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Please see the below article from Brewin Dolphin, providing a brief analysis of the latest movements in global investment markets. Received last night – 20/08/2024

Japanese political drama

A lot of economic data and a few key earnings reports were expected last week. What was unexpected, although not entirely surprising, was the announcement from Japanese Prime Minister Fumio Kishida that he won’t take part in the race to become party leader in September, effectively resigning the premiership.

Kishida has been dogged by scandal this year, but still had a relatively long tenure of nearly three years; his predecessor served just over a year as prime minister, which is not unusual in Japan.

Kishida’s replacement will be important. Currently, the most popular of his potential replacements is former Defence Minister Shigeru Ishiba. He has expressed a desire to see Japanese monetary policy normalised, which seems the most pronounced threat to the Japanese economic status quo.

At the time, only Takayuki Kobayashi, the Minister of Economic Security, had declared his candidacy and he has yet to comment on Japanese monetary policy. There’s still plenty of time for other candidates to join the race.

Yields rose and the yen rallied upon Kishida’s announcement, possibly because of Ishiba’s stance. Nevertheless, the week saw strong performance from risk assets and Japanese equities. That could be because last week saw information that could support or refute the case against the U.S. economy. Is it plunging into recession, or is the consumer just taking a breather?

Overall, the data was reassuring. This meant less pressure for sharp interest rate cuts in the UK and it may even have rekindled the carry trade.

U.S. inflation

The U.S. consumer price index (CPI) was the most important monthly data for a long time, as inflation remained the main source of angst for investors. But weak price growth in May and June seemed to help investors channel their neuroses elsewhere.

Inflation’s certainly not the demon it was. Prices rose at 2.9% over the last 12 months, which is still too high, but well down on the 9% rate reached in June 2022.

Although headline inflation hasn’t dropped much in the last year, one of the bright spots about this month’s report was that it dropped below 3% for first time since June 2022. Since then, inflation has been stubborn and is unlikely to fall much faster over the coming months.

An alternative perspective

Investors, however, have learnt to look beyond the headline CPI rate. The Federal Reserve’s (the “Fed”) preferred inflation gauge is the personal consumption expenditure price index (PCE), but CPI gets the headlines because it’s released earlier in the month.

In terms of the differences between the two, CPI is increasingly reflecting increases in rental costs. For example, rent makes up 38% of the CPI basket and contributed 1.8% of the 2.9% rate.

Rental costs accelerated this month, which was very disappointing, but it’s not something to be worried about. We can say with enormous confidence that they’ll fall in the coming months, as the CPI basket, which measures one sixth of the rent revisions of the overall inflation basket, lags the timelier All Tenants Regressed Rent Index. The latter has been slowing rapidly and implies that the path of rental CPI normalisation has further to run.

To reflect the part of the economy that can actually be influenced by monetary policy, the Fed has placed more emphasis on a measure called ‘core services excluding rent’. This seems the most important number to take away from CPI, as it will influence how the Fed considers changing interest rates. When core services excluding rent declined in May and June, it suggested that inflationary pressures had finally been tamed. But having stripped out many of the volatile prices, what’s left really ought to be quite a stable number, so two months of declines seemed unsustainable.

This month, these prices rose by 0.21%, which would be consistent with a 2.5% annual rate. 2.5% CPI is only just above the equivalent 2% rate for PCE, so things are definitely moving in the right direction. These CPI numbers would not dissuade the Fed from cutting interest rates in September.

The only warning sign for policymakers here would be the persistence of alternative measures of CPI. Measuring price increases without the most volatile elements can be done by excluding food and energy (to give ‘core’ CPI), or it can be done by literally excluding the most volatile elements, no matter what they are (the ‘trimmed mean’ CPI) or by only measuring the median price increase each month.

These approaches show that inflation is slowing, but remains above the headline rate of inflation, and the most recent month actually saw prices increase. And that belies the true message of last week’s CPI report: that inflation remains above target, but not far enough above target to prevent the Fed from cutting interest rates when it meets in September.

The Fed believes rates are currently restrictive and can see a change in consumer behaviour, so it has become very concerned about the economy being too weak, and less concerned about inflation being too hot. Expectations that rates might be cut twice look wide of the mark though.

The UK economic recovery continues We also had the UK inflation report last week. It was biased by some volatile numbers, but again, the alternate measures of CPI, for example the median CPI, show that inflation hasn’t normalised yet.

