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Weekly Market Analysis - “Leveraging” Volatility for Potential Gain
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Behind the Yen Surge: Unaffordable Leverage
The Japanese yen surged nearly 12%, catalyzed by a rate hike of a mere 0.2 percent. The Japanese stock market posted a similar 12% drop before mounting a partial recovery. Why? Traders funded investments with leverage they couldn’t afford to hold if markets moved against them.
But Unwinding Leverage Has Little Fundamental Impact
The unwinding of leveraged positioning can drive sharp market dislocations but will generally have much less fundamental impact on the underlying value of assets and the economy itself. Private debt booms like the US housing market bubble and collapse of the mid/late 2000s – reflecting consumer or business leverage – are a different matter.
Opportunities Beckon
The unwind of trades betting on an ever-lower yen reached world markets last Monday. It temporarily saw US equity implied volatility jump to levels only reached during the pandemic surge of March/April 2020. While the move in underlying equities was far less extreme than that period, we’ve seen opportunity to realign parts of our portfolio strategy as US tech shares fell sharply (the Philadelphia Semiconductor index fell 25%). Conversely, US long-term bond yields fell below 4%, reducing opportunity for strong returns.
Summary
Uncertainty is high. Risk is ever present. Yet in the past week, we’ve heard discussion of nearly every dark macro-economic scenario many of our readers have lived through. Do we need an easing of US monetary policy? We believe we do. The reported 114,000 gain in US hiring in July likely won’t be the weakest reading of this year. But do we need an emergency easing of monetary policy because the Fed’s September 18 meeting is too late to avoid doomsday? We are quite skeptical.
We don’t believe the next few months will lack volatility. We are not making short-term bets on market performance. Rather, this tactical allocation is aimed at potential return opportunities we judge over the coming 12-18 months. We have also removed a “long yen” recommendation from our list of opportunities for near-term appreciation. While the yen could of course rally and still appears undervalued for the long-term, we have reduced near-term confidence in its direction (we acknowledge the yen’s negative correlation with global risk assets still provides an interesting hedging property.)
Portfolio considerations
With the S&P 500 down 8%, our Global Investment Committee eliminated an underweight in large cap US equities. We kept a range of other overweight positions in small and mid- cap US growth shares, healthcare equipment and “broadening strategies” in the US, Asia and Europe. With long-term US Treasury yields falling below 4% we eliminated an overweight to long-duration US government bonds to fund the purchase. Implied volatility moderated quickly over the past week as investors saw signs that the market turmoil didn’t represent a new economic collapse. However, volatility remains high enough that it may generate extra income for those looking to rebalance concentrated holdings or provide yield before taking a new position in equities.
Source: Bloomberg as of August 5, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Behind the Yen Surge: Unaffordable Leverage
Against a background of political uncertainty, geopolitical strife and a routine mid-summer growth panic, conditions were ripe for unwinding one serious market risk: borrowing yen to fund the purchases of other assets.
Since the Fed tightened monetary policy sharply in 2022, the Bank of Japan has dramatically bucked that trend. Until last month, the difference between US and Japanese policy rates was the largest in 24 years. This encouraged some to put on perpetually riskier trades dependent on an ever-lower yen.
Fed easing would of course work against the “short yen” trade. But what is really most worrisome is the yen-funded purchases of other assets. For Japanese investors, those purchases might be US stocks and bonds. For foreign investors, it might be Japanese shares. In unwinding this “carry trade,” the Japanese stock market dropped 12.4% on August 5, the largest single-day drop since the crash of October 1987. The yen appreciated by a similar amount, but over the course of a month. Much of this significant “risk off” event was catalyzed by a mere 0.2 percentage point Bank of Japan rate hike, with mild expectations of more to come.
Mixed in with US growth fears, political and geopolitical angst, the market dislocation went global. Implied volatility on US shares briefly hit levels that were the highest since the March/April 2020 pandemic shock.
But Unwinding Leverage has Little Fundamental Impact
When Japan volatility reached foreign shores on August 5, it did not hit markets equally. It hit semiconductors and broader technology shares much more significantly than economically-sensitive firms such as industrials and financials. The wide dispersion of gains and losses is typically indicative of a mild, rather than severe correction. This is not what one would expect from an incipient US recession. It’s what we would expect if investors “reeled in” their risks on this year’s highest-flying shares.
Opportunities Beckon
On Wednesday of last week, with the S&P 500 down 8.2% from its high, our Global Investment Committee met and eliminated its underweight in large cap US equities, raising our overall equity allocation to +4.5%. To fund the position, we eliminated our overweight in long-term US Treasuries. We don’t believe the next few months will lack volatility. We are not making short-term bets on market performance. Rather, this tactical allocation is aimed at potential return opportunities we judge over the coming 12-18 months.
We have also removed a “long yen” recommendation from our list of opportunities for near-term appreciation. While the yen could of course rally and still appears undervalued for the long-term, we have reduced near-term confidence in its direction (we acknowledge the yen’s negative correlation with global risk assets still provides an interesting hedging property).
The basic concern we had for excessive growth expectations and tech concentration risk in large cap US equities has been meaningfully reduced. Long-term investors in technology should see the related sectors as highly dynamic. The winners of today may not be the winners of the future. However, as discussed in our Wealth Outlook, the tech and healthcare sectors are what the economy is “becoming.” A modestly lower entry point for long-term investment is quite welcome even if we see it better valued among smaller, profitable firms.
