Does soaring volatility mark regime change in markets?

The questioning of the no/soft economic landing narrative and the partial unwind of the yen carry trade have seen equity markets whipsaw in recent weeks. While we are always scrutinising the fundamentals of the companies we own, and the wider investment universe, it is in periods of high uncertainty like this where our incorporation of macro analysis is vital. This helps us navigate the risks, opportunities and regime change which can occur when volatility skyrockets.

VIX Index explodes as US recession fears rise and yen carry reverses

Source: NS Partners & Bloomberg

Goldilocks thinking unravelling

Last October we published a piece warning against complacency in markets, given a poor monetary backdrop signalling economic weakness ahead – Is this a Wile E. Coyote moment for markets?

Our view was that central banks were maintaining policy that was unnecessarily tight and that a rosy consensus on the macro outlook appeared misguided:

The delayed impact of vertiginous rate hikes across DMs on all maturing debt is now hitting consumption and investment. Yet central banks continue to talk tough and market pundits fret over the implications of “higher for longer rates.” It feels like we are in a critical juncture for markets and the economy. Resilience of assets outside of fixed income appear out of step with the reality of higher rates and a weakening global economy, as illustrated by global PMIs falling for a fourth consecutive month.

Poor money numbers globally suggest that further economic contraction is likely. Despite this, central banks continue to talk tough on rates and many investors cling to hopes of a no landing/immaculate disinflation scenario unfolding, despite the cracks emerging in the global economy.

This underpinned a shift to a more defensive portfolio exposure in the expectation that economic growth was set to surprise to the downside over the next “3-6 months.”

In hindsight this was slightly early. What we missed was the buffer provided by the huge stock of money built up during the pandemic, cushioning the economy from rapid monetary tightening.

However, as you can see in the chart below, this stock has been burnt down below the pre-pandemic trend.

Money stock below trend

Source: NS Partners & LSEG Datastream

The effects of tighter liquidity are now flowing through to the real economy, with global manufacturing PMIs falling sharply in July.

PMI dip corresponds to low in six-month real narrow money momentum a year earlier

Source: NS Partners & LSEG Datastream

Investors panicked in late July as deteriorating US employment data set off calls for the Fed to deliver an emergency rate cut before the September FOMC meeting.

Unemployment boosted by a sharp rise in temporary layoffs (ex-temp rate is also trending higher)

Source: NS Partners & LSEG Datastream

Japan’s attempt to exit zero interest rate policy (ZIRP) roils markets

Meanwhile in Tokyo, the Bank of Japan announced that it would take steps to end decades of unconventional monetary policy by raising rates, with an eye to acting against signs of inflation and currency weakness. The hawkish turn saw the yen surge relative to the USD, blowing up speculators shorting the yen. It also forced the unwind of some carry trades exploiting lower interest rates in Japan by borrowing in yen, and then investing in currencies with high rates such as the USD, Mexican peso or Brazilian reai.

JPY surge leaves it still lagging collapsing yield spreads

Source: NS Partners & LSEG Datastream

Japan’s decades-long deflationary trap has been the basis for BOJ monetary experiments going back to the 1990s, which gave rise to the yen carry trade phenomenon. Financial historian Russell Napier recounts the “rise of carry” in his book The Asian Financial Crisis, emphasising its tendency to yank liquidity from markets in response to shifts in monetary policy:

What has changed to turn global equity markets bearish? The only surprise over the past few weeks has come from Japan. In the United States, the bond market has been well behaved, the shape of the yield curve unchanged and Greenspan’s comments supportive. Earnings growth in the United States has been ahead of expectations. However, in a three day period, the yen rallied 3.1% against the US dollar on speculation that Japanese interest rates would rise. This currency movement would appear to be the catalyst for the sell-off.