In the UK, of course, interest rates have already been reduced. There’s also less evidence of the economy slowing.

Earlier in the week, it did seem as if there was a reducing number of job vacancies, but an apparent reduction in payrolled employees a few months ago has turned out to be a misestimate, which has been corrected by revisions.

The employment data are acknowledged as being unreliable due to low response rates to surveys. Fundamentally, it seems unlikely the labour market is particularly weak, because the economy has been picking up speed. Retail sales announced Friday morning reflected this, and the slowdown in inflation the UK has experienced so far, coupled with increases to the National Living Wage and the cut in National Insurance, have been wind in consumers’ sails.

What do U.S. retail sales tell us?

Flipping back to U.S. retail sales, and these were more upbeat than anticipated. We’ve heard a downbeat story from many retailers during earnings season, and this broadly continued with Home Depot confirming customers have spent more on wares to spruce their homes up over those required to perform major renovations.

Walmart saw similar focus on value from customers. It’s difficult to square with the official retail sales numbers. Perhaps the message that some retailers have seen things pick up a little at the start of August is the most telling.

What’s next?

The Democratic National Convention kicked off on Monday and will continue until Thursday. The conference began with President Joe Biden and former secretary of state Hillary Clinton endorsing Vice President Kamala Harris in November’s presidential race. While it’s unusual to see policy surprises at the convention, the change in nominee means the Democratic agenda is still being put together. If that does lead to any policy announcements, they’ll come later in the week.

Tim Walz, the current Governor of Minnesota and somewhat surprising vice-presidential nominee, will speak on Wednesday, while current Vice President and presidential nominee Kamala Harris will speak on Thursday.

This week will also see the publication of meeting minutes from the European Central Bank (ECB) and the Fed, as well as provisional purchasing managers indices for August.

Fed Chair Jay Powell and Governor of the Bank of England Andrew Bailey will both speak at the Kansas City Fed’s Jackson Hole Economic Symposium, which takes place between 22 and 24 August. The symposium features keynote speeches from prominent economists and policymakers. These speeches often provide insight into the Fed’s monetary policy thinking. They can also move financial markets and offer an opportunity to hear from some of the world’s most prominent central bankers.

Bank of Japan Governor Kazuo Ueda has a prior engagement and will instead attend a special session at Japan’s parliament to discuss the 31 July rate hike. This took the market by surprise and was seen as a significant contributor to the sharp sell-off in Japanese equities that took place thereafter. It will be a busy week for him.

Please continue to check our blog content for the latest advice and planning issues from leading investment firms.

Alex Kitteringham

21^st August 2024

Please see the below daily update article from EPIC Investment Partners:

As the financial world keenly observes the Jackson Hole Economic Symposium for clues about the future of monetary policy, another critical event looms on the horizon: the BLS’s Annual Benchmark revisions. While perhaps less captivating than a gathering of central bankers, these revisions hold the potential to shed light on a perplexing puzzle: if payrolls have been so robust over the past year, why has US employment growth been so lacklustre? 

We’ve long observed a curious divergence between nonfarm payroll job gains and actual employment levels. From September 2020 to early 2022, these two measures moved in tandem. However, around March 2022, they began to part ways. The past 12 months have seen strong payrolls with an average of 209k new jobs added per month, totalling a healthy 2.51 million. Yet, over the same period, the employment level has barely budged, increasing by a mere 57,000. Even more concerning is the decline in full-time employment, which has dropped by 508,000. 

The BLS relies on surveys and models to estimate economic data, but these estimates are often based on samples and can be subject to lags and revisions. Benchmark revisions, incorporating more comprehensive data sources, provide a more accurate historical record, although they can lead to significant changes in previously published figures. The 2023 benchmark revision, for example, resulted in a downward adjustment of nearly 500,000 jobs. 

While the BLS rarely provides explanations for its revisions, one likely culprit behind the payroll-employment discrepancy is the birth/death model used to estimate job creation from new businesses. This model relies on historical trends and can be less reliable at economic turning points. 

This is why we prioritise the unemployment rate, which is unaffected by these statistical adjustments. The recent surge in unemployment has triggered the Sahm rule (a simple but effective recession indicator that looks for a 0.5 percentage point increase in the three-month average unemployment rate from its recent low), suggesting a possible recession – a stark contrast to the more rosy picture painted by payroll numbers alone. Tomorrow’s BLS revisions may finally offer some clarity on this divergence. While the birth/death model may not be the sole culprit, the report could have significant implications for our understanding of the true state of the US labour market. 

