“What’s behind the market’s volatility?… In the real world, things fluctuate between ‘pretty good’ and ‘not so hot,’ but in investing, perception often swings from ‘flawless’ to ‘hopeless. That says about 80% of what you need to know on the subject.” – Howard Marks
Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities. As well, no part of this content was AI-assisted or created.
Friends & Partners,
Summer doldrums they were not. My fears came to fruition quickly – not a week after last month’s Partner Memo, markets faced a significant bout of volatility, which cratered the S&P500 by ~7%, and the TSX by ~6% in the course of a few days. This is the type of stuff that tests investor resilience and pain tolerance – we have been expecting and positioning for market volatility, a potential ‘growth scare’, over-bullish positioning in Artificial Intelligence stocks, and market instability exacerbated by certain ‘carry trades’ – all of which came to fruition and unwound earlier in August (and may again). Our clients barely felt a breeze from the storm outside, which is the goal of our portfolio construction.
So far, markets have bounced back in the following weeks. But, many are still bullish, and keep ‘buying the dip’. No one has a crystal ball, but there is still a respectable chance that we will see a recession. And get another ‘growth scare’. And this all gets exacerbated by market structures like the ‘carry trade’.
Over the past two weeks, we’ve seen all of the negative factors I noted above partially reversed. First, the yen has declined moderately as Japanese officials “talk down” the yen and the idea of more rate hikes. Second, AI earnings have been a bit better lately. Third, economic data has pushed back against the idea of an imminent economic decline. Those events, combined with chasing from investors who wanted to buy the dip and think they’ve missed it, has underwritten this bounce in stocks.
However, do not confuse the near-term optimism with longer-term issues that must be considered. First, the Bank of Japan (BOJ) is still doing the opposite of every major central bank in the world (i.e. they are still tightening policy and increasing interest rates). Yes, the market reaction slapped them back, but it’s not over. BOJ policy will continue to tighten while in the rest of the world, policy is getting easier (i.e. lower interest rates). That means we should expect more bouts of yen carry trade unwinds, because the yen is still extremely low vs. the US dollar and that likely will not be allowed to exist deep into the future (the weak yen is inflationary for the Japanese economy which is what the BOJ is trying to fix).
Second, U.S. economic data has been better than feared, but those fears were irrational and they are obscuring the fact that the U.S. economy is slowing. The truth in the data is that U.S. growth is slowing and the only question is by how much. That’s often not a great environment for risk assets (like stocks) over the longer term.
So, are we going to get a recession or what? In short – maybe. Think of it this way: the message from all of the data points (in my view), is that things are weakening, but it’s still signaling a ‘soft landing’ (meaning we likely skirt an actual recession). It’s like being at a hockey game and your team is leading by three goals. You go to get some concessions and when you get back to your seat, your team is only up by one. Yes, they’re still winning, but the trend is worrisome. That’s how to think about economic data right now.
Short Aside – What The Heck Is A Carry Trade?
Many of you have heard quite enough about the Japanese Yen carry trade, which was a contributing factor to the market noise in early August. Here it is in a nutshell:
Since Japan has essentially zero interest rates, you can borrow yen in Japan, pay 0% interest, convert it into Mexican pesos (or USD, or a million other things), and stick it in a Mexican bank where it will earn 8% interest. You earn the ‘carry’. The yen carry trade involves massive leverage, which magnifies a seemingly insignificant 15 basis point rate hike into a major bottom line hit for traders. This is a “picking up nickels in front of a steamroller” type of trade – I know a thing or two about these types of trades, having run a ‘risk arbitrage’ desk for well over a decade. I wouldn’t classify these as good trades a lot of the time. But I digress.
It wasn’t just the unwind of the leveraged Yen carry trade that caused the market noise last month, it was an unwind of a series of trades based on the complacency that the markets were going to stay in a low-volatility and stable environment. Investors have been piling into a series of volatility-selling products to enhance income for quite some time. Things weren’t going to end well; it was just a question of when. We saw this exact movie just a few years ago! Memories are short in financial markets.
These trades work – until they don’t. When things start to turn, they turn fast, and a carry trade can get crushed. Volatility happens in spurts. I don’t know if the storm has passed, but for now it seems to have. But I’m acting as if it has not. You can still make money and not be out the risk curve. That’s what we do.
Putting all of this together, markets are growing guarded and are becoming more attuned to a growth slowdown (as we have been warning about for a few months). Spending is becoming more cautious with less support in the US from anticipated rate cuts, while the unemployment rate is climbing. Sentiment towards the AI boom has been overextended and wavering, and the party is over in Japan which was the last cheap place to borrow in the world. As always, we assess the positives as well as caution signs, and tactically build defensive and resilient portfolios. The markets tend to climb a wall of worry over time, but we remain prudent as always. As the great Howard Marks noted, ‘you can’t predict, but you can prepare’. Which is what we do.
Other Interesting Updates
Join us in extending a warm welcome to Robert Amos, who is joining the Chapman Private Wealth Group. Robert recently graduated from St. Francis Xavier University with a Joint Honours in Business and Economics (BBA) where he had the privilege of managing a portion of the university’s endowment fund through Xaverian Capital (a student-led investment fund).
