Every Tuesday afternoon we publish a collection of topics and give our expert opinion about the Equity Markets.

The global stock sellout intensified yesterday thanks to the Japanese stock market experiencing its second-largest-ever single-day loss in history. The sea of red came off the back of US markets melting down on Friday off the back of weak jobs data. ABSI this week takes a closer look at the current market sentiment and the cause of this chaos. 

The Goldilocks narrative is breaking down in the US economy with the July jobs report coming in weaker than expected. Non-farm payrolls rose by 114k last month against a consensus estimate of 175k and down from 179k in June and 216k in May. The unemployment rate also ticked up unexpectedly to 4.3% from 4.1% due to an increase in the participation rate which saw the number of unemployed people rise by 352k to 7.2m. 

The weak jobs report adds to a flurry of disappointing macro data which has prompted a selloff in equities and a shift into bonds as market prices in aggressive interest rate cuts by the Fed. The Nasdaq is now down 10% from its peak and the VIX has spiked to levels not seen since 2022. Continually, yields on US bonds are also surging lower (meaning bond prices are higher) as a flight to safety and as investors make bets that the Fed will have to cut more aggressively. The market is pricing in an 80% chance of a 50 bps cut in Sept.

Source: World Government Bonds

It is important to appreciate that the repercussions are being felt globally with stock markets witnessing a sea of red across the board. The ASX200 is down almost 6% since August 1st but nothing compares to Japan which saw the Nikkei slumped ~12.4% on Monday, its second biggest single-day drop. The loss also comes off the back of weakness across last week which has the index now down over 25% from its record high set in July.

Source:  X

So why is Japan getting hit worse than most?

Last month the Bank of Japan ended eight years of negative interest rates and other monetary stimulus policies aimed at reflating an economy in perpetual decline. While the first interest rate rise in 17 years only takes interest rates to 0%, the BoJ Governor, Kazuo Ueda, has indicated a desire to return to a normal monetary policy target in line with other global central banks. This rhetoric has set off a cascade of dominos. 

The carry trade is a popular strategy which involves borrowing in a low-interest-rate currency and investing in a high-interest-rate currency. Given the Japanese negative interest rates, traders would borrow Yen, sell the currency for US Dollars and invest in US financial markets making money in the US while also being paid to borrow Yen. The risk to the strategy is the forex risk, to be profitable a trader must hope that the USD doesn’t depreciate against the Yen which would make its debt more expensive to pay.

Source:  Forex Live

As a result, the carry trade has seen the Yen depreciate significantly over the past few years. While this is good for Japanese exports and business, resulting in new record highs in the Nikkei, it also imports inflation as imports become more expensive. Japanese inflation has gone from deflation (negative inflation) to a peak of 4.3% in Jan 2023, highs not seen in a decade. This consistently high inflation is the underlying reason for the BoJ to switch its monetary policy stance and start to increase interest rates. 

The increasing interest rate environment in Japan coupled with a decreasing interest rate environment in the US is resulting in an unwinding of the carry trade. Traders are liquidating their US investments and selling USD to buy Yen. The result, an explosion in appreciation of the Yen and weakness in the US stock market as money exits the system. Additionally, a strong Yen is bearish for Japanese business as exports become more expensive and will likely lower revenue growth rates. The final nail in the coffin for the Japanese stock market is that you have the domestic investors who took out margin loans at extremely low interest rates and invested them into the Nikkei. There appears to be a cascading death spiral of margin calls adding fuel to the fire. 

So what does this all mean?

There was a bubble in the USD/JPY carry trade and the Japanese stock market was propped up with unnatural monetary stimulus. The BoJ has burst the bubble and what we’re witnessing is a normalisation of the Japanese financial market, though it will take a while to play out and remains to be seen if the BoJ will continue along the path given the debt burden at a public and private level. The duration of this volatility is uncertain but it creates a fantastic buying opportunity in quality stocks whose fundamentals have not changed. 

How does that old Buffett adage go…

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