Global markets continue to see extensive selling today after last week’s very volatile action. Japan slid a very substantial 12.4% overnight, and the U.S. markets are down more than 2% today.1
Is this a market crisis or an opportunity?
After the volatility last week, we wrote a brief update on Saturday to send this morning. Given the significant market shifts since Saturday, we wanted to provide you with an updated perspective. While the challenges we outlined previously persist, new developments have emerged.
Here are the three key points we highlighted in our previous update that remain relevant today:
- The big tech names (Mag Seven), which have done so well, are down a lot more than the broad market.
- Japan continues its very sharp decline after the Japanese Central Bank raised rates, which appears to be driving a stronger Yen.
- Interest rates in the U.S. are falling further, and the yield curve stopped being inverted for the first time in two years, as the yields on the Two- and Ten-Year Treasuries are currently both trading around 3.80%.2
There are lots of moving parts as investors digest data showing a slowing U.S. economy, the decision by the Federal Reserve to defer a cut in federal funds rate until September (although that could change), the Japanese Central Bank raising rates, and leading U.S. technology companies reporting overall good but not stellar results.
In addition, concerns over more direct military engagement between Israel and Iran are suddenly front and center, as the situation in the Middle East appears to be getting worse. That is a wild card, and there’s not much we can do about that but pray for the best.
Big picture – this kind of rapid dislocation can really hurt traders and market timers (e.g., hedge funds) who make big bets and “get caught with their pants down”, so to speak. Big positions in tech stocks and short yen, for example. In the short run, those people who have to sell things rapidly disrupt the markets. However, long-term investors with well-diversified portfolios are better positioned to weather difficult markets, as always.
What is the Issue with Japan and the Yen Trade?
The Japanese story involves a common trading strategy implemented consistently for many years where hedge funds across the globe convert the funds they manage to the Japanese yen and buy Japanese bonds. They then have been able to borrow at near zero interest rates against those bonds and use those borrowed funds to buy stocks in the U.S. and elsewhere. With Japan now running an inflation rate near 2.6%, the Central Bank increased interest rates, which have caused the yen to strengthen, and the overall cost to borrow in yen to become more expensive.3 The hedge funds are now quickly unwinding the trade, which is a major contributor to this dislocation in Japan and worldwide. The unwind is painful and does happen rapidly. It is impossible to declare that the selling is mainly over with, but Japan’s market has been down 26% since its July 11 high.4 Cleary, there has already been a very large price adjustment.
Summary
This is not the time for panic (as if there ever was such a time). These things unfold rapidly and unpredictably. When things settle down, there will be opportunities to rebalance and harvest tax losses, and add to the parts of the portfolio that have fallen the farthest to be positioned for the recovery that eventually comes. As we know, it takes discipline, patience, and time.