What has been behind the volatility?
Even by recent standards, global equity markets have experienced heightened volatility over the last four weeks. This has been driven by a confluence of factors that have shaken investor confidence and forced many to look at the underlying economic data through a different lens. The primary contributors include the unwinding of the Japanese carry trade, political rhetoric, and mixed US employment numbers.
The sell off began on the 17th of July, following reports that Washington was considering using the most severe trade curbs to prevent companies from continuing to give China access to semiconductor technology. This had a significant impact on the industry, with the US semiconductor index shedding more than $500 billion in market value during Wednesday’s session. Such seismic moves spilled over into other areas of the tech sector and the market more broadly, with the S&P 500 Index falling almost 3% by Friday’s close.
This was followed by the decision of the BoJ (Bank of Japan) to raise its key interest rate from 0.10% to 0.25%. Whilst this rate hike was only a modest one, the bank signalling its intention to continue tightening monetary policy in the future had a profound impact on markets, particularly the Japanese carry trade. This financial strategy involves borrowing money in Japan, where rates have been near zero for years, and investing in higher-yielding assets elsewhere, such as treasuries or equities. The carry trade has been a significant source of liquidity in global markets, helping to drive up asset prices as investors sought returns in riskier markets, such as the US tech sector. Such areas of the market have also been supported by leverage, which investors such as hedge funds can use to multiply returns. Using leverage involves posting collateral, usually cash or other securities, with the leverage provider, and in return being able to increase the size of trades, by as much as 15x in some cases. Leverage therefore enables certain investors to significantly increase returns, but also involves taking on substantially more risk.
This risk manifested in markets shortly after the BoJ signalled further rate cuts to come, which would decrease the attractiveness of the carry trade due to increased borrowing costs, thereby reducing the return available. This caused a significant unwinding of these positions and a repatriation of capital back to Japan as investors dashed for liquidity to cover their yen-denominated liabilities. This caused equity markets to drop sharply, whilst the yen moved in the opposite direction, rising steeply as investors dashed to repay yen-denominated loans, causing further pain for traders exposed to the carry trade and exacerbating the sell-off in equities. This dynamic created a feedback loop, with the strengthening yen prompting more unwinding of the carry trade, leading to further market declines.
Adding to the market’s woes was the release of U.S. labour market data on the 2nd of August, which showed that the US economy added only 114,000 jobs in the month of July, far fewer than the estimate of 175,000 and the average monthly gain of 215,000 over the last 12 months, indicating that the pace of job creation is slowing, and more people are being laid off than anticipated. July unemployment crept up to 4.3%, up from 4.1% in the month prior. Whilst the market had previously welcomed a cooling in the labour market, due to its implications for inflation and therefore more dovish stance on monetary policy, this more significant development raised concerns about the health of the U.S. economy, and whether the Federal Reserve have acted too late in order to secure a “soft landing”. This fuelled fears of an economic slowdown or even a potential recession.
However, two consecutive weeks of falling US weekly jobless claims, both of which came in below estimates, buoyed the recovery in equity markets. Data released on the 8th and 15th of August showed a reduction in the number of people claiming unemployment benefits, calming investor nerves of a recession. Strong retail sales boosted the rally further, with data showing a 1% rise in July from the month prior, far surpassing the 0.3% estimate. This, along with strong earnings from Walmart and an increase in the retailer’s annual profit forecast, propelled retailers higher as the overall market continued to climb.
Investor reactions to different economic and geological issues show just how much uncertainty remains. This was epitomised by the reaction of the S&P 500 Index, which leapt 2.3% on the day that it was reported that US weekly jobless claims were 233,000, 7,000 below the 240,000 estimate. With the outlook for US monetary policy still unclear, and the race for the White House becoming more difficult to call, should investors brace for yet more volatility ahead?