It ain’t what you don’t know that gets you in trouble. It’s what you know for sure that just ain’t so.
– Mark Twain
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 not to run for reelection? The CrowdStrike-sourced shutdown of the internet? The reversal in fortune of the Magnificent 7 stocks? The S&P 500 itself was up 1.2% for the month, but the S&P 400 MidCap was up 5.8%, and the S&P 600 SmallCap was up 10.8%, while five of “The 7” posted losses ranging from -5.2% (Amazon) to -8.4% (Microsoft). Reuters’ news service had an explanation at hand in an article published on July 18. “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 U.S. equity markets, but U.S. 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 U.S. dollar, in contrast to $1.2 trillion for global bonds and just over $500 billion for U.S. 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 that 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–U.S. dollar relationship, though, has belied this characteristic in recent years. In the five years from 2016 through 2021, the U.S. dollar rose in value against the yen by 20%. In the just over two and a 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 rose 19.4% against the yen. So why should we care? Unless we’re planning to join 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 U.S. 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 receiving 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 using these accounts is U.S. equities and individual stocks. Flows into these investments have reached monthly levels of $5.6 billion. While less than the flow of U.S. investors’ $30 billion into U.S. equities, that amount is material and focuses more on technology stocks than U.S. investor asset flows. With the additional benefit of the declining value of the yen, since the end of 2022, Japanese investors in U.S. technology stocks have experienced returns of over 100%.
A counterparty 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 it 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. Since 2016, the yen has steadily fallen against the US dollar, making the trade both extremely popular and profitable. However, the declining value of the yen has created economic problems for Japan, leading to higher levels of inflation. At 8:30 a.m. on July 11th, a weaker-than-expected inflation reading for the US was released, resulting in a modest pullback in the value of the US dollar. Eleven minutes later, Japan’s Ministry of Finance stepped into the market, selling US dollars 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 the month’s end. Thus, Japan’s individual investors fed a market trend supported by the global carry trade, which 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, returned 1.625%. There is more than a faint whiff of disinflation in the air, so perhaps bonds will “spring” as we step into fall.
Mark H. Tekamp