Storm Before the Calm

This is a long one, so we thought we would provide some bullet points up front before getting our hands dirty.

• Global markets led by Japan are down sharply to begin the month of August;
• The main drivers of the decline are:

1. weaker U.S. economic data exacerbated by Friday’s job report, which has stoked renewed fears of a U.S. recession;
2. the belief that the U.S. Federal Reserve is going to be too slow in cutting interest rates to spur the economy;
3. a more hawkish Bank of Japan (BoJ), which has caused a rapid unwind of the so called “yen carry trade”, which is a popular risk-taking tool for hedge funds;

• Friday’s jobs report showed job creation of 114k, which was below consensus of 175k. Further, there were downward revisions to prior months. While the headline was bad, beneath the surface, the fundamentals of the job market remain strong with prime-age employment at the highest levels in nearly a quarter century;
• Second quarter earnings are not reflective of an economy that is sliding into recession; however, elevated valuations have led to some weakness as some stocks were priced for perfection;
• The U.S. market has been led lower by the Magnificent 7 stocks with declines of between 10% and 25% since mid-July; however, all are still positive for the year;
• Things settled down a bit intra-day on Monday and more so overnight. The Japanese market, which was down ~12% on Monday bounced ~10% on Tuesday, while North American markets are trying to carve out a rally early on Tuesday;
• When the masses are headed for the one exit at the back of the arena, our inclination is to stay in our seats and assess the situation. This is not necessarily a recipe for doing nothing, but rather, mass exits often lead to those really juicy 3–5-year opportunities as markets tend to overshoot on the way up and on the way down;
• There have been 12,754 trading days over the past 50-years. The S&P 500 has traded down 2% or more in 386 of those days, which is ~3% or one in every 33 trading sessions. Over that period, the S&P 500 has risen 5,317% or 8.3% per annum.

Got to have a J-O-B if you wanna Be with Me

Global markets have come under heavy pressure in the past 48-hours with some wild swings. While there are several factors at play, the match that has lit the candle was the weak non-farm payroll number out of the U.S. on Friday, which has stoked recession fears. In addition, while the last Federal Reserve meeting struck a more dovish tone, the Fed Funds rate remains above 5% and with the next meeting not scheduled until September, there does not appear to be immediate rate relief coming for an investment landscape that seems to believe that the U.S. economy is sliding, and the Fed is going to be too slow in helping to prevent this slide.

Let’s start with Friday’s payroll numbers and provide some thoughts, before taking a look at some of the market impact.

We use the 6-month moving average largely because the month-to-month figures will tend to be quite volatile, but the bottom line is that payrolls have slowed considerably in the past few months. Now, we are going to note that the slide in the jobs data has coincided with the Biden Administration’s stiffer stance on immigration. The U.S. labor pool has taken a bit of a hit as a result of this tougher border stance, so we would be a bit cautious in overreacting to the decline. Further, one of the key indicators we look at in conjunction with non-farm payrolls has yet to show any signs of a slowdown:

The job market is often look at as a whole, but this masks the different subgroups that make up the overall system. The key subgroup is 25–54-year-olds, which comprise so called “prime-age employment.” While any weakness in the jobs market is bad (an economy not creating jobs is an economy that is not performing well), if the weakness is attributable more to the fringes of the job market – college aged men and women as well as those approaching retirement – then there is less cause for concern. As you can see from the above, the percentage of prime-age employment hit a cycle high in July (just under 81%) and is at its highest level in more than 23-years. Further, we would add the following chart:

Not only does employment remain very strong for prime-age workers, but it is doing so against a backdrop of a very high participation rate (highest since 2000). Further, we are going to note there was some noise in July around the hurricane in Texas with a surge in jobless claims within the state that was not matched nationally. So, while the jobs data is concerning, we would not have the panicked reaction we have seen from the broader investment community.

Okay, let’s pivot from the jobs data to the market’s reaction.

