Carried Away

The most important trigger for the recent equity sell-off wasn’t the U.S. jobs data, or the Fed, or even mega-cap tech earnings, but the Bank of Japan.

We could talk about the recent U.S. nonfarm payrolls report in this week’s Perspectives: Was it really as bad as all that? We could dissect the last U.S. Federal Reserve meeting: Should the central bank have cut rates, and did it just commit a significant policy error?

But if we want to pinpoint the single most important catalyst for last week’s exceptional market volatility, we think we need to look to the other side of the world. The Bank of Japan’s July 31 rate hike looks increasingly like a game-changer.

Trigger

That change in monetary policy has suddenly reversed a prolonged decline in the Japanese yen, which has soared by around 10% against the U.S. dollar in the past month.

That, in turn, appears to have been the trigger for the recent equity market sell-off, which started with a 3.3% drop for the Topix Index before spilling across global markets and culminating in a precipitous, 12.2% plunge in Japanese equities last Monday. The Bank of Japan’s Deputy Governor Shinichi Uchida certainly drew the connection: Following the rout, he strongly suggested there would be no more hikes until markets had settled down.

The declines in Japan were steepest in stocks that have exhibited strong momentum over recent months. Ironically, that included financials, even though they had been outperforming because investors expect them to benefit from higher rates—a big sign that these moves were more technical than fundamental. The other sector to get badly hit was large-cap technology, a move that was mirrored by the subsequent losses in the U.S. market. The yen and the Nasdaq Index have been moving virtually in lockstep for the past 18 months.

A Harder Bargain

Why were the Bank of Japan and the yen at the center of these events?

Raising rates by 25 basis points may not seem like a big deal, especially when it is the second hike in the cycle. But it is a big deal when it’s Japan, and when the central bank signals more to come, and when the country’s inflation rate appears to be settling well above 2% for the first time in more than 30 years.

It is especially big news because, as my colleague Robert Surgent observed last week, the yen has been the most emblematic source of funding for global carry trades for years.

If you’re going to borrow to invest, you borrow the currency with the cheapest interest rate and the lowest expected volatility. There have been plenty of candidates since the Global Financial Crisis, particularly since multiple yield curves slumped after the COVID-19 pandemic, but with Japan stuck in near-zero inflation since the 1990s, the yen has been the cheapest and steadiest of them all.

The sun may have finally set on that era. With funding costs and funding risks now rising, tolerance for higher equity market valuations may be wearing thin. An affordable mortgage allows you to borrow more and pay a higher price to secure the house of your dreams; if the repayments look likely to stretch your budget, you’ll drive a harder bargain.

Investors just started driving a harder bargain—especially for large- and mega-cap tech, but also for other speculative, leveraged and carry-trade-funded assets, from Bitcoin to emerging markets currencies.

Recession

This is not to say that the sell-off was entirely due to carry trades unwinding, or the technicalities of a pick-up in yen rates and volatility.

In an exquisite case of poor timing, the Bank of Japan’s move coincided with some earnings reports indicating that there might be a limit to mega-cap tech profit growth, after all. At the same time, many of these companies are having to pivot from being capital-disciplined generators of enormous free cash flow to combatants in an artificial intelligence capex arms race. Not only has the mortgage rate risen, but the dream house needs a little more fixing up than first thought.

What we would say, however, is that we believe this sell-off is not about the market pricing for a generalized U.S. recession, or even for a broad-based rerating of every equity sector.

In our view, the latest, severely weather-affected U.S. jobs report was weak, certainly, but not disastrous. The Atlanta Fed’s GDPNow model estimates that the third-quarter annualized growth rate will be 2.9%. It’s good to keep in mind that a soft landing is still a landing—but economic activity is slowing, not grinding to a halt.

Opportunity

As such, we do not believe this is a time to shrink from equity markets, and we think the ongoing recovery from the sell-off reinforces that view. Rather, the recent volatility offers investors three useful reminders.

First, be cautious about mega-cap tech and its dominance of the major benchmark indices. Second, recognize that the ramp-up phase in artificial intelligence was always likely to require significant capex and R&D spending for many tech companies, and to provide a boost to other sectors at substantially lower upfront cost. And third, respond to this by broadening and diversifying your exposures.

Big carry trades don’t get unwound overnight, so investors should add this, along with politics and the monetary policy transition, into the mix of things likely to keep volatility elevated over the coming months. When these dynamics spill into other segments of the market, however, we see a source of opportunity rather than anxiety.