Finding Focus in Volatility

I recently finished reading Stolen Focus by Johann Hari, an insightful investigation into the collapse of humanity’s collective ability to concentrate. Amongst several ideas, Hari argues that as a society, we are obsessed with distraction and, whether we like it or not, our attention is being sold to the highest bidder. The book convincingly dissects the global attention crisis, which has been guided by our increasing use of technology, social media, and access to information. Humans, in general, are finding it increasingly more difficult to focus on one thing at a time. 

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Ironically, it took me about 6 months to finish this book, but its conclusion comes at an interesting time for reflection. Earlier this week, we witnessed one of the most significant market panic events of the last four decades. This correction was driven largely by a weaker than expected US Jobs report that prompted recession concerns and was exacerbated by an unwinding of the Yen carry trade. Unlike individuals, markets often appear to be more than comfortable with directing their focus to one thing at a time, but like individuals, this is often brief, as they move to focus on the next inflation print, the next earnings call, the next polling result, the next regional conflict, and so on so forth. Market volatility is simply an expression of the fleeting focus of its participants. This is a basic concept, but one that investors must understand on the path to long term wealth preservation and creation. 

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In this note, I will reflect on the market volatility of this week, the probability of a US recession, and what a recession means for client portfolios.

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The Yen Carry Trade 

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Markets are more complexly intertwined than most could ever imagine, and the interrelation of US equity valuations and Japanese Monetary policy is a perfect example of this. The Yen Carry Trade played a key role in market volatility this week, pushing Asian stock indexes to their worst 1-day loss since Black Friday in 1987. A ‘carry trade’ simply involves an investor borrowing currency from a place where interest rates are low and using it to invest in a currency where rates are higher. This trade is only successful when the borrowed currency remains cheap, and market volatility remains low. The most lucrative carry trade of recent years was borrowing a weak Yen at rock bottom interest rates to buy high-yielding assets in other markets, such as US equities. When the Bank of Japan decided to strengthen the Yen by raising interest rates earlier this week, an unquantifiable amount of money invested in the Yen carry trade was forcibly unwound, sparking a broad-based sell-off that spilled into global markets. 

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Despite recent price action, most investors would maintain that the Yen is still relatively undervalued, and JP Morgan Currency Strategist Arindam Sandilya believes there is scope for this trade to continue to unwind as the yen moves higher, albeit with less velocity. With an estimated 50 to 60% of the carry trade left to unravel, further volatility is to be anticipated. However, it should be noted that the BoJ has signalled that they won’t raise rates further amidst current market instability. 

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At EW&L, we have minimal exposure to Japanese equities, and do not believe that the unwinding of this trade will have a medium to long term impact on portfolio outcomes. Throughout the last quarter, we have been purposefully positioning our equity allocation away from the expensive mega-cap tech stocks that have been at the centre of this week’s triggered sell off. 

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US Recession Fears

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The second quarter ended with the continuation of a narrow stock market focused on AI disruptors, and markets pricing big tech as the beneficiaries of a dreamy productivity boom that would help deliver the US economy to the Valhalla of a soft landing. Whilst consensus on Wall Street still appears to be a soft-landing narrative (inflation lowered to target, no recession), US Job creation data for July slowed to 114k, which is less than the 150k markets believe is representative of a solid economy. At the same time, the unemployment rate rose to 4.25%, representing a 0.90% increase since April 2023. This employment data was released on Tuesday and fuelled the S&P 500’s biggest drop since 2022. 

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So, is there cause for concern, or is this simply a knee-jerk re-action as markets take a breather from their recent re-test of all-time highs?

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Equity markets rebounded after the flash crash of Tuesday, but the implied probability of rate cuts by the bond market this year paints a picture of panic. As illustrated in the below chart, the market has moved rapidly from expecting no cuts this year to 3 jumbo cuts of 50bps. This is a  magnitude of change only previously exhibited as we moved into the 2001 and 2008 recessions. 

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In effect, the market appears to be pricing in a recession because it believes the Fed hasn’t cut rates fast enough to engineer a soft landing, as evidenced by softening employment data. 

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Managing Director and PIMCO economist, Tiffany Wilding, believes there are mitigating factors at play not reflected on paper that dimmish the credibility of recent employment data in substantiating recession risk. The first of which is Hurricane Beryl, which hit Texas and left some 436,000 unable to work and forced a little over 1 million people to part time work. Moreover, the change in unemployment rate has occurred without a notable fall in the level of employment, indicating that the labor supply has expanded. Importantly, the participation rate is on the rise, and this works to dull the recession signal triggered by a rising unemployment rate.  

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Whilst a labor market slowdown is materialising, in our opinion, there is not enough data to suggest that this is accelerating at a rate that justifies recession talk. In the last quarter US GDP came in a +2.8%, and above market expectations. It is timely to remember that the term ‘recession’ is not a buzz word to categorise economic catastrophe, it is a technical definition defined by two consecutive periods of (inflation adjusted) negative economic growth. A slowing economy is not the same as a crashing economy and put simply, macroeconomic data is not yet supporting recession risk with the degree of confidence that bond traders are. 

