August Market Volatility Update
Recent moves
The reversal of many market trends began around the middle of July. There were unique catalysts to many of these moves, but that shifted to a correlated down move across markets. It’s not unusual to see these kinds of down drafts in August. Many traders and investors are on vacation and larger moves tend to happen during periods of lighter trading volumes.
Here are some of the idiosyncratic events that have combined to cause markets to panic:
- US Interest Rate Policy – market expectations have changed throughout the year with the most recent focal point being an expected rate cut in September. Chairman Powell clearly put this on the table at his recent FED presser.
- Weak US Jobs Growth – the slowdown in the job creation numbers in the US last week caused quite the concern to the market, with more focus on the prospect of slower growth across the economy believed to be caused by the FED taking too long to adjust its policy rate.
- Japanese Rate Policy – Japan is in the opposite situation facing rising inflation and the persistent downward pressure on the Yen compelled the Bank of Japan to break from its longstanding ultra-low-interest rate policy and begin to implement a rate increase.
- AI Related Earnings – Big Tech couldn’t prove to be the saviour this quarter with weaker than expected results, forcing many market commentators to ponder whether AI will be a productive use of their capital and whether it will deliver on profits to make up for the billions already invested.
Market reaction
Many of the moves in the markets have been extreme but this is largely driven by extreme positioning in the first place:
- The technology laden Nasdaq 100 Index has corrected around 15% over the last 4 weeks. It has been the go-to trade for many for the last 2 years and the recent sell-off appears to be driven by investors seeking to liquidate positions and secure cash.
- The Japanese Yen has strengthened remarkably, gaining around 13% against the US Dollar. This movement is particularly noteworthy given the Yen’s status as one of the world’s most important currencies. The moves are extreme because of the unwind of popular, so-called “carry trades”. A carry trade is where speculators borrow in one currency (their funding source) to invest in another. In the case of Japan, speculators or businesses could borrow at close to 0% interest rates and invest in US Dollar assets, where the expected return from cash was 5% or higher. Many would also have invested further along the risk spectrum including US tech stocks. The moves higher in Japanese interest rates and the moves lower in US yields, compressed the profitability of these carry trades, leading to many speculators unwinding these positions
- Volatility has spiked. This market uncertainty has led to a sharp increase in volatility. This surge reflects the heightened cost of risk protection in turbulent times, analogous to the premium spike one would experience when trying to purchase home insurance during an active fire.
How Are We Reacting?
First, as extreme as some of these moves are, the volatility in markets this year has been very subdued. Over the course of the year, it is very normal to experience pockets of volatility such as we are seeing recently. This pattern of calm interspersed with brief turbulent episodes is a normal feature of market behavior. Secondly, so far these moves are the public market’s reaction to recent events and not necessarily a reflection of the economy.
Within our public market portfolios, we will not be immune to the market turmoil. We do expect to see some differentiation from both fixed income and equities from here as our strategy focuses on diversification and capitalizing on market inefficiencies. Within equities we are long Japanese equities in Yen terms. Although the sell-off in Japanese equities denominated in Yen has been significant, it has been partially offset by the strengthening of the Yen resulting in our performance in Canadian dollar terms remaining in-line with US equity markets. We will continue to look to diversify our equity exposure with opportunities outside the US and away from other crowded trades. Within public fixed income, we have positioned the portfolio with more floating rate debt and with exposure outside Canada. We expect to see some other opportunities arise from the volatility in fixed income markets.
More importantly, we build robust portfolios with heavy allocations to alternatives, for exactly these reasons. Our alternatives allocations within private markets (private credit and private equity) are unlikely to be impacted yet. The opportunity set for private equity will get more interesting with lower interest rates and while we expect we will see some expansion in credit spreads in private credit, we also expect this will be offset by lower interest rates. Our hedge fund portfolio is designed to weather these kinds of storms and we expect it will play an important defensive role during this sell-off.
We will watch for signs of economic weakness which could spill into weak company fundamentals and the potential for credit related issues. It’s very early in these moves and there will certainly be other pockets of pain that we haven’t seen yet.
My favourite Warren Buffett quote is “be scared when everyone else is greedy and be greedy when everyone else is scared”. There will be some opportunities from this sell-off and we will be spending time identifying these. Also to quote Mr. Buffett, “when the tide goes out, you see who is swimming naked”. I can assure you we are wearing our swimsuits.
We build portfolios with diversification in mind to ease the impact of market volatility. Diversification away from U.S. equities hasn’t been rewarded over the last 18 months but looks to be the best form of protection today.