US recession fears rattle markets

Japan’s Nikkei 225 Index closed down 12.40% on Monday morning (5th August), which has sent shockwaves through financial markets. That is its largest one-day points fall ever, dropping more than 4,450 and passing the 3,836 fall seen on ‘Black Monday’ in October 1987¹.  At the time of writing European and UK stock markets are down around 3%.²There a several issues that have built up and triggered a sell-off.

The yen carry trade is a currency trading strategy where investors borrow yen at low interest rates and buy currency in a country that pays a high interest rate on its government bonds such as US Treasuries.  

Last week the Bank of Japan raised its interest rate to 0.25% from 0.1%. Whilst this may seem a small shift, it was significant for a country which has been used to zero or negative interest rates and surprised investors as it was in the face of weak economic data.

More importantly, in the context of the carry trade, it meant Japan is putting up interest rates just as western economies are starting to cut theirs, with the US expected to follow the Bank of England and European Central Bank. On Monday morning investors were looking to unwind their positions in the carry trade, that is buy yen, which led to the huge sell-off in Japanese equities. 

The severity of the fall in Japanese markets was also driven by fresh concerns that the US Federal Reserve has been too slow in cutting interest rates and may now have to cut further and faster than had originally been priced in by investors. This would naturally also impact the carry trade, but fear of a US recession has much wider implications for investors.

The trigger for these concerns was a sharper than expected fall in US Non-farm payrolls for July, which was announced on Friday 2nd August. The unemployment rate also rose 0.2% to 4.3% in July.²  Jerome Powell, the Fed Chair, had stressed in their July meeting that he “would not like to see material further cooling of the labour market.”  A September cut was already on the table, but with the outlook deteriorating some economists are predicting that will need to be 0.5% rather than the 0.25% that was pencilled in²

The current fall in stock markets needs to be put in perspective. The S&P 500 and other leading stock indices in the US and other countries have reached new all-time highs in the first half of the year as corporate earnings, particularly from the artificial intelligence led technology stocks, have remained healthy.  However, the second quarter earnings season has been fairly mixed, with some signs that corporate earnings are slowing down adding to concern the US economy is slowing. These concerns along with light volumes, which means you don’t need as many sellers to cause share prices to fall, and elevated valuations in some parts of the market have put pressure on the US stock markets. 

Geopolitics has not been far from the headlines for the last few years and whilst investors have been able to shrug off the rising tensions when there was good news elsewhere, these risks are now adding to their concerns. Tensions in the Middle East are rising following the killing of a senior Hezbollah commander in Lebanon and a Hamas political leader in Iran. With Iran, Hezbollah and Hamas having vowed to avenge the killings, the threat the war spreads to Lebanon and possibly Iran has grown. 

It is times like this a well-diversified portfolio of different assets such as equities, bonds, gold and hedge funds should come into its own.  The purpose of investing in a range of asset classes is so investors are prepared for the volatility and occasional sell-offs that happen in markets. It is hard to forecast when they will happen and often even harder to know what the trigger for any sell-off maybe and therefore which areas of the markets are more affected. A diversified portfolio of various assets means that investors are prepared for the volatile markets that are expected as well as those that may come out of the blue, such as the Bank of Japan raising interest rates when the economy was already weak.

We have been concerned over valuations of global equities, particularly the magnificent seven stocks, for much of this year. We expected the market performance to broaden out as interest rate cuts came in. Whilst areas of the stock markets have been driven up, valuations elsewhere look more attractive. Cuts in interest rates across developed markets (excluding Japan) should be beneficial to their economies, and support businesses with higher levels of debt and growth-focused companies. On balance, we remain positive on equities but have not been increasing exposure in recent months as the economic data has been weaker.

We continue to prefer longer dated government bonds, particularly in portfolios with more equity exposure. They typically offer better protection when recession concerns increase and expectations for interest rate cuts rise. Alongside this exposure we have also continued to favour shorter-dated corporate bonds as, whilst we remain positive on the economic outlook, we believed the current pricing in corporate bond markets had fully reflected this view. This meant the risk was greater in owning longer-dated corporate bonds which are more sensitive to changes in outlook.

1. Japanese stocks suffer worst day since 1987 as global route intensifies. FT.com
2. LSEG Datastream / Evelyn Partners