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Adding to the macroeconomic data, is the latest earnings call for the S & P 500. For Q2, 78% of S&P 500 companies have so far reported a positive EPS surprise (as of writing this note, 430/500 companies have reported Q2 earnings). This is higher than the 10-year average of 74%. Moreover, analyst expectations for Q3 have been lowered at average levels, according to FactSet – a median decrease of 1.8% for all companies in the index. Again, this is a sign of slowing growth, not rapidly contracting growth. 

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I started writing this note last night and I have awoken 8 hours later to observe a US stock market rally and ten-year yields dropping off the back of the market responding to a new point of employment data: Jobless claims, a proxy for layoffs. The figure came in at 233,000 vs the expected estimate of 240,000, and down from the week prior of 250,000. Point proven, markets are bi-polar. 

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What does a Recession Mean for Markets? 

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The only people that like the word ‘recession’ sell newspapers, or hair transplants. It’s an evocative word, but often misunderstood.  Recessions are an inevitable part of the economic cycle, categorised by weak spending, employment and income. Importantly, they are all different, and the next recession will be different to 2008, which was the most severe economic depression since the great depression ended in 1939. In a previous note, I touched on the relative health of our financial and banking system in the post GFC world of today. Thanks to regulators, the risk to the outlook won’t be exacerbated by predatory lending, excessive risk taking by banks, or toxic balance sheets.  

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There have been 31 recessions in the US since 1869, and markets delivered positive returns throughout 16 of these periods. In fact, if you strip out the pandemic induced recession of 2020, the correlation of GDP to stock market performance is near zero. (Source: Adam Field, Evgenia Gvozdeva and Eric Thaut, "U.S. Stock Markets During Recessions", Russell Investments Research, April 2023.).

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In short, it’s a coin toss as to how a recession will impact stock markets, and for how long. For our clients, shares play one role in a multi asset portfolio, and the best insulation to volatility is a well-diversified portfolio of quality assets. Today, portfolios look very different than they did in 2021 and early 2022, when cash rates were close to zero. As central banks hiked rates aggressively closer towards long term averages, opportunities returned in traditional fixed income, public and private credit, private equity, and certain pockets of the stock market. For this reason, there is now significantly lower equity correlation in client portfolios – a feature not as available to investors seeking above cash returns in a low-rate environment.

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With that said, we have positioned our equity allocations defensively and opportunistically, and believe portfolios should fair well in a slowing growth environment. These allocations are complemented by fixed and floating rate credit, alternatives, and private assets, which should serve to buffer volatility if we continue to see shocks like those exhibited earlier in the week. 

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When we talk about our defensive equity allocations, we are referring to listed infrastructure and property, or non-cyclical stocks that trade with a high degree or forecastability and present cashflow. These types of stocks are lower beta than the rest of the market, meaning that the exhibit less price swings than the broader index. Many of these stocks have underlying holdings with contracted cashflows and inflation linked growth. Despite capital value volatility, they will continue to generate income irrespective of the way in which the market moves in the short term. 

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When we talk about opportunistic equity allocations, we are talking about our small to mid-cap exposure, where relative valuation remains at multi decade lows. The key point here is that if a recession was to occur in the U.S. this cycle, small caps have generally already underperformed large caps by more than they have historically in any recession. So, I posit that this may limit the magnitude of any underperformance should a recession happen, and it is our hope that they outperform. 

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Where to next?

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In any worthwhile endeavour of human pursuit, success over the long run is generally defined by an ability to focus on the ‘right’ things. For portfolio managers, this is particularly true, but I would argue that our job as long-term investors is more straightforward than that, success can be aided by simply considering more than one thing at a time. 

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The market has predicted 12 out of the last 3 recessions, so it’s fair to say that no one knows with certainty where we are headed too from here. Whilst the economy is clearly de-accelerating, US inflation appears to be moving in step, and the combination of these two factors should provide the Fed with the cover it needs to cut interest rates and start QE. A steeper yield curve would improve the outlook for growth assets, and lower short-term rates would support flailing sectors such as real estate. These outcomes should positively improve the return expectations of client portfolios and ultimately support the re-calibration of US economic growth.

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We expect to see sustained and heightened volatility in markets in the near term. Inflation, economic growth, and resultant policy will continue to be the core drivers of this price action. Ongoing developments on the geopolitical front, elections, currency shocks, and whatever else we can’t see coming will add to the commotion. This is simply noise that will create opportunity. More often than not, this is the best time to invest or stage new capital into markets. Volatility is simply the price investors pay for healthy long-term returns.  

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Irrespective of slowing growth, market volatility, or the Fed’s policy path, investors should be reminded that a recession, if it were to eventuate, is not the end of the world. Banks and consumers are very healthy, and we aren’t staring down the systemic credit issues that proliferated the crisis in 2008.  

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Until next time, 

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Charles

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