Markets overreacted to recent unwinding of carry trade in Japanese currency. By Kean Tan
The Chicago Board Options Exchange Volatility Index, which measures volatility on the S&P 500 index, rose to an intra-day high of 66% on Aug 5.
To put that in perspective, its average over the past three decades is 19%, and 66% has only been seen twice — once during the global financial crisis in 2008, and the other during the Covid pandemic in 2020. The index is now back at a more normal level of 20% at the time of this writing.
While the reasons contributing to the spike in volatility are multi-fold, most investors would agree the main perpetrator was the unwinding of the yen-funded leveraged carry trade — borrowing in a currency with a low interest rate and investing in an asset that provides a higher rate of return. Extended investor positioning, tensions in the Middle East, coupled with a stream of weak employment and manufacturing data in US did not help either.
As a result, the Nikkei index suffered its worst one-day decline, 12.4%, since October 1987. Not surprisingly, the Nasdaq 100 was also one of the markets leading the way down, just as it did on the way up.
We are of the view that the sell-off in Japan was unwarranted as fundamentals seen in the July Tankan survey indicated that manufacturing activity is still steady. Japan’s core inflation in June was a tame 2.2% year-on-year, and we forecast Japan’s economy to contract by 0.5% in 2024, before growing 1.2% next year.
In our view, there is no real need for the Bank of Japan to continue raising interest rates much more than it has already done.
On the equities front, international revenues are around 40% of Japanese manufacturers’ total revenues. On the surface, while an appreciation in the yen would make them less valuable, most Japanese companies hedge their foreign currency exposure to neutralise currency risk.
In addition, Japanese listed companies had been using an average dollar/yen rate of 145 in their guidance to the analysts covering their shares. That level is close to the dollar/yen rate today, so despite the recent strengthening in the yen, we do not anticipate material cuts in earnings forecasts.
BIG RATE DIFFERENTIAL
While the US Federal Reserve is expected to cut rates gradually, the interest rate disadvantage versus the dollar is unlikely to narrow more than previously expected. With the yen policy rate gap likely to remain above 400 basis points versus the dollar at the end of the year, investors may also regain confidence that the yen remains an attractive carry-trade funding currency.
We retain our overweight recommendation on Japanese equities for the following reasons:
- Wage growth of over 5% in 2024 (for perspective, wages rose only 7% over the previous 20 years);
- Corporate reforms, including increased dividend payouts and share buybacks;
- Brand equity on a scale that exists in no other Asian country;
- A large and liquid market of around 4,000 listed companies, of which hundreds have return-on-equity in the high teens and above;
- Earnings growth for the Nikkei 225 Index is forecast to be a decent 7% this year, and 8% next year.
In the aftermath, the extreme moves in asset prices have also led some to conclude that the Fed will now proceed to ease more aggressively. The federal funds futures market has priced in between four to five rate cuts of 25 basis points until the end of the year.
SOFT LANDING IN PLAY
On this front, we expect the Fed to be reluctant to cut rates more aggressively to avoid the perception that it is coming to the rescue as financial markets grapple with a rise in risk aversion. We still believe the current batch of soft data in the US marks a temporary pause in the ongoing economic recovery rather than the start of a recession, hence we are sticking to a soft landing in our baseline scenario.
Real-time data on the US economy still paints a solid picture, while US companies overall delivered solid results in the second quarter despite rather ambitious expectations from investors.
In summary, the events in markets over the past weeks have little to do with fundamentals, and much to do with market technical factors and flows, which have become increasingly stretched in recent months. In that sense, the current consolidation phase is not only healthy, but also necessary.
We view the recent moves as an intermediate correction in a primary uptrend within a secular bull market.
That said, positioning data has started to come off but remains elevated, particularly for the Nasdaq. This, in combination with continued recession fears, will likely result in better buying opportunities for the broad equity market in the not-too-distant future.
Kean Tan is Head of Investment Solutions at SCB-Julius Baer Securities Co Ltd.