Please continue to check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Charlotte Clarke

20/08/2024

Please see the below article from Tatton Investment Management detailing their thoughts on global markets over the past week. Received this morning 19/08/2024.

Tornado rather than hurricane

The market storm looked like it would become a hurricane in early August, but it ended as fast as whirlwind: stocks climbed last week without hesitation. Positivity is good, but a little unnerving. Our medium-term outlook is bright, but there might be further storms ahead.

Last week’s recovery was helped by surprisingly good economic data – including 0.6% Q2 growth for the UK. Markets mainly got excited about US retail sales, which grew 1% month-on-month in July. US consumers are still proving the doubters wrong – counter to the recession fears in recent weeks. If unemployment was about to spiral, consumption would be the weakest part of US data, but in fact it’s the strongest.

We shouldn’t get ahead of ourselves though. A ‘soft landing’ (growth slows without going negative) is on the cards, but not a ‘no landing’ (growth doesn’t slow at all) scenario. Markets reacted like July’s figure was great news, but month-to-month data is noisy and next quarter’s profit growth still looks likely to be a little soggy. We can’t tell yet if market optimism is justified – but should get a better idea after central bankers’ Jackson Hole conference.

In other news, a US judge ruled that Google illegally monopolised the search engine market, and the Justice Department is reportedly considering breaking up the tech giant. That would be terrible news for US tech – a signal that regulators will tackle their market power. We suspect a Harris administration would be tougher on them than a Trump one, but anti-tech sentiment is a rare point of bipartisanship in Washington.

Finally, there is talk that the Bank of Japan might be able to cut rates in December after all. That would add to yen strength, which would benefit neighbours China. Maintaining a renminbi-dollar peg amid a falling yen has forced China into tight policy, so if the yen strengthens authorities will be able to loosen their grip.

Would ‘Kamalanomics’ mean US fiscal expansion?

Vice-President Kamala Harris is now the slight favourite to win the US presidential election, across polls, betting markets and most forecasts. She has begun to announce policy measures – mostly focused on support for children and families. But the market implications of a Harris presidency are unclear, largely because she had been tactically vague on the big issues. Neither party is likely to win a clean sweep (the House, Senate and Presidency), so we will probably see a degree of policy gridlock and status quo anyway.

It isn’t a given that Harris would continue President Biden’s economic agenda, given Americans’ disapproval of his handling of the economy. If she wants to distance herself from unpopular parts of his record, she will likely focus on lowering inflation. That could make her administration more fiscally disciplined than either Biden or Trump. However, she will likely extend time-limited Trump-era tax cuts that are set to expire, which could push Trump to promise more tax giveaways (he has already suggested making the time-limited cuts permanent).

US fiscal metrics have deteriorated under Trump and Biden, but there has been no ‘Liz Truss moment’ in treasury bonds, thanks to America’s status as the world’s leading market. This invulnerability is harder to maintain the worse debt metrics become, particularly if coupled with tariffs that limit capital inflow. External observers have warned there is not much capacity to expand US fiscal policy further – but that is unlikely to stop Trump from trying.

While neither party will be fiscally conservative, we suspect Harris will be less willing or able to run the risk of a ‘Liz Truss moment’. Both candidates will probably be tempted to offer ‘giveaways’, given the lack of public concern over the budget. Just like in the UK, opposition to fiscal expansion will come from bond markets, if at all. And just like here, any turmoil would probably be a short-lived buying opportunity. 

The long-term case for Japan

Despite an intense market shakeout, the long-term case for Japanese assets is strong. Profitability has improved, thanks to corporate reforms. These should help companies’ capital efficiency – which is much worse in Japan than the US or Europe. Firms have become less averse to foreign ownership, and shareholders appear more willing to vote against company directors. The shakeout of speculative investors this month should actually help here, aligning incentives more toward long-term profitability.

The yen is still cheap, despite sharp recent gains (it was ¥100 to the dollar at the start of 2021, and it is ¥148 at the time of writing). That, together with comparatively low inflation, means Japanese labour (among the world’s most highly skilled) is highly competitive in dollar terms. Exporters seem to be reaping the benefit, as shown by Honda’s recent earnings. Many company outlooks assume a ¥140-to-the-dollar rate, and the Bank of Japan’s structural dovishness means it is likely to stay there or weaker.

