By Ben Norris, CFA, Senior Investment Strategist, Vice President
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The week of August 5 began with a continuation of the prior week’s mayhem as the S&P 500 (SPX) suffered a 3% loss, its worst daily performance since September 2022. The technology-heavy Nasdaq Composite lost 3.4%, while the Dow Jones Industrial Average fell 2.6%. At the same time, the CBOE Volatility Index (VIX) shot up more than 60% after a uniquely prolonged period of subdued volatility. The spike in volatility was a continuation of investor anxiety from the prior week’s weak labor data paired with a new phenomenon—the unwinding of an apparently crowded Japanese yen carry trade that rippled across global markets.
In simple terms, a currency carry trade is a strategy that involves borrowing in a lower interest-rate currency and using the proceeds to fund the purchase of a higher interest-rate currency. The profitability of this strategy is often enhanced with the use of leverage. However, the use of leverage also increases the risk of the strategy if there are sudden changes in market environment. In this real-world case, the yen carry trade saw large institutional investors borrow at very low interest rates in Japan in yen (this leads to an effective short position in the currency) to then buy other assets with higher yields (U.S. Treasury bills) in a different currency (the U.S. dollar). The trade works well if the yen remains weak relative to the dollar and Japanese interest rates remain low—allowing investors to benefit from both an appreciation of the dollar relative to the yen and a spread between the prevailing interest rates in the two countries.
Until recently, the Bank of Japan maintained a target interest rate of 0.00-0.10%, while the U.S. Federal Reserve targeted a rate of 5.25-5.00%. The relatively attractive yield on U.S. Treasuries has helped the dollar remain strong relative to many other global currencies—the yen notwithstanding. Investors need to use U.S. dollars to fund the purchase of Treasuries, which in turn creates demand for the dollar, pushing its relative price higher. Recently, the Bank of Japan felt that the depreciation of the yen was becoming too extreme—a weak currency can result in higher import costs, which can fuel inflationary pressures.
Through July, the yen was down approximately 13% relative to the dollar, a large swing over a relatively short period of time. In response, the Bank of Japan raised rates at the end of July to 0.25%, a unique move in a global environment where many other central banks are cutting rates. This caused a sharp rally in the yen relative to the dollar and forced many investors who were previously short the yen to cover their positions. In a scramble to cover those shorts (and to avoid large losses), it appears that many investors were forced to sell equities. While weak labor market data from the first week of August certainly played a role in recent market volatility, it is now assumed that the unwinding of the yen carry trade actually played a more significant role in the turmoil. The good news is that the trade is now almost completely unwound; also, last week’s labor market data showed that the initial reaction to the spike in the unemployment rate was probably overblown.
On the topic of the unemployment rate, the esoteric “Sahm Rule” received a good amount of attention over the past few weeks as investors worried that the labor market was signaling a looming recession. The Sahm Rule is an economic rule of thumb created in 2019 by economist Claudia Sahm. She intended the rule to be an “early diagnosis” of a possible recession. The rule says that when the three-month average U.S. unemployment rate rises by 0.5% or more from its 12-month low, a recession is underway. The latest 4.3% reading of the unemployment rate met this definition. The rule is getting a lot of attention because it has been historically accurate—it has coincided with every recession since 1970. It appears the current environment may be different from prior recessionary periods in a nuanced, but key, way—the recent rise in the unemployment rate is less because of an increasing number of people losing their jobs and more because of people re-entering the labor pool. In reality, the weakening of the labor market probably isn’t that bad. Last week’s initial jobless claims came in lower than expected and much improved the week prior. Yes, there has been a slowdown in hiring and an increase in layoffs, but both measures are still indicative of a historically stable labor market. At the same time, the labor force participation rate is at its highest level since the late 1990s, an otherwise encouraging sign. Finally, corporate earnings commentary hasn’t begun to flash warnings signs of mass job cuts as it typically does in a recessionary environment.
While Monday was a particularly bad day in the markets, the rest of the week was a great comeback story—think Seabiscuit, the Mighty Ducks, Rocky Balboa, the U.S. Men’s Olympic Basketball team, etc.— the 3% loss on the SPX turned into a breakeven by the end of the week. U.S. stocks had fallen nearly 9% at their worst but are now just 5% below their recent highs, and the sell-off is being described as more technical than fundamental. In a typical year, the SPX experiences three 5% drawdowns, and one 10% correction—the recent price action is not out of the ordinary—in fact, I would argue that it is healthy and sets us up for an even greater comeback in the latter half of the year and into 2025.
Further support for a continued comeback is supported by the second-quarter earnings season. Over 90% of the SPX have reported earnings, and results have been solid. The magnitude of earnings surprises (results better than consensus expectations) has been slightly lower than historical averages, but still positive; 78% of companies have beaten estimates, which is above the historical average of around 75%. Total second-quarter SPX earnings growth is expected to finish just shy of 11%, which is higher than initial estimates leading into the reporting period. Full-year estimates across sizes and styles also look strong, with the second half of the year looking particularly promising for small- and mid-cap stocks. Stock prices follow earnings over time, and a strong growth environment paired with potentially lower interest rates could be just what the market needs to get back in the race.
This week’s economic calendar is headlined by inflation data, with the Producer Price Index (PPI) on Tuesday and the Consumer Price Index (CPI) on Thursday. Both reports are expected to show a slight but continued easing of price pressures. Later in the week, we will get updates on consumer trends, the job market and home building trends. Initial jobless claims will be particularly impactful this week as investors and economists look for any significant deterioration in the labor market. There are just a few notable members of the S&P 500 who have yet to report second-quarter earnings, and this week will be relatively slow with just Home Depot (HD), Cisco Systems (CSCO), Walmart (WMT), Deere & Co. (DE) and Applied Materials (AMAT) as the reporters of note.
| TIME (ET) | REPORT | PERIOD | MEDIAN FORECAST | PREVIOUS |
| MONDAY, AUG. 12 | ||||
| 2:00 pm | Monthly U.S. Federal Budget | July | ||
| TUESDAY, AUG. 13 | ||||
| 8:30 am | Producer Price Index (y/y) | July | — | 2.6% |
| 8:30 am | Core PPI (y/y) | July | — | 3.1% |
| WED., AUG. 14 | ||||
| 8:30 am | Consumer Price Index (y/y) | July | 3.0% | 3.0% |
| 8:30 am | Core CPI (y/y) | July | 3.2% | 3.3% |
| THURSDAY, AUG. 15 | ||||
| 8:30 am | Initial Jobless Claims | Aug. 10 | 235,000 | 233,000 |
| 8:30 am | U.S. Retail Sales | July | — | 0.0% |
| 9:15 am | Industrial Production | July | 0.0% | 0.6% |
| 8:30 am | Capacity Utilization | July | 78.6% | 78.8% |
| FRIDAY, AUGUST 16 | ||||
| 8:30 am | Housing Starts | July | 1.35M | 1.35M |
| 8:30 am | Building Permits | July | 1.44M | 1.45M |
| 10:00 am | Home Builder Confidence Index | July | — | 42 |
| 10:00 am | Consumer Sentiment | Aug. | 66.6 | 66.4 |
Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Market Commentary/Market