Perhaps the greatest challenge for investors in July was to choose the single most important news story for the month. The shooting at the Trump rally in Pennsylvania? President Biden announcing his intention to not run for reelection? The CrowdStrike sourced shut down of the internet? The reversal in fortune of the Magnificent 7 stocks? The S&P 500 itself was +1.2% for the month but the S&P 400 MidCap was +5.8% and the S&P 600 SmallCap +10.8% while five of “The 7” posted losses ranging from -5.2% (Amazon) to -8.4% (Microsoft). Reuter’s news service had an explanation at hand in an article published July 18th. “U.S. small-cap stocks are having a long-awaited moment, ignited by expectations of interest rate cuts and improving prospects for the election of Republican presidential candidate Donald Trump…” There may be an explanation for the dramatic reversal of fortune in US equity markets but US presidential politics may not be its source.
The world’s largest financial market, that of foreign exchange, the selling of one nation’s currency for the purchase of another’s, is larger than all other financial markets combined with a daily trading volume of $6 trillion, half involving the US dollar, in contrast to $1.2 trillion for global bonds and just over $500 billion for US equities. As nations’ economies have become increasingly interconnected the foreign exchange market has become “the dog” wagging “the tail” of other financial markets and yet its role is often overlooked or simply ignored. That is a mistake for this is the market where the global economic and financial systems which have become increasingly out of balance must literally “balance their accounts.”
Foreign Exchange markets normally have much lower levels of volatility than equity markets with market trends typically very gradual and of extended duration. The Japanese yen – US dollar relationship though has belied this characteristic in recent years. In the five years from 2016 through 2021 the US dollar rose in value against the yen by 20%. In the just over two and one-half years from 2022 to July 11, 2024, it rose 40%. Year to date through July 11 the dollar fell 1.74% against the euro, rose 5.11% against the Chinese yuan but 19.4% against the yen. So, why should we care and unless we’re planning on joining our one million fellow citizens who visited Japan during the first five months of this year to take advantage of an entire country on sale for holders of US dollars why would this matter?
Since 1989 Japan has frequently experienced falling prices so Japanese investors had been content to hold their savings as cash and bank deposits without being paid interest. In 2022 Japan began to experience inflation of just over 2%. To encourage Japanese savers to assume a measure of risk to earn returns on their savings Japan’s government introduced the Nippon Investment Savings Account (NISA). In January the allowable contributions to those accounts were doubled to $24,000 with lifetime contributions also increased to $120,000. Returns on these accounts are exempt from tax. A preferred investment for investors making use of these accounts is US equities and individual stocks. Flows into these investments have reached monthly levels of $5.6 billion. While less than the flow of US investors $30 billion into US equities that amount is material and, more than US investor asset flows, focused on technology stocks. With the additional benefit for Japanese investors of the declining value of the yen, since the end of 2022 Japanese investors in US technology stocks have experienced returns of over 100%.
A counter party to the role played by Japan’s individual investor is the global “carry trade” in which hedge funds borrow money in a low-interest rate currency, the Japanese yen, and use those to purchase US dollars to invest in bonds and equities in US financial markets. The size of this trade is estimated to be as large as $20 trillion dollars. Since 2016 the yen has steadily fallen against the US dollar making the trade both extremely popular and profitable. The declining value of the yen though has created economic problems for Japan leading to higher levels of inflation. At 8:30 am on July 11th a weaker than expected inflation reading for the US was released. This led to a modest pullback in the value of the US dollar. Eleven minutes later Japan’s Ministry of Finance stepped into the market selling US dollar’s and buying Japanese yen causing the yen to rise against the US dollar. At that point the algorithmic trading platforms kicked in selling those assets which had previously outperformed the market (think the “Magnificent 7” stocks) and buying the previously underperforming asset class, small cap stocks. This likely explains the 19% “reversal of fortune” of the two asset classes from that point through month’s end. So, Japan’s individual investors fed a market trend supported by the global carry trade manifested through the use of electronic trading platforms that then fell victim to Japan’s monetary authorities seeking to arrest the decline in the value of the yen. Amidst “the tempest and tumult” 60/40 equity/fixed income investors “enjoyed” a 2% positive month and 11.7% year to date. Equities returned 2.25% and fixed income, with the interest rate declines occurring late in the month,1.625%. There is a more than faint whiff of disinflation in the air so perhaps bonds will “spring” as we step into fall.
Mark H. Tekamp/August 3, 2024
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