 

The Unwind

While we do not wish to get too technical, we are going to get our hands a bit dirty. There is something known as the yen carry trade, which involves borrowing money in Japanese yen because interest rates in Japan are near zero and thus borrowing there is cheap. The investor then converts these yen to U.S. dollars and invests either in U.S. treasuries, where rates are considerably higher, or in riskier assets such as stocks. Sometimes the investor will hedge out the currency risk (less risky, but there is a cost to hedging, so some return will be sacrificed) and sometimes the investor will not hedge (more risky as a sharp move in the currency can create losses). Let’s start with a chart and then comment:

As you can see, from the beginning of 2023 through mid-July of 2024, yen per USD rose from ~130 yen/USD to 160. Thus, investors both hedged and especially unhedged (a rising yen to USD ratio means that the yen is depreciating, so when you convert to USD and then convert back later on, you are making money on the currency) were doing extremely well with the yen carry trade. However, along with the aforementioned signs of U.S. economic weakness, the Bank of Japan raised interest rates by a quarter point last week in large part to combat the continued weakness in the yen. As a result, we have a double whammy of sorts in which U.S. interest rates are dropping on the back of signs of economic weakness and Japanese rates are rising on the back of a more hawkish BoJ.

This has caused many to unwind their yen carry trades, which has not only led to a sharp rally in the yen (again, a declining yen to USD ratio is a sign of yen strength), but also a sharp selloff in Japanese and global stocks. Sharp market selloffs are generally associated with rapid unwinds of leveraged positions and the yen carry trade has been at the forefront of leveraged investing for many hedge funds over the past couple of years.

 

Ready! Fire! Aim!

Let’s start with a chart and then comment:

 

The market has been led by the so called “Magnificent or Mag 7” since late 2022 (note that we substitute Eli Lilly for Tesla because 1) Elon Musk is a detestable human being and 2) Tesla is no longer magnificent). The group was up between 20% and 166% at their peaks in 2024, but since have given back between 11% and 23% of these gains. The S&P 500 is down ~7% from the peak, while the equal-weighted S&P 500, which mitigates the impact of the Mag 7 is down ~5%, which comprises roughly half of its 2024 gains. In other words, while the rally was top heavy, so has been the decline; although, the “average stock” has given back about half of its 2024 gains.

 

Big Declines are not Uncommon – Selling them is a Bad Strategy

Let’s look at a chart and then comment:

Over the past 50-years, there have been 386 trading days in which the S&P 500 declined more than 2% and 131 trading days in which the S&P declined by 3% or more. While these sorts of declines seem rare, the S&P 500 has averaged a 2%+ decline roughly once every 1.5 months and a 3%+ decline roughly once every 5-months. Despite this, the S&P has risen over 5,000% over this period (~8.3% per annum). Further, the median 1-year return post these declines has been ~17% with positive results ~75% of the time (note that 2008/09 and 2020 do skew this a bit, but even when excluded, the median return is still 15% and positive outcomes occur ~74% of the time).

Some General Final Thoughts

• The VIX, which is a good gauge of investor fear has gone from ~15% to ~30% in a matter of days. Too much complacency is generally a bad thing as it leads to too much risk-taking. Conversely, too much fear is generally a good thing as it leads to good long-term opportunities.
• In times like these, our first inclination is to take some deep breaths and ignore the urge to do something drastic. This does not mean the answer is to do nothing at all, but when everyone is trying to crowd through the out-door, you do not want to join the stampede.
• As we have highlighted a number of times over the years, stampedes for the exits tend to create opportunities to buy good businesses at distressed prices. This is not about catching the bottom in stocks, but rather thinking 3-5 years out and looking at projected returns when you can pick up something high in quality at a significant discount.
• While there are clear signs the U.S. economy has slowed, we have seen soft patches such as these over the past 2-years. In each of these instances, the knee jerk reaction has been to declare that a recession is nigh. While we would not rule out a recession in the next 6-12 months, we do not believe that the data currently suggests that a U.S. recession is a base case outcome. Rather, we believe that a slowing of nominal growth from the elevated levels over the past couple of years is more likely.
• We would be more concerned if there were signs that credit markets were beginning to break down. There are currently no signs of this and despite the sharp moves in stocks and some currencies, most indicators remain quite benign.