The sudden strength of the yen is indicating that the flow of excess liquidity out of Japan had been the source of liquidity which had been driving the US equity and bond markets. The reason that the flows overseas are probably abating is that the economic recovery in Japan is requiring these funds. The period of history when an accommodative stance by the BOJ drove markets is over.

The experience of July 1996 that Napier recounts rhymes with today’s volatility, fed by speculators who had borrowed yen to finance investments in the US and other markets forced to liquidate positions to buy yen and reduce yen borrowings.

Tech names routed

When liquidity drains out of a market, it is often the “speculations of choice” which are hit hardest, as investors sell profitable trades to raise cash. Names with exposure to the boom in enthusiasm for AI technology were among the victims of the unwind, an example of where liquidity can overwhelm even stellar fundamentals.

July pullback for tech as defensive sectors such as healthcare outperform

Source: NS Partners & LSEG Datastream

Buy the dip or steer clear?

In the lead up to July, we had been steadily reducing our above-benchmark exposure to IT names in the GEM strategy, and now maintain a modest overweight. Much of this shift has been through selling down more niche semiconductor names which rallied hard on demand for AI chips. The highest quality names such as TSMC were hammered through July despite posting outstanding results, and look attractive at these levels.

Our view is that the risks of carry trade unwind will ultimately be constrained by economic realities in Japan (despite the domestic unpopularity of yen weakness).

Broad money weakness suggests that the BoJ’s latest attempt to exit ZIRP will be no more successful than previous efforts in 2000 and 2006

Source: NS Partners & LSEG Datastream

The monetary backdrop in Japan suggests that all is not well in the economy, and that raising rates will make the situation worse. However, it is entirely possible the BOJ will look to push its luck again. In addition, while speculative bets against the yen have been reduced significantly, JGB yield spreads versus US Treasuries suggest potential for further yen strength. Given this backdrop, our bias is to avoid reflexively buying dips here.

Implications for EM

Last month’s commentary made the case that the vicious cycle weighing down emerging market equities was coming to an end: Are emerging markets on the cusp of a “virtuous circle”?

It emphasised the importance of a weak dollar and supportive liquidity as key drivers of EM outperformance. While the slowing economy and carry trade volatility warrant some caution over the next few months, they may also support a shift to a backdrop more supportive of EM equities in the long run.

Big move down in the USD on slowing US economy and carry trade unwind

Source: NS Partners & Bloomberg

It argued that the balance of factors we monitor to assess prospects of EM vs DM equities (relative money growth, global excess money, valuations, earnings, industrial momentum, commodity prices and USD strength/weakness) favours EM for the first time in years. Recent downward moves in Treasury yields and the dollar support the positive trend. Although global money growth has slipped with poor numbers in China and Japan.

Favour liquidity sensitive exposure

The tech cycle upswing and the story of India’s rise up the development ladder have dominated EM returns in recent years. While these trends remain intact, a falling dollar and Fed cuts are likely to see other winners emerge. This easing is set to take pressure off EM central banks forced into tight monetary policy to stabilise their currencies. This should boost the prospects of more liquidity sensitive economies, which are typically open, trading economies with managed exchange rates.

Indonesia is a potential winner in this respect. Its central bank surprised investors with a Q2 rate rise to support the rupiah, leading to a market selloff. US Fed cuts and a dollar bear market should allow for a shift to monetary easing in Indonesia to prevent excessive appreciation of the currency that would harm the competitiveness of its exporters.

US Treasuries yields falling

Source: NS Partners & Bloomberg

As well as rate cuts, easing would likely involve the central bank buying US dollars from Indonesian commercial banks, crediting the banks’ reserve accounts in payment. Additional reserves would encourage bank lending and money creation, with positive follow-through to asset prices, economic growth and corporate earnings, consistent with the virtuous circle sketched out below. While fundamentals matter, we think it pays to understand how liquidity can often act to shape these fundamentals, particularly in emerging markets which are highly sensitive to the monetary backdrop.

Virtuous liquidity circle

Source: NS Partners