Wild Wild East!

The month of July was mixed for the North American markets as the rotation out of the heavyweights in favor for small-and-medium capitalization companies continued for the most part. The technology sector heavy NASDAQ index ended up in red at ~-0.73%, S&P 500 Index at ~+1.2%, while S&P TSX Index played catch up and was up by ~+5.9%. However, the market tremors at the beginning of the month of August revealed that there is more to the recent market moves than the rotation trade.

The Bank of Japan raised the policy rates to +0.25% on July 31st, in alignment with market expectations that were building up over the month. The increase in policy rates by the Bank of Japan was at a time when the rest of the world is on the other end of the cycle, i.e. close to embark on a cycle of cutting policy rates, which led the Japanese YEN to appreciate more than +10% against the USD during the month. This made the ‘carry trade’, a practice of borrowing from lower yielding economies and investing in high yielding economies, unattractive to a lot of investors. As they were forced to unwind their positions, the NASDAQ nosedived almost in unison with the USDJPY currency pair (See figure 1).

Figure 1: NASDAQ vs. USDJPY, year-to-date

Base: 2 January 2024 = 100

Source: Bloomberg

Given the ultra-low interest rates in Japan for a very long time, the country has been a source of capital for the rest of the world’s financial markets. Should this dynamic change in a quick and disorderly fashion, it has the potential to bring more wild swings in the financial markets, in our view. The recent comments from the deputy governor of Japan that the ‘Bank of Japan will not hike interest rates while the financial and capital markets are unstable’ restored some calmness back into the markets.   

Apart from the shockwaves from the east, the recent economic data releases also added to investor anxiety. The unemployment rate in the US increased from +4.1% in June (reported in July) to +4.3% in July (reported in August), triggering the Sahm rule indicator, which indicates the start of recession if the three-month average unemployment rate is +0.50% above its low in the previous 12 months. The unemployment rate in Canada also increased from +6.2% in June (reported in July) to +6.4% in July (reported in August); higher-than-expectations of +6.3%. The Bank of Canada reduced policy rates by 25 basis points to +4.50%, and while the US Federal Reserve held policy rates during the July meeting, it hinted at a possible rate cut in September. The emphasis during the press conference was that the job market seems to be better balanced, but the Federal Open Markets Committee (FOMC) will be more attentive to any sign of deterioration. The Central Bank’s indication of becoming more sensitive to the labor market followed by weaker job data did not help ongoing investor concerns.

The worries of a potential recession given the cooling of economic data could persist for some time, keeping a lid on further market gains in the short-term, in our view. That said, we note that factors such as Hurricane Beryl might be behind the surge in unemployment numbers and thus prove temporary. The Institute of Supply Management’s (ISM) Manufacturing Purchasing Managers’ Index (PMI) dropped to +46.8 for July (reported in August) from +48.5 in June (reported in July) indicating contraction in manufacturing activity. However, the ISM Services PMI Index jumped to +51.4 in July (reported in August) from +48.8 in June (reported in July) indicating expansion in the services activity. As per world bank data, services sector constituted about +76.7% of United States GDP in 2021. Overall, we think the balance of economic data does not lend much credence to the concerns of a significant slowdown at present, in our opinion.