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At first glance, the sharp swings in global markets over the past ten days appear to have been driven by rising fears of a US recession and that the Federal Reserve had been caught off guard. Weak labour market data, coupled with gloomy survey evidence on the state of the country’s manufacturing industry, induced weakness in crowded and exuberantly valued areas of the US stock market, such as technology. In short, an army of momentum-driven traders was dramatically caught off guard by the extreme volatility in August markets.
Yet the recession obsession borders on the perverse, given that the economy was growing at 2.8% in the second quarter and a weaker labor market is a precondition for meeting the Fed’s 2% inflation target. This is a reminder that one of the dangers of data-driven monetary policy (the Fed’s phrase for looking in the rearview mirror) is the constant overreaction to new data releases.
A more fundamental point behind the sky-high volatility is the relative shift in monetary policy between the United States and Japan. While the Fed chairman Jay Powell has clearly pointed out In a statement, his Japanese counterpart, Kazuo Ueda, announced that a cycle of rate cuts would begin in September, and last week he aggressively modified monetary policy. In addition to raising the reference rate, he indicated that more adjustments were on the way.
The ensuing rise in the yen triggered a dramatic unraveling of the yen carry trade, whereby investors borrow in the low-interest Japanese currency to invest in higher-yielding assets elsewhere, including U.S. technology stocks. yen Weakness and negative interest rates have caused this operation to take off. In the absence of good data, the dynamics of the unwinding are difficult to interpret. But TS Lombard estimates that investors may need to find as much as $1.1 trillion to repay the yen carry trade loans.
The risk now is that Fed cuts to address weak labor markets and the threat of recession will unravel more carry trades, with further disruption to markets globally.
All of this marks a radical change in the evolution of the business cycle. During this century and within the memory of most people who now participate in the stock markets, recessions have been precipitated by financial booms that turned into crises. Central banks have then acted as lenders and market makers of last resort to deal with the resulting financial instability. These actions have been carried out against a backdrop of latent inflation, courtesy of globalization and the erosion of the pricing power of workers and firms.
In contrast, in the 1980s and 1990s, recessions were induced by a tightening of monetary policy to control inflation. Because financial institutions were more regulated, there was less financial instability. Inflation was the main criterion for judging the sustainability of economic expansions, as opposed to financial imbalances.
The combination of the pandemic and the war in Ukraine has created economic circumstances very similar to those of the late 20th century, but thanks to financial liberalisation, the scope for financial disruption in a monetary tightening cycle is much greater, as demonstrated by the collapse of Silicon Valley Bank and others last year.
It is unclear how far financial vulnerability will be exposed in this cycle. Because of the long period of ultra-low interest rates since the 2008 financial crisis, much of the private sector’s borrowing has been at fixed rates and with long maturities, so the credit stress resulting from the sharp interest rate hikes of the past two years has been delayed. And there is also enormous uncertainty about the degree of risk-taking in the burgeoning non-bank financial sector.
There are reasons to view the stocks’ pullback as a healthy correction, however. Market momentum this year has been overly dependent on the hype surrounding artificial intelligence in the so-called “magnificent seven” tech stocks. It is worth noting that Elroy Dimson, Paul Marsh and Mike Staunton, in UBS’s global investment performance yearbooks, have established that for more than a century investors have assigned too high an initial value to new technologies, overvaluing the new and undervaluing the old.
One benign feature of the correction is that price correlations between bonds and stocks have turned from positive to negative. That is, they no longer move in lockstep and provide investors with the benefit of diversification because they act as hedges for each other. This is important because diversification helps address the problem of market concentration and the overweight of technology stocks in the US market.
In a tense election year in the United States, it’s a safe bet that… volatility It won’t go away, although history tells us that over the long term it is in mean reversion. For investors looking for safe haven assets, gold was a disappointment this week, as it fell along with stocks. But that was likely a reflection of investors selling to meet margin requirements on riskier assets.
Over longer periods and against a backdrop of continued geopolitical turbulence and financial fragility, the yellow metal will offer valuable diversification, as it has done for centuries. Don’t expect anything remotely comparable from cryptocurrencies.