Growth has been disappointing, but the comprehensive picture is arguably better than individual indicators. Export growth should feed through into stronger domestic demand, which Goldman Sachs note has been decent. Exporters will get a profit boost even if domestic demand is lethargic, and in any case Japan’s equity valuations are very cheap (a reflection of weaker growth). To stay that cheap, you would have to assume that growth will be as weak as it has been recently.

We have little reason to be that pessimistic. Japan is not suddenly seeing a ‘new dawn’ or an end to its long-term malaise, but its long-term profit outlook is improving. Since stock values are based on those earnings, and Japan remains cheap in terms of currency and valuations, the long-term case for Japan still looks solid.

Please continue to check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Alex Clare

19/08/2024

Please see Brooks Macdonald’s Daily Investment Bulletin covering their thoughts on global markets:

What has happened

Equity markets were in confident mood on Thursday. Buoying the economic outlook and pushing back on recession worries, yesterday’s US weekly initial jobless claims data was better than expected for the second week running. Initial claims fell by -7,000 in the week to Saturday 10th August, to 227,000 and below the Bloomberg consensus estimate of 235,000. The continuing claims number also fell. Reflecting the better news, the US S&P500 equity index ended yesterday up +1.61% in US$ terms. It is now up +8.28% above the intra-day low it reached last Monday (5th August) and is now only -2.19% below its record all-time high … a reminder for investors of the risks of trying to time short-term market exit and entry points. Within equity markets, as well as megacap US tech shares leading, smaller company share prices also outperformed with the US Russell 2000 equity index up +2.45% having its best day in four weeks. European equity markets also gained on Thursday, with the UK, French, and German equity markets all up on the day.

US recession positioning dealt a blow by better retail sales

Anyone still positioning for an impending US recession were dealt a blow by US retail sales yesterday. US retail sales month-on-month (MoM) saw their biggest gain since January 2023, up +1% MoM, and easily surpassing the consensus estimate of +0.3%. That the previous month saw a small downward revision didn’t seem to impact the positive market reaction. Adding to the resilient consumer picture, US retailer Walmart came out with better Q2 results yesterday and raised its sales and profit outlook for the full year as well. Walmart shares ended the day up +6.58% and notched up a new record closing high. Walmart CEO Doug McMillon summed up the view neatly, saying that “we aren’t experiencing a weaker consumer”. For completeness, it would be remiss not to mention that US industrial production numbers for July missed estimates yesterday, recording the first annual drop in three months – that said, the weakness was put down to the recent weather impact from Hurricane Beryl impacting factory certain factory activities.

China’s economic malaise continues

The economic malaise in China has continued into the calendar Q3, according to Chinese government data published yesterday. The standout was a surprise slowdown in fixed asset investment, to +3.6% for the first seven months of the year (versus the same period last year). It was below consensus estimates and is the fourth month in a row of declining growth rates. Industrial production growth was also weaker than expected and the third month in a row of falling growth rates. While retail sales looked better, it was thought to be largely down to a seasonal uptick and remains well below pre-pandemic levels of growth. Elsewhere, China’s arguably all-important housing market continues to be problematic: new home prices fell -4.9% year on year in July, the sharpest annual drop since June 2015, and deeper than the -4.5% slide in June.

What does Brooks Macdonald think

Economic performance doesn’t necessarily always correlate to equity market performance, but in China’s case this year, they are both suffering. So far in 2024, against the MSCI World (developed markets) equity index up +14.0% in US$ total return terms, China is lagging, up just +3.1%. And for context, China’s relative underperformance in FY 2023 was much worse. This has led to some to suggest China is worth looking at, if only on valuation grounds – but we continue to see China more of a value trap than a value opportunity. China’s policy makers are stuck between a rock and a hard place – desperate to deleverage the economy after decades of overbuilding in its property market in particular, this, more than anything else perhaps, explains why Beijing appears to be so reluctant to sign off on a large-scale fiscal stimulus to pump up growth rates.

Please continue to check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Andrew Lloyd DipPFS

16/08/2024

Please see the below daily update article from EPIC Investment Partners:

We appreciate that recessions have negative connotations and often create hardship for many. However, when viewed from an economic standpoint, they can be a necessary evil to lower prices, correct imbalances and serve as a catalyst for restructuring and removal of wasteful endeavours. If we look through the unique COVID-19 period, we have not had one of these ‘corrective’ episodes since the Great Financial Crisis, which was over 15 years ago! 

