We have been talking for some while in our quarterly valuation letters about limiting exposure to expensive equity themes, such as large cap US technology companies, and the importance of broad diversification in underlying equity exposure. Movements in equity prices on Monday this week are a good example of the extent to which prices can be impacted in expensive sectors of the market in a risk off environment.
At the time of writing we have witnessed a partial recovery in US and Japanese stock markets although the drivers of short-term volatility have now changed moving us into a different market phase.
Looking firstly at what has already happened:
US Economy
On Thursday last week the US Institute of Supply Management (ISM) report, which gauges the strength of the US economy, registered a fall of 1.7 points for July (down to 46.8) when it was expected to rise. Numbers below/above 50 signify economic contraction/expansion. The report also showed a sharper slowdown in hiring versus expectations adding fears that higher interest rates are now having a more negative impact on the economy. There were also reports that consumers, who make up approx. 60% of the US economy, are starting to slow spending.
Some of the highly valued US tech names have recently reported disappointing earnings and with news emerging over the weekend that Berkshire Hathaway (Warren Buffet’s main investment vehicle) sold half of it’s holding in Apple during the second quarter of 2024, this left the US market vulnerable to a setback on Monday morning.
Japan Central Bank Policy and the Carry Trade
At the same time, concerns have been growing in Japan about a structural change in central bank policy. For many years the Bank of Japan (BoJ) has been trying to generate growth through selling its own currency, to maintain a competitive export advantage, and keeping interest rates low, through regular purchase of Japanese bonds (otherwise known as quantitative easing). This process has finally worked with inflation running at 2.8% for the year to end of June 2024.
To offset this higher inflation rate, the BoJ increased interest rates in March this year, which it has not done since the beginning of 2016, up to 0.1% and again up to 0.25% at the end of July and also confirmed it would be halving its bond purchasing program. In the last four weeks these actions have increased the value of the Japanese Yen by approx. 11.0%.
Leveraging off a central bank policy designed to suppress currency value over the medium term, institutions have been investing in something called the ‘carry trade’ whereby they have been borrowing at low interest rates in Japan to fund the purchase of higher yielding assets in other markets. With the Japanese Yen having gone up sharply over the last month the value of these investments has fallen dramatically.
Stock Market Declines
Over the course of last weekend, rising concerns over a potential slowdown in the US economy combined with concerns over an unwinding of the Japanese carry trade led to a fall of 12.2% in the Japanese Topix index on Monday morning and a fall of 3.0% in the US S&P 500 index by end of that day. The fall in the Topix index was the worst since Black Monday in 1987.
The S&P 500 index rose by 20% over the calendar year to 16th July with the ‘Magnificent 7’ (US tech stocks) representing 52% of that growth. By the end of Monday, the index was down 8% from its July peak with the US Technology weighted Nasdaq index down by 13% demonstrating significant impact in an expensive sector of the market.
Nvidia who make high speed Graphics Processing Units (GPUs) used in Artificial Intelligence and Machine learning applications was down 25% from its peak in June and Intel, one of the biggest chip makers in the US, was down 30% over the week after unveiling plans to cut 15,000 jobs as part of a turnaround plan.
Looking forward:
Interest Rates
Prior to last weekend the US market was indicating only two interest rate cuts of 0.25% each before year end whereas the softer jobs data released last week has now changed that outlook with expectations moving to a cut of close to 1.2% by year end. This is a big change indicating that two of the cuts, out of the remaining three Federal Open Market Committee (FOMC) meetings, could be 0.50%. Assuming the jobs data levels out over the remainder of this year, three cuts of 0.25% may be more realistic.
The speed at which interest rates fall in the US will clearly depend on future economic data, however, current expectations are for a terminal/resting interest rate of 3.5% by the end of 2025. Interest rates will be falling in the UK and Europe at the same time which will be positive for broader economic growth adding support to our smaller company allocation across all portfolios.
Portfolio Actions
Our central view is that we do expect to see positive equity market returns as interest rates come down in the US, UK & Europe over the next two to three years. In the short term, however, we do see some potential downside for equity markets depending on the rate of economic slowdown.
Given our positive medium term view we would see any short-term weakness in equity markets as a buying opportunity. We will raise funds for equity purchase from our overweight in fixed income investments (government and corporate bonds) whilst maintaining a neutral weighting to Alternative Assets (global infrastructure, property and absolute return funds). This positioning will be aimed at maximizing portfolio return opportunities over the next two to three years.
Conclusion
The general feeling is that the US economy looks OK at the moment and that the FOMC have plenty of room to cut interest rates which they can do quickly if required. The BoJ have also confirmed they will not increase interest rates further during unstable market conditions. Whilst we do expect market volatility to persist in the short term, we will seek to use that volatility to adjust portfolio positioning into what we believe will be a positive phase for equity market returns in 2025 and 2026.
If you have any questions regarding the above, please don’t hesitate to contact PK Wealth via investments@pkgroup.co.uk or +44 (0)20 8334 9953
The information in this document does not constitute advice or a recommendation and is for the information of the recipient only. Past performance is not a reliable indicator of future returns. The value of investments and the income derived from them can go down as well as up and you may not get back the amount invested. PK Wealth Ltd is a limited company registered in England and Wales (number 08991126) and is authorised and regulated by the Financial Conduct Authority.
