“Leveraging” Volatility for Potential Gain
What happened last week?
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.
3 Things to Know
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.
See our weekly CIO Strategy Bulletin for more details