Market selloff due to weaker economic data and diverging central bank expectations
What happened?
A negative market reaction was triggered by a sharp selloff in Japanese stocks into the close earlier this morning, with the Topix and Nikkei indices suffering 12% declines – their worst day since 1987. Australian equities sold off by 3.7%, with the large banks underperforming. New Zealand equities sold off by less than Australian and other Asian markets. The selloff cascaded through global markets with the EuroStoxx 600 trading down over 3% on Monday and S&P 500 futures were off 4% ahead of the New York open. The selloff was catalysed by a combination of weaker economic data in the U.S. (payrolls and manufacturing surveys) and diverging central bank expectations, which drove a sharp appreciation of the Japanese Yen.
Reaction
The impact has been widespread but has been particularly significant in the Japanese equity market and currency. The aggressiveness of the market movement has been surprising, reflecting stretched initial positioning and investor optimism, but also a potential overreaction to recent fundamental developments.
For example, markets now expect five interest rate cuts by the Federal Reserve into year-end, including two supersized rate cuts at the September and November meetings. We think this is an overreaction to the U.S. employment numbers released on Friday which showed positive, albeit slowing, jobs growth, with extreme weather1 likely contributing to the miss. We are monitoring the sharp decline in yields in our multi-asset and fixed income portfolio strategies, with an eye toward rebalancing and profit-taking, as Treasuries no longer look cheap to us at these levels. Australian government bonds have similarly rallied, with the market focus now turning to the August RBA meeting. New Zealand government bonds have been underperforming Australian bonds over the last two weeks, after significantly outperforming before that.
Notably, we have also seen a large appreciation of the Yen against the U.S. dollar in recent weeks, from a level of 162 on July 10, to 142 (-12%) at today’s New York open. The sharp move reflects diverging central bank expectations—with the Bank of Japan hiking into expected Fed rate cuts—and an unwind of the recently popular ‘Yen carry trade’, with investors using the lower-yielding Yen currency to fund higher-yielding currency positions in the U.S. and emerging markets. The Australian dollar has been volatile against the USD, hovering around $0.65 USD. The New Zealand dollar has been much steadier against the USD and is trading close to $0.60.
We continue to remain highly attentive to market moves and portfolio positioning but given markets are extremely volatile, it is important not to over-react. We remain guided by our investment process.
The bottom line
In summary, while the Bank of Japan rate increase was a surprise to investors and the weak U.S. job numbers increased concerns around growth and interest rate cuts in the U.S., stretched positioning and crowded carry trades appear to be driving much of the moves in the Japanese yen and global markets right now.
We think the market could be overreacting to both the data flow from the U.S. and Japan. As such, we will be watching our sentiment indicators closely for potential opportunities and dislocations coming out of this. For now, we plan no major changes to positioning in portfolios, as we were already neutral-to-slightly-defensive. We are closely monitoring markets and will keep our clients posted of any updates.
1 https://www.fema.gov/disaster/4798