Market Update August 5th

Global risk off around the world on Monday, but volatility and the decline in prices have calmed significantly as we write this letter. Interestingly, the 30-day futures contract on volatility still remains high (Table 1).

Bearish talk around the ongoing ramp in AI scrutiny, Middle East tensions, US political uncertainty, weekend release of the Buffett cash pile from recent sales and negative seasonality helped fuel the selloff, triggering lots of "Fed behind the curve" chatter and speculation of an inter-meeting Fed rate cut. Our take is that in the more intermediate term, politics, earnings, and valuations will play an important role in the market performance while today was likely triggered by the Yen carry trade. Let’s take a deeper look.

The Bank of Japan recently raised rates to 0.25% ending their negative rate policy. For years, traders took advantage of these low rates to conduct a carry trade. In this trade, investors would borrow Yen at low rates, convert Yen to dollars (and other currencies), then invest in assets such as the NASDAQ. The wide spread in rates between the US and Japan lent itself well to this trade. Then, last week, the Federal Reserve signaled they would cut rates in September while the Bank of Japan raised rates, thus decreasing this spread which strengthened the Yen and started margin calls. Margin calls, or forced selling / unwinding of trades, can lead to excessive volatility in the market as seen this morning. This trade in the Nikkei 225 resembles what occurred in 1987 during Black Monday (Table 2).

Many are calling on the Fed to trigger an emergency rate cut to help the market, however the economic data that has come out of the US is not dire and the Fed has successfully slowed the economy:

Negative - July 31st ADP Non-Farm Payroll: July Change in Employment was 122k vs 147k estimate

Negative - August 1st Initial Jobless Claims: Change was 249k, higher than 236k estimate

Negative - August 1st Manufacturing PMI: Lower than estimated in contraction at 46.8

Negative - August 1st Atlanta Fed GDPNow quantitative model: 3Q GDP 2.5% estimate down from 2.8% Negative August 2nd July Unemployment Rate: 4.3% vs 4.1% estimate

Positive - August 5th Services PMI: 55 for July, still expansionary yet 1pt lower than the 56 estimate

Positive - August 5th ISM Non-Manufacturing PMI: In line at 54.4, up from 48.8 at last read

Given manufacturing data remains weak while services are strong reinforces the theme we have been discussing for over a year. The economy has been in an industrial recession but not a consumer one. The September rate cut is now all but cemented, with some extending their concerns to the possibility of a hard landing. While the suddenness of the “crack” in the labor market is unideal, this portends near-term rate cuts, but not necessarily a hard landing

While markets are down <10% (>15% for Nasdaq and Japan) from their highs, growth and the market cap index remains expensive. (Figure 3) Our initial reading into Q2 earnings suggests relative weakness vs Q1. While current growth rates are positive and even higher than Q1, future trajectory remains questionable. An increasing proportion of issuers has missed Q2 earnings and lowered their Q3 guidance signaling the ability to maintain a high growth trajectory might be too rosy.