Politicians and central bankers, quite sensibly from a political point of view, will throw the kitchen sink at avoiding recession. Yet, long periods of economic expansion can lead to inefficient resource allocation, unsustainable business models and inflated asset prices. The June 2024 Bank of International Settlements (“BIS”) Annual Economic Report showed that c.13% of all US corporates are ‘Zombies’ (unprofitable firms whose earnings are less than interest payments and the ratio of market value of their assets to replacement cost is below the industry median). They remain in business when interest payments are low, and lenders find it easier to ‘extend and pretend’. Some companies borrow simply to service existing debt and/or avoid bankruptcy/restructuring. The BIS go on to state that “…empirical evidence confirms this contributes to the misallocation of labour and capital by crowding out more productive businesses.”  

Ultimately this hinders competition, which can mean more expensive products for consumers or negatively impact innovation, reducing productivity and contributing towards stagnation. Long-run these factors reduce GDP growth, which will have a knock-on impact on living standards for households too. 

A simple technical recession is classed as two consecutive quarters of GDP decline. A more prolonged or deeper one has typical characteristics that all sound bleak – economic contraction, decreased consumer spending, business failures, rising unemployment and falling asset prices etc. However, a recession can prick asset bubbles and rebalance economic activity. It can force innovation, efficiency and productivity gains, within an industry through creative upcycling and new product creation, but also within an economy to regear for industries of the future through invention and discovery. Broadly speaking, households, businesses and governments must alter their mindset and focus on their budgets to live within their means. This can often end up improving long term debt burdens and fiscal positions after times of contraction. All these items lay the foundations for an economy to push through the cycle into expansion again.  

Recessions can effect dynamic change and lead to a price reset which otherwise can never happen, and without which a perpetual expansion leads to fiscal troubles, cost of living crises and large wealth inequality. Unchecked growth leads to increased demand and higher prices which necessitates higher wages and can then lead to a wage / inflation spiral. A short period of deflation can help those on fixed incomes. Reduced asset prices can create opportunities for opportunistic or strategic buyers. Companies can reshape, as skilled workers may be willing to accept lower wages or new career paths. 

We do, however, absolutely recognise the human cost of any recession and appreciate that it is a delicate balance to manage the economic cycle and the very real impact of job / salary cuts to individuals and households over a significant period. However, the previous era of peaceful globalisation and its many benefits may well be over. A return to more traditional economic policies could be beneficial, where growth and inflation cycles are better controlled by managing debt, demand and supply through recessions and expansions. In this regard, the developed world may have a lot to (re)learn from its emerging counterparts.  

Please continue to check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Andrew Lloyd DipPFS

15/08/2024

Please see the below article from EPIC Investment Partners detailing their thoughts on the Economic Resilience and Cultural Innovation of Abu Dhabi. Received this morning 13/08/2024.

In the face of global economic challenges, Abu Dhabi continues to serve as a beacon of stability and growth. The emirate’s recent economic performance and strategic investments paint a picture of a forward-thinking, diversified economy that’s propelled the wealthy emirate’s ascent to the global stage.

Since the beginning of the month, amidst market turbulence, Abu Dhabi’s sovereign and quasi-sovereign holdings have demonstrated remarkable resilience, outperforming expectations in the EPIC Fixed Income strategies. This performance is no surprise to those who have long recognised the value of Abu Dhabi’s Aa2 rated bonds. The emirate’s journey in the international bond market, which began in 2007 with its first USD denominated bonds, has been a testament to its financial acumen and long-term vision.

Abu Dhabi’s economic prowess was further underscored by its impressive GDP growth of 3.3% in the first quarter of 2024 compared to the same period in 2023. What’s particularly noteworthy is the stellar performance of the non-oil sector, which grew by 4.7% and now accounts for 54.1% of the emirate’s economy – its highest share since 2015. This shift clearly demonstrates Abu Dhabi’s successful efforts to diversify its economy beyond hydrocarbons.

The growth story spans across multiple sectors, with construction, finance and insurance, telecommunications, and hospitality all showing significant upticks. The transport and storage sector, in particular, exhibited a remarkable 14.4% growth rate, highlighting the emirate’s increasing importance as a global logistics hub.

Ahmed Jasim Al Zaabi, chairman of Abu Dhabi Department of Economic Development, attributes this success to the emirate’s resilience and its journey towards becoming a smart, diversified, and sustainable economy. The numbers speak for themselves – the construction sector alone contributed 8.8% to the overall economy, reaching its highest level in five years.

