End of the carry on?
End of the
carry on?
Bubbles tend to pop, but some deflate without a bang. Investors may be wondering if the inflated valuations in the technology sector are deflating? Since better-than-expected US inflation data on 11th July, it feels as if the ‘bubble’ in Artificial Intelligence (AI) companies is escaping. Nvidia has fallen 23%, even though analysts continue to expect robust profits growth when the company next provides updates at the end of August.
The lower-than-expected US inflation data fuelled expectations of interest rate cuts in coming months. As mentioned in the March Investment Outlook, