So not only is there no clear path
towards monetization, customers are possibly steering clear of AI branded products.
MIT researchers argued in a recent report that the types of AI being developed at the big
tech firms is not designed to solve the kind of complex problems that would justify the costs,
and the costs may not decline as many expect.
Big tech has been a crowded trade for
quite some time and investors have made a fortune owning these stocks, but they
are possibly getting a bit nervous.
An other big story during the big sell off on
Monday was that brokerages like Charles Schwab, Vanguard and Fidelity experienced outages on
their trading platforms, leaving some retail investors unable to trade on Monday. This is
somewhat reminiscent of the brokerage outages that occurred during the meme stock frenzy
a few years ago, and indicates how excited investors got over the market drama,
During the market sell-off on Monday, the treasury yield curve, which has been inverted
for two years briefly returned to normal. An inverted yield curve — where two-year interest
rates rise above 10-year interest rates — is said to signal that a recession is on the
way. An inverted yield curve has probably predicted twenty of the last seven recessions.
Anxieties prompted by the bad jobs number were also heightened by the fact that the data release
triggered what is known as the Sahm rule, devised by and named after the economist Claudia Sahm.
The purpose of the rule is to act as an early warning signal of recession. Claudia Sahn came
up with the rule in early 2019 to act as an automatic trigger for policymakers to step in.
The way it works, according to its creator, is that when the three-month average
of the US unemployment rate is half of a percent or more above its low of the prior
12 months, the US is already in a recession. This rule back tests well, but Claudia Sahn
warned earlier this week on Bloomberg that as any investment prospectus will tell you: Past
performance is no indication of future results.
Some economists have argued that some of
the surge in the recent unemployment number reflected a temporary Hurricane Beryl effect
as power outages on the gulf coast led many businesses to stay closed and temporary
workers to sign on for unemployment.
Matthew Klein pointed out on his blog that
while the job market may not be great, it is better than it first appears. He points
out that economic downturns normally feature large increases in the number of workers
who lose their jobs and don’t expect to be rehired. These “permanent” job losses are quite
distinct from situations where people enter the labor force but don’t immediately find a
job, or when people are temporarily laid off but expect to be rehired shortly, there
are also people who finish temporary jobs, and “job leavers” who quit without
immediately finding another job.
He says that bad labor markets also feature
large increases in the number of workers who lose their jobs and stop actively looking for
work. This group are not counted as unemployed, but they are counted as people outside
the labor force who “want a job now”.
He highlights that the recent increase
in the unemployment rate is almost entirely attributable to the categories of
joblessness that are least representative of bad underlying economic conditions.
Claudia Sahm also wrote on Bloomberg that there are signs that stronger labor supply, not
just weaker labor demand, helped push the Sahm rule past its half a percent threshold. Unemployed
entrants to the labor force (new or returning) accounted for about half of the increase which is
a notably higher share than in recent recessions, when most of the contribution came from
unemployed workers who had been laid off temporarily or permanently. She says that the
current Sahm rule reading is likely overstating the weakening in demand and is not at recessionary
levels. She does argue however that the federal reserve should be thinking about cutting rates.
It has been quite an interesting week in markets, with many wondering if we are in a period of
regime change. Rate increases are supposed to slow the economy as that is how they reduce
demand for goods and bring down inflation, and that is exactly what they are doing. The
higher rates have by no means eliminated risk taking, as evidenced by the fact that meme
stocks and crypto are still riding high.
One way higher rates slow the economy
is by weakening the job market – last weeks video on Tech layoffs looked at how low
interest rates can lead to moonshot projects, but when rates go up, investors start expecting to
see a return on their capital, and they begin to care about the timing of the cashflows.
Real US GDP grew at an annual rate of 2.8 percent in the second quarter of 2024,
so it’s not like economy is doing badly and most global equity markets have reversed the
majority of Monday’s losses. Volatility is higher than before, and a lot of big earnings
numbers still have to come out. A big signal of the health of the US tech sector will be the
Nvidia earnings report at the end of this month.
One of the big lessons of the week is that it
usually doesn’t pay to panic in a sell off. The brokerage website outages on Monday likely
saved a few panicked investors some money if they were trying to sell near the lows.
If you enjoyed this video, you should watch my video on the rise and fall of Japan next.
Don’t forget to check out our sponsor NordPass using the link in the description. Talk
to you again in the next video. Bye.