Moreover, Abu Dhabi is expanding its global ambitions beyond traditional economic sectors. The emirate’s sovereign wealth fund, ADQ, is set to acquire a minority stake in Sotheby’s, a world-renowned auction house, in a USD 1bn deal. This strategic investment underscores Abu Dhabi’s commitment to becoming a global cultural hub.

By partnering with a 280-year-old institution like Sotheby’s, Abu Dhabi is bridging the gap between East and West. This collaboration not only promises to strengthen Sotheby’s presence in the Middle East but also positions Abu Dhabi as a key player in the global art world. The investment signifies more than financial gain; it represents Abu Dhabi’s vision to be at the forefront of cultural innovation and exchange.

As the world grapples with economic uncertainties, Abu Dhabi stands out as a model of sustainable growth and strategic diversification. From its robust non-oil economy to its bold investments in global cultural institutions, the emirate is crafting a future that’s not just prosperous, but also culturally rich and globally connected. Abu Dhabi’s journey is a testament to what can be achieved with vision, resilience, and strategic planning. 

Please continue to check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Alex Clare

13/08/2024

Please see the article below from Tatton Investment Management providing an insight into the markets over the past week.

Market correction turns into pothole

Last week started with some of the worst stock market losses in nearly two years – prompted by recession fears and Japanese liquidity problems – but ended with most of those losses recovered. Volatility spiked across most regions and almost all asset classes. The sell-off proper started in Japan (where stocks were routed last Monday) after higher interest rates unwound the ‘carry trade’ (borrowing where rates are cheap and investing where yields are higher) but US liquidity has also been under pressure for a while, which suddenly became apparent. We suspect the growth of high-frequency trading amplified volatility, since it shortens the timeline between trades and increases market sensitivity.

US recession fears are arguably overdone, considering that corporate credit remained relatively stable – and in fact corporate cost of finance fell thanks to sharply lower ‘risk free’ government yields. Recession risks are certainly higher than a few months ago, but our base case is still a ‘soft landing’. Business sentiment in the services sector continues to be strong, for example, counteracting weakness in manufacturing unemployment. Even Bitcoin (a fairly reliable risk indicator) recovered strongly into the end of the week.

There is still much to be positive about. Lower yields should help US mortgage rates, for example. The gap between mortgage rates and long-term treasury yields has come in from the highs of 2023, but it still has a way to come down in terms of historical averages. That should support growth. 

The market shakeout was brewing for weeks, judging by the positioning activity of some hedge funds. This need not threaten stability (volatility settled down pretty quickly) but we seem to be in a different phase, in terms of medium-term outlook. Equity valuations have fallen but still look pretty optimistic in terms of expected earnings growth. Falling yields will help those valuations – but probably at the expense of the expected earnings growth they are based on. That could mean higher valuations but slightly soggier profits. Decent returns perhaps, but with a different set of winners.

Japan’s carry-trade catharsis

The Bank of Japan’s rate rise has unwound the yen ‘carry trade’ (borrowing cheaply in Japan and investing in high-yield assets like US stocks) and knocked markets everywhere in the process. Japanese stocks had their worst day since 1987 last Monday, erasing all of the TOPIX’s year-to-date gains. It regained ground in the following days, after dovish comments from the BoJ. This volatility is bad for confidence: Japanese risk appetite is slow to build and quick to collapse, and there is little economic momentum to fall back on. 

The BoJ felt it had to dial back rate rise talk, but it will be wary of staying too easy. The problem for policymakers is that international hedge funds have been much more willing to take advantage of cheap Japanese rates than domestic investors. The carry trade grew massively this year, with money flowing out of Japan and into the US and Mexico – sinking the value of the yen. The BoJ probably turned hawkish because it saw the small impact its easy policy was having on the domestic economy, compared to the huge impact it was having on the yen. This hurt hedge funds involved in the carry trade, amplifying volatility across global stocks.

Domestically, volatility could spook Japanese investors, but the long-term case for Japan remains strong. Recent corporate reforms are a positive for profitability – one of the reasons Japanese stocks broke all-time highs earlier this year. And the yen is extremely cheap on a purchasing power parity basis (even with the currency’s sharp recent gains) making Japanese exports extremely competitive. The ingredients are all there for profit growth over the long-term – exemplified by Honda’s strong Q2 earnings against a difficult backdrop for carmakers. If that comes through, Japanese stocks will start to look very cheap. Hopefully, the carry-trade shakeout is a much needed catharsis.  

