Financial Update from Brewin Dolphin - 9 August 2024

August 2024

The Weekly Round-up

Friday 9 August 2024

In our latest weekly round-up, Guy Foster, our Chief Strategist, discusses the Japanese carry trade and its impact on the investment market, and fresh U.S. economic data.

Most of the activity took place in the early hours of Monday morning when the Japanese TOPIX index fell a stunning 12% in a single session. This capped a three-day descent into the technical definition of a bear market (a 20% cumulative decline).

Before we get too carried away, the TOPIX had recovered by 11.5% when the Japanese market closed today, and a major driver of the weakness in Japanese stocks has been the strength of the Japanese yen. So, the peak-to-trough decline of the Japanese market since mid-June was 24%, but is now just 15%. In sterling terms, this would represent a 15% total decline and just 7.5% following the partial recovery. The decline in Japanese stocks is different depending upon whether you’re a Japanese investor (in yen) or a UK investor (in sterling).

The carry trade revisited

The difference in returns by currency reflects that Japanese equities have not just been affected by currency; they have arguably been driven by it.

Apologies for the repetition for regular readers, but the Japanese carry trade has been a major influence on markets. A carry trade involves borrowing money in a low-interest rate environment (like Japan) and investing it in a high-interest rate environment (like the U.S.). The returns are made up of the interest earned in the invested currency less the interest due in the borrowed currency, plus the gain (or loss) in the invested currency relative to the borrowed currency.

The carry trade does not need to be invested in bank deposits or even bonds in the invested currency. It seems likely that some of it has flowed into U.S. equities, or maybe specifically tech shares (based on the observation that tech shares rose as the yen fell and fell as the yen rose).

Understanding the size of this trade is very difficult. However, this week J.P. Morgan gained a lot of headlines announcing that it had unwound by 75%. How did it estimate this? By checking how much of the currency appreciation has reversed since 21 August.

I’m not convinced by this because it’s using a basket of carry trades that together seem to have been much less effective than the yen/dollar carry trade we’re trying to measure (it went up less and came down more).

Looking at that specific trade, over the period J.P. Morgan measured, the trade has only unwound by around 25%. That would seem more in line with data on positioning by investors, but unfortunately, that data is not timely enough to account for this week’s movements.

In summary, I think it’s hard to tell how much carry trade is still in place.

Focusing on liquidity

The Bank of Japan (BoJ) seems worried about the carry trade. It’s been keen to move very slowly in its interest rate normalisation process – so much so that during its last monetary policy meeting, it referenced a statement saying that so far, interest rate increases have not yet led to tightened monetary policy.

This week, the BoJ’s deputy governor, Shinichi Uchida, also sent a strong dovish signal in the wake of historic financial market volatility in Japan by pledging to refrain from hiking interest rates when the markets are unstable.

It seems likely that the BoJ is very focused on the impact interest rate differentials could have on financial conditions, not least because its domestic demand could be impacted by currency volatility.

Japanese domestic investors have been buying overseas assets in their own funded version of the carry trade. By contrast, U.S. investors invest principally at home, allowing the Federal Reserve to be more parochial with its monetary policy. Any weakness in the U.S. economy will be met by interest rate cuts, inflicting more potential pain on carry traders.

U.S. slowdown

There hasn’t been much data this week that provides more insight into the fundamentals that may drive U.S. rate cuts or Japanese rate hikes.

As mentioned, the BoJ will tread carefully. In the U.S., weekly jobless claims cut a reassuring tone, with new claims falling well below previous troughs during economic expansions. The caveat to this is that it seems far fewer people claim the unemployment insurance benefit in the U.S. now than previously. Why? The explanation seems to be that either they are migrants who may not yet qualify for insurance, or they find opportunities in the gig economy that are preferable to the hassle of claiming insurance.

The difficult thing for investors is that the week after the payroll report is always a quiet one for economic data, so there has been little to reassure or intensify worries about U.S. growth. In addition, we remain in a liquidity trough due to the summer holiday season, and the earnings season is unlikely to change the market’s perception of consumer strength (although it will be interesting to hear from the discount retailers still to report).

This morning saw the Taiwan Semiconductor Manufacturing Company report a sharp increase in revenue in July, which bodes well for suppliers like ASML following the bruising market response to Intel’s planned reduction in capital expenditure last week.

Technology shares have suffered during the current earnings season due to fears they might be overinvesting.

What’s next?

Next week we’ll see what’s happening to inflation in the U.S.

It’s easy to imagine the market has moved on from inflation. After two months of reassuringly low inflation, focus has shifted to growth. Continued weakness of inflation will be good for bonds, but bad news for carry traders, who are invested in the dollar market.

There’ll also be UK inflation and employment data. The Bank of England has taken the plunge and started cutting interest rates. It could probably do with seeing its decision validated by some modest weakness.

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