Special Market Commentary August 2024
Written by Brian Andrew, CFA® – Chief Investment Officer
In last month’s video, we mentioned that August is becoming less attractive for vacations and that we might just get an opportunity to take advantage of some volatility. Little did we know just how soon that postponed vacation would come in handy!
Bond prices have rallied while interest rates have fallen precipitously, and stock prices have begun to take that breather everyone has been talking about for several months. The reasons for market sell-offs are different and the rationale used by most pundits is a best fit for the immediate situation. We can dig into this some and provide an explanation as to what is happening and how we’re responding.
What is Happening?
Several things. We know that technology stocks, the largest, have been moving higher with an AI (artificial intelligence) tailwind. Stocks don’t move straight up and so a break there isn’t surprising. As markets are led by fewer and fewer stocks, it is usual to have them take a break. Does that mean the tail wind is gone? No, it just means that companies have to convince their stock investors over time that the multiple of earnings is worthwhile because actual revenue growth is taking place.
The Bank of Japan (BoJ) raised rates from .10% to .25%. So what, you might say. Japan has some of the lowest interest rates on the planet and they aren’t the first Central Bank to begin raising rates. While our own Federal Reserve usually leads the world in cutting interest rates, our economy has been performing much better than most and so they’re taking their time.
There is estimated to be over $4 trillion in a dollar/yen carry trade. This is where investors across the globe borrow money in Japan at those low interest rates, and cheaper currency and buy better earning assets in other parts of the world, like U.S. stocks. The BoJ move signals to investors that rates are moving higher in Japan. When that happens, a currency improves in value (the yen has appreciated by more than 13% against the dollar in a month) so the “carry” isn’t as attractive, and people unwind the trade.
Markets always experience disruption when a large trade is being unwound quickly. The only way to make the door bigger is to move asset prices lower!
Bad news is bad again! In the U.S., every time we have seen weaker economic data, the stock market has rallied with the expectation of lower interest rates in the future. This happens because stock investors use interest rates to discount future earnings growth and the lower the rate the better the stock value. So bad economic news is good for prices. As you get closer to the actual reduction in interest rates, sentiment shifts because rates have moved down ahead of the first cut. We see this in the U.S. as the 2-year Treasury has declined in yield from 5.25% last fall to 3.9% today! This is the market anticipating the Fed’s move.
Last week, the Fed confirmed that they believe their next move will be to reduce rates, maybe in September. Investors take note as this reduction gets closer because they recognize that the lower rates are due to a slowing economy which could hurt corporate earnings.
The Fed worries about two things, inflation and employment. They believe they’re getting close to being done fighting inflation, they noted last week that they are beginning to worry about employment. Two days later the unemployment rate jumped up to 4.3% and the new jobs created was less than 120,000. Investors took this to mean that the Fed’s concerns were coming to fruition and the economy is going to weaken more quickly. This led to selling risk assets like stocks and buying less risky assets like bonds (bonds rallied more than 1% on Friday).
What Now?
In our video we mentioned that August and September might be a time to find some opportunities. That’s what we’re going to do. As investors become more concerned about the economy and earnings growth, it shifts toward companies with better quality balance sheets (less borrowing) and decent earnings quality. In a move like we’re seeing, even these stocks will be temporarily sold providing an opportunity.
In addition, the decline in bond yields raise prices and provides an opportunity to look at our bond portfolio positioning, selling winners and looking for a time to buy longer dated bonds as yields move higher again (this level of bond yields is likely an overreaction to the risk-off environment we’re seeing). We can use the bond rally to reduce our exposure to higher credit risk as well.
Finally, we can all retest our risk attitude. Does this sell-off create nervousness and an overreaction. While it is significant and quick, the market is still 50% higher than it was at the low in October 2022.
You and your advisor can have this conversation now, discuss portfolio positioning and then you can go back to rescheduling that vacation knowing that the markets have presented another opportunity!
Please reach out to your Merit financial advisor if you have any questions.
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