Interest rate expectations

Interest rate expectations have moved down sharply after capital market turbulence. The US Federal Reserve has a rate cut pencilled in for September, which the Fed all but confirmed in its July meeting. Recent job market data was disappointing, and the acceleration in unemployment has now triggered an historic recession indicator (the ‘Sahm rule’). Markets now expect the Fed funds rate to be 4.5% by January (down from current 5.25-5.5%). The Fed will have to do something extraordinary to meet current market expectations – but we doubt it will. Recession fears are arguably overplayed, and Jerome Powell has proven his willingness to stick to the plan, even if markets don’t like it.

The Bank of England cut rates in July, but cautioned against further cuts. The sell-off since has moved down markets’ rate expectations – but not as sharply in the UK as elsewhere. Bond traders see the BoE settling on 3.5% rates in 2026, much later than the US and Europe. This is partly cyclical: the UK economy is improving, unlike most developed countries. But it is also structural: the BoE’s 2% inflation target is written in law, unlike its peers who have more discretion. With talk about changing targets globally, we think that makes the BoE structurally more hawkish.

The ECB cut in June and is expected to do so again in September. Markets now put Eurozone rates at 3% by January and close to 2% by the end of 2025. Even though growth and inflation recently beat expectations, forward looking economic indicators are weak and Europe faces many headwinds. If the ECB cuts in line with market expectations, it would mean a rate-lowering cycle almost as aggressive as the pace of hiking before. Europe’s ailing economy might need it.

Please continue to check our blog content for advice, planning issues and the latest investment, market and economic updates from leading investment houses.

Charlotte Clarke

12/08/2024

Please see the below update from EPIC Investment Partners on a current focus point for global markets, the rise in Japan’s interest rates and the implications for the Yen carry trade. Received yesterday – 08/08/2024

Please see the below update from EPIC Investment Partners on a current focus point for global markets, the rise in Japan’s interest rates and the implications for the Yen carry trade. Received yesterday – 08/08/2024

The recent volatility in the Japanese yen, culminating in a sharp appreciation against the dollar, has sent shockwaves through global markets. While some have interpreted the Bank of Japan’s (BOJ) recent comments as dovish, a closer look reveals a different picture. BOJ board members, including Naoki Tamura, have indicated that the neutral interest rate in Japan is likely above 1%, suggesting that the central bank has ample room to tighten monetary policy further. This revelation should have triggered a reassessment of the yen’s trajectory and the viability of the long-standing yen carry trade. Unfortunately, some have misinterpreted the recent BoJ comments as dovish, adding to their short yen positions. 

The yen’s recent strength signals an end to the era of the yen carry trade, a strategy built on the flawed premise that Japan’s low interest rates would persist indefinitely. This trade, where investors borrow yen to invest in higher-yielding assets elsewhere, has always been a house of cards, propped up by investor naivety and a misunderstanding of economic fundamentals.

Japan’s persistent trade surpluses and vast net foreign assets (NFA) paint a different picture. These assets, representing Japan’s claims on the rest of the world, have long suggested that the yen was undervalued. Yet, the allure of easy profits blinded many investors to this reality. As BOJ board member Toyoaki Nakamura put it, “The real effective exchange rate of the yen is still weak compared with its long-term average.”

The carry trade’s unwinding isn’t merely a technical adjustment; it’s a long-overdue reckoning. As investors repatriate capital to Japan, seeking the safety of a creditor nation with a strong economic foundation, the yen’s appreciation is set to continue. The BoJ’s path towards policy normalisation, even if gradual, further reinforces this trend.

The fallout of this unwinding is already evident in the Tokyo stock market’s recent tumble. However, the implications extend far beyond Japan. The dollar, as the world’s reserve currency, has been artificially propped up by the carry trade’s distorted incentives. As the yen strengthens and the carry trade unwinds, the dollar faces a looming reckoning, especially as the Federal Reserve signals a potential easing of its monetary policy.

The yen’s ascent is a harbinger of a broader shift, a signal that the era of easy money in Japan and distorted valuations is coming to an end. The fact that the Fed is set to ease will further undermine the US dollar, accelerating this shift. Investors who fail to heed this warning do so at their own peril. 

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Alex Kitteringham

9^th August 2024