@theMarket: Storm Clouds of Volatility Roil Global Markets

It was a week of massive moves, both up and down. A host of unanswered questions made pricing stocks at the right level almost impossible. Are we on the brink of recession? How low will the unwinding of the Japanese yen carry trade take the U.S. equity markets? Will conflict in the Middle East spill over into something even more serious?

 

There are no quick or easy answers to these questions. Last week's down draft in the US nonfarm payrolls numbers triggered an 8 percent decline in the S&P 500 index and more than double that for the tech-heavy NASDAQ. Was that even justified?

 

If the labor market is truly rolling over, say the bears, then a recession cannot be far off. The bulls disagree, pointing to an economy still growing, even if it is not at the same pace as last year.  At most, they say, we may be experiencing a growth recession. What is that, you might ask?

 

It is a period of slower economic growth that is not low enough to be considered a technical recession. The economy may still be growing, but at a rate that is too slow to keep up with demand for new jobs. Growth recessions are uncommon and usually don't last more than a few quarters. It is unlike a traditional recession where the economy experiences a significant decline in economic activity over multiple quarters. 

 

My take is that we are putting the cart before the horse in either case. A one-month jobs report does not mean much. It could have been a reporting error or faulty data. Some economists blame the weather (Hurricane Beryl)  for most of the shortfall in employment data.

 

This week's jobless claims did not indicate a rapidly deteriorating job market. The number of claims dropped to 233,000 from last week's 250,000, which was much fewer than economists were forecasting. Whatever the case, we will have to wait almost a month for the next nonfarm payroll report to show more deterioration or improvement.

 

The other issue that could be as contentious, if not more so, may be the unwinding of the yen-carry trade. Let me explain how that works. For decades, American financial institutions and others have been borrowing the Japanese yen, at super-low interest rates. They then turn around and use those borrowed funds to buy the U.S. dollar. From there, they can either invest that money in 'safe' U.S. Treasury bills and bonds with higher yields than the yen or, if they want to speculate (which many do), they can buy stocks (think FANG and AI favorites) or any number of high-flying assets.

 

Now, no one knows how much money is involved in these yen-carry trades, but it is a lot ( trillions of dollars). And because of the leverage and money involved, carry trades are far more sensitive to currency moves and interest rate expectations. For years, as long as the Bank of Japan(BOJ) kept interest rates at a negative to zero return, the carry trade was extremely profitable, so more and more of the world's financial institutions participated.

 

However, that began to change a few weeks ago. Over the last few months, inflation began to rise in Japan, and as a result, the BOJ began to change course. They announced a small rise in their overnight lending rate to just 0.25 percent with more to come. That is tiny, right (especially when you compare that to the U.S. dollar lending rate of roughly 5.5 percent), but not so in the carry trade leverage business.

 

The mere talk of future rate rises in Japan, plus the almost certainty of Federal Reserve interest rate cuts beginning in September drove the yen up 13 percent in a few weeks and the dollar down. The combination of the two events has narrowed the yield gap between the yen and the dollar almost overnight.

 

 Suddenly, the profitable yen-carry trades have turned into multi-billion-dollar losses. It forced big, leveraged investors to unwind not only the carry trade but also forced them to de-leverage overall by shedding other stock and bond holdings.

 

The fact that no one knows how or when more trades will be unwound has traders glued to the yen/Dollar index night and day. The instability this week in global markets spooked the BOJ. On Wednesday, Shinichi Uchida, a deputy governor at the BOJ said the bank would not hike interest rates further while the financial and capital markets remain unstable.

 

That reassured investors and lifted stocks. I think the carry trade debate might continue, but most of the damage has been done, in my opinion. In that sense, the carry trade is yesterday's worry.

 

I estimate that there is about $100 trillion in equities and about the same amount in bonds worldwide. If we declined 10 percent, as we have in just a few weeks, that is equivalent to a drop of $20 trillion in global money flows all-in. Of course, lobbing off that much wealth in a short period should cause some dislocations and require some backing and filling over the next few weeks in the equity markets.

 

Last week, I warned readers that "a full 10 percent correction would not surprise me" on the S&P 500 Index by early this week. Most of that decline occurred by Monday mid-day. Since then, we have seen 1-2 percentage point moves daily. The good jobless claims numbers on Thursday saw all three indexes climb by between 1.6 percent to 2.75 percent. By Friday, most of the losses for the week have been recouped. That left many investors to ask if this correction is over or do we have more to go.

 

Finding a bottom is usually a process. Normally, when markets fall like they have in such a short time frame, there is a dead count bounce. We are in one as I write this. But then the markets fall, re-testing, or breaking the recent lows. Over time, the markets then normalize before moving higher. However sometimes (although not often), we have a "V" shaped recovery, in which case, the rest of August may be much calmer. In any case, after this week, most of the downside has already happened in my opinion. Let's see what happens.

 

Bill Schmick is the founding partner of Onota Partners, Inc., in the Berkshires. His forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners Inc. (OPI). None of his commentary is or should be considered investment advice. Direct your inquiries to Bill at 1-413-347-2401 or email him at bill@schmicksretiredinvestor.com.