The decisions made last Tuesday (July 31st) by two central banks, one on either side of the Pacific, were the prime catalysts. The Bank of Japan (BoJ) increased rates to 0.25% as it seeks to normalise policy following a prolonged period of zero or negative rates. On the same day, the US Federal Reserve decided to hold interest rates at 5.5%, as they decided to wait for more evidence that inflation has been brought under control. Unfortunately, these decisions preceded two disappointing updates about the health of the US economy. On Thursday (August 1st), ISM Manufacturing data showed a greater than expected slowdown for construction spending, new orders and employment. This was compounded by a weak jobs report the following day.
While fears over a slowing US economy partially explains the fall in equity markets, it is compounded by an unwind of what is known as the ‘Yen Carry Trade’. Having had such low short-term funding rates for a prolonged period, investors could borrow yen at these low-rates and use the capital to fund investments in other countries and currencies that offered a higher-rate of return. These investments are often levered to increase the returns even further for investors. They are, however, susceptible to any hint of a paradigm shift. Signs of weakness in the US economy and a more hawkish attitude from the BoJ have undermined the basis of many of these trades, leading to an unwinding of positions and increasing market volatility. The prolonged period of lower rates had also made Japanese equities attractive to both retail and institutional investors alike, helping fuel a 62% rally in the Nikkei since the beginning of 2023. The Yen over that same period weakened by 23% versus the US dollar. By raising rates, the BoJ has prompted a swift reversal in both.
In our view, the moves seen over the past week are more indicative of a problem on Wall Street rather than Main Street. As frightening as market sell-offs might seem, they’re not necessarily a predictor of impending doom. Famously, ‘Black Monday’, the 1987 market crash, did not lead to an economic recession or any sort of wider banking crisis. Right now, the evidence definitely points towards a cooling in the US. The data from last week certainly suggests that and it would be a surprise if the lagged impact of higher rates is not having some impact. Claims that a ‘hard landing’ is imminent, though, still feels like something of a stretch. The Atlanta Fed’s GDP Now estimate suggests that the US economy is currently growing at a rate of around 2.5%, a slower pace than seen earlier in the year but still fairly healthy. ISM Services data that was released this week was also more positive than expected. If someone wants to predict a certain outcome then it’s never that hard to find an indicator to match.
Within our portfolio, many companies have direct exposure to the US economy. These include the likes of CRH, the provider of building material solutions for use in a range of infrastructure and construction projects. Irrespective of the near-term noise and impending election, we think that the US government will continue to prioritise spending on infrastructure. Some, like Bodycote the heat-treatment specialist that generates a third of its revenues from the US, are exposed to more cyclical industries. Current share prices for these names already seem to discount a fairly weak outcome and we consider the risk/reward balance to be favourable.
So, how concerned are we? We don’t see any obvious signs of market excess which could unwind and have a catastrophic impact on the broader economy or cause distress in the financial sector. Capital ratios at systemically important financial institutions across developed markets remain very healthy. There are some sectors in the US equity market where valuations look a bit rich for our tastes, but as dour presbyterian Scots when’s that never going to be the case? A black swan event could upend markets, but by its very definition we wouldn’t be aware of this until it occurs. As detailed in our update post the UK election, we are still very optimistic about the outlook for the UK domestic economy.
In our opinion, the events of the past week have been driven by positions being unwound at pace in a market that have been unusually benign for a prolonged period. Declines of this nature are commonplace – the S&P 500 sees drawdowns of 10% or more in nearly two-thirds of all years. While staying alert to the risks, we see no reason to panic. Which is a pity, as I really could do with something hair-raising.
KEY RISKS
The value of investments and any income generated may go down as well as up in response to general market conditions and the performance of the assets held, and is not guaranteed. An investor may not get back the amount originally invested.
Past performance is not a reliable guide to future results.
Changes in exchange rates may have an adverse effect on the value, price or income of investments.
There is no guarantee that the Fund will meet its stated objectives.
The movements of exchange rates may lead to further changes in the value of investments and the income from them.
There is a risk that any company providing services such as safe keeping of assets or acting as counterparty to derivatives may become insolvent, which may cause losses to the Fund.
