Shower | I’m looking for Alpha

By Shannon L. Saccocia, CFA

The biggest trigger for the recent sell-off in stocks wasn’t the US jobs data, or the Fed, or even mega-cap tech earnings, but the Bank of Japan.

We could talk about recently This week’s US non-farm payrolls report Perspectives: Was it really as bad as all that? We could dissect the US Federal Reserve’s last meeting: Should the central bank cut rates and did it just make a significant policy error?

But if we want to identify the 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 is looking more and more like a game changer.

Trigger

This change in monetary policy abruptly reversed a prolonged decline in the Japanese yenwhich is up about 10% against the US dollar in the past month.

This, in turn, appears to have been the trigger for the recent stock market sell-off, which began with a 3.3% decline in the Topix before spreading to global markets and culminating in a steep 12, 2% of Japanese stocks last Monday. . Bank of Japan Deputy Governor Shinichi Uchida certainly made the connection: In the wake of the rout, he strongly suggested there would be no more hikes until markets settle.

Japan’s declines were heaviest in stocks that have had strong momentum in recent months. Ironically, that included financials, although they outperformed as investors expect them to benefit from higher rates – a big sign that these moves were more technical than fundamental.

The other sector hit hard was large-cap technology, a move that was mirrored by subsequent losses in the US market. The yen and the Nasdaq have moved virtually in lockstep over the past 18 months.

A tougher business

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’s the second hike of the cycle. But it’s a big deal when it’s Japan, and when the central bank is signaling more to come, and when the country’s inflation rate looks set to settle well above 2 percent for the first time in more than 30 years.

This is particularly big news because, as my colleague Robert Surgent noted last week, the yen has been the most iconic source of funding for global transactions for years.

If you’re going to borrow to invest, borrow the currency with the cheapest interest rate and lowest expected volatility. There have been plenty of candidates since the global financial crisis, particularly since multiple yield curves collapsed after the COVID-19 pandemic, but with Japan stuck in near-zero inflation since the 1990s, the yen has been the cheaper and more stable of 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 thin. An affordable mortgage allows you to borrow more and pay a higher price to secure your dream home; if repayments seem likely to stretch your budget, you’ll be driving a tougher deal.

Investors have just started to drive a harder bargain – particularly in large-cap and mega-cap tech, but also in other speculative, leveraged and carry-traded assets, from Bitcoin to emerging market currencies.

Recession

This is not to say that the sell-off was entirely due to a resumption of trading or the technicalities of a rise in yen rates and volatility.

In an exquisite case of bad timing, the Bank of Japan’s move coincided with some earnings reports that indicate there may be a limit to mega-cap tech profit growth after all.

At the same time, many of these companies must transform from being generators of capital disciplined by enormous free cash flow to fighters in an artificial intelligence arms race. Not only has the mortgage rate gone up, but the dream home needs a little more repair than first thought.

What we would say, however, is that we don’t think this sell-off is about the market pricing in a widespread US recession or even a broad-based revaluation of every equity sector.

In our view, the latest weather-hit US jobs report was weak, to be sure, but not disastrous. The Atlanta Fed’s GDPNow model projects the annualized growth rate in the third quarter to be 2.9%. It’s good to remember that a soft landing is still a landing – but economic activity slows, not stops.

Opportunity

As such, we don’t think this is a time to bear down on equity markets, and we think the continued recovery in sales reinforces that view. Rather, the recent volatility offers investors three useful reminders.

First, watch out for mega-cap technology and its dominance of major benchmarks. Second, recognize that the acceleration phase of AI has always been likely to require significant capital and R&D spending for many technology companies and provide a boost to other sectors at a substantially lower upfront cost. And third, respond to it by expanding and diversifying your exposures.

Large transportation operations don’t happen overnight, so investors should add this, along with politics and the monetary policy transition, to the mix of things that could keep volatility high in the coming months. However, when this dynamic spills over into other segments of the market, we see a source of opportunity rather than anxiety.

In case you missed it

• Euro zone producer price index: -3.2% year-on-year in June
• Index of ISM services: +2.6 to 51.4 in July
• China Consumer Price Index: +0.5% year over year in July
• China Producer Price Index: -0.8% year-on-year in July

What to watch for

• • Tuesday, August 13:
    • US producer price index
  • Wednesday, August 14:
    • US Consumer Price Index
    • GDP in the euro area second quarter (second preliminary)
    • Japan’s Q2 GDP (processing)
  • Thursday, August 15:
    • US Retail Sales
    • NAHB Housing Market Index
  • Friday, August 16:
    • US housing starts
    • US Building Permits
    • University of Michigan Consumer Sentiment

Investment Strategy Team

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