We have a unique business that goes above and beyond, so Robert is a perfect fit. Robert will be a dedicated and invaluable member of the team, supporting clients and advisors on the road to reaching their wealth management goals, and will grow in his role in short order I am sure. We’re thrilled to have you on the team, Robert! You will do great things.
Time Away
A stunning place – we went for a week in mid-August for a family vacation which was fantastic. But it got me thinking.
There’s a saying that if you love what you do, you’ll never work a day in your life.
Not many of us are blessed with truly loving what we do to our core – some talk that talk, but few walk that walk.
I do truly love what I do. Many entrepreneurs are in that boat. And for those in that boat, the concept of fully “checked out” vacations is usually a bit baffling. I don’t set an ‘out of office’ alert on vacation (at least when I have access to cell service) since I always stay on top of emails and messages. My clients know I’m never more than a few minutes away from responding – whether that’s on evenings, weekends, holidays or vacation.
This doesn’t take a tremendous amount of time or bandwidth to do, but keeps me checked in and accessible to my clients, who are like family to me. And my team is second to none, and is always there to back me up and support me and our clients.
Perhaps this is a sickness, and doesn’t work for many – it’s opposite of being a procrastinator, a form of ‘precrastination’ I suppose (but certainly not at the expense of the output or final product). But being this way works well for me, my team, and certainly our clients.
Caution Signs To Heed*
The yield curve is uninverting, an event that has historically occurred on the eve of recessions:
A spike in volatility is usually a sign that the economy is about to slow ... in this case it is "discounting" or "pricing" in an abrupt slowdown. We shall see.
Source: Trahan Macro
If recession hits, it’s often too late to get out of the way. History shows that a recession arrives suddenly and is difficult to see coming:
Even Fed rate cuts tend to be too late. They cut before the recession but the damage is already done:
Company earnings aren’t jiving with GDP, they’re heading in opposite directions. It is possible this can persist, but based on 40 years of data, looks unlikely the divergence will last. Someone is wrong.
Finally, investor positioning isn’t good. There is evidence of the greed in markets, which can be seen in the largest ever allocation to equities on the part of households:
There Are Positives As The Markets Climb ‘The Wall Of Worry’*
The markets have been rattled by a series of weak economic data, but it’s not time to panic. Economic growth is decelerating, but it’s not recessionary at this point. The Fed and Bank of Canada are signaling imminent interest rate cuts as long as inflation data remains soft. The U.S. economy is in a not too hot, not too cold Goldilocks growth scenario that should continue to be investor friendly.
JP Morgan noted this past week that it was the first time since November 2020 (and only the 46th time since 1950) that the S&P 500 followed a 10-day loss of at least 6% with a 10-day gain of more than 8%. Historically, rebounds like this have been powerful: average returns are nearly 20% six months later and over 25% a year later.
So the question is whether the stock market sees a short-term bottom or continues to fall after the initial volatility spike. There appears to be two categories of bottoms:
- Sudden panics, usually from unexpected reversals of crowded positions, and these tend to reverse themselves quickly.
- Longer term declines occur when the roots of the decline are macro or fundamentally driven, such as the Financial Crisis in 2008, the Eurozone crisis of 2011, and the COVID Crash of 2020. In all cases, stock prices were higher a year later!
The latest panic appears to be in the first category. And stock prices are recovering accordingly and could well continue.
With interest rates heading lower in both the US and Canada, we have to also heed that bonds historically have a good run following that point:
My friend and former colleague, Brian Belski, who is the Chief Strategist at BMO, notes a few interesting things as well. Cash on the sidelines is a tailwind for the TSX which could drive Canadian equities higher through the remainder of the year and beyond. As of the end of the first quarter 2024, Canadian households continued to hold decade high levels of cash and cash equivalents, with both household money market funds and cash holdings near 10-year highs. In fact, his work shows that the TSX tends to bottom and exhibit strong returns when cash positions decline from peak levels, with peaks in money market assets under management often coinciding with troughs in TSX performance:
He also reminds us that September is usually choppy. But there’s a silver lining: September has been the weakest month of price performance for the S&P 500 registering an average loss of 0.7% and significantly lower than February, the second worst month with an average loss of 0.1%. Nonetheless, even if the market repeats this trend this year, we should remain optimistic longer-term because the market staged an impressive comeback during 4Q in each of those years, with an average gain over 10%:
Labour market is softening which is key to the outlook on the economy – but Claudia Sahm, the creator of the Sahm Rule recessionary indicator which everyone is pointing to as having recently been triggered, pointed out a key anomaly in the current circumstances. What’s really unusual is new job entrants to the labour force aren’t losing their jobs compared to last Sahm Rule recessionary triggers. Sahm attributed this to the effects of immigration: “Increased labour supply from immigrants pushing up unemployment and not a sign of weakening demand as is typical in a recession.”
For equity investors, whether the economy is recessionary or pre-recessionary matters. The stock market has continued to rise in past rate cuts if the economy continues to grow, but fallen if the economy is in recession.
Is the economy collapsing? No. References to a recession on earnings calls have fallen to 2021 levels when there were hardly any worries of a weakening economy. It is also notable that truck tonnage is improving, something you would not expect to see if the economy was dropping hard:
