A smooth sea never made a skilled sailor

I suspect some of the regular readers of this blog will have been scratching their heads this week trying to understand what is going on in financial markets across the globe. Suffice it to say that it has been a wild ride recently, with the standout feature being the Japanese equity market, which on Monday fell over 12% and on Tuesday bounced back, rising over 9%. This is no normal event; in fact, this is the largest fall in this major index (Topix) in 37 years.

These dramatic events were preceded by general market weakness last week following weak economic data from the US. The ripple effects, combined with some pronounced currency moves, seem to have triggered this financial market hissy fit, affecting global equity and currency markets, as well as cryptocurrencies, gold and oil.

At times like this, market commentators try to piece together the evidence to explain why markets have behaved as they have. They do not always agree, but prime suspects begin to emerge quite quickly, and, in this case, the finger of blame is being directed at the yen carry trade and fears of a US recession.

Briefly, the yen carry trade refers to “traders” (I have never really understood who these “traders” are despite the fact that the media is always referring to them) who take advantage of Japan’s very low interest rates to borrow in yen, convert to an alternative currency and invest in higher returning assets. Clearly, this sort of trade looks great until the currency the trader has borrowed starts to appreciate against the higher returning asset currency, and this is what has been happening in recent weeks, with the yen appreciating by about 12% against the US $ since mid-July.

In addition, last week's weak labour market data from the US has fed the increasingly common narrative that the FED has been too slow to reduce interest rates and that maintaining excessively tight monetary policy for too long will tip the US economy into recession.

Added to this mix, of course, is my old favourite: excessive valuation and the crowded trade in the leading US technology stocks (the Magnificent 7), which has also been unwinding somewhat in recent weeks. See below, for example, the chart of Nvidia’s share price this year. It has been a great investment over the last twelve months, but the recent setback from its peak in the second half of June has taken over US$860 billion off its market value.

I am not going to attempt to explain why these global market events have occurred simply because I don’t know, and, importantly, I am not at all sure that the precise causes are knowable. Global financial markets are inherently complex interlinked systems that can be disturbed by the interconnectivity of countless dynamic variables whose relevance and importance vary over time. I have long believed that in the short-term markets are anything but efficient and can exhibit anomalous behaviour that is impossible to rationalise. For example, yen strength, the chief culprit for this two-day hiatus in financial markets, has been evident since early July (see below), and the FED has been very clear about its approach to loosening monetary policy for months. In other words, neither of these two “events” was new news.

Having said this, I do have some observations to make which have helped to guide me through these sorts of events over the last 35 years because as much as the fall in Japan was extraordinary, these sorts of events in global financial markets are pretty common. For example, although the 3% fall in the S&P 500 on Monday felt extreme, there were eight occasions in 2022 alone when that market fell by more than 3%.

1. If you are investing in equities, it helps to remember that you are investing in businesses, not “the market”. And it is fundamentally important to remember that the objective is to buy and own the undervalued ones (for those pursuing an active approach). That is, the businesses whose intrinsic value is higher than their market value. It helps to remember this when markets wobble as they have in recent days.
2. When financial markets go through the sort of hiatus we have seen in recent days, if you don’t know why you own shares in an individual business or a portfolio, in other words, you don’t have a clear understanding of your investment rationale, you are far more likely to react to market perturbations and end up selling at precisely the wrong moment.
3. When markets panic about an event, whatever it is, before reacting, it is important to try to evaluate whether that event has or will have any impact on the intrinsic value of the businesses you are invested in. If it has no impact at all, then it makes sense to sit tight and not react to a market panic. This can be hard to do when the crowd is gripped with fear, but it will ensure you don’t get mugged by the market.
4. Warren Buffett once said that if you weren’t willing to own a stock for ten years, you shouldn’t even think about owning it for ten minutes. Ultimately, this is the best protection when something like this week’s market wobble occurs. Once you are anchored to the concept of long-term investing and focused on creating value over an extended period, the relevance of the events we have seen this week can be properly quantified.

I don’t plan to comment here on the unwinding of the yen carry trade, but I thought I should comment on the other worry that appears to have had some impact on market sentiment in recent days, which is the likelihood of a US recession. My view is that monetary policy is too tight in the US, as it is in the UK and probably in Europe too. But I don’t think this means a US recession is likely. Fundamentally, the US labour market is strong, and unemployment is low, and neither point to the sort of circumstances that would lead to a US recession. I continue to expect US inflation to fall and that US interest rates will follow suit starting in September. Lower rates will support the economy and the equity market (but not excessive valuation). So, I am cautiously optimistic, albeit that I believe the UK economy and stock market will outperform both over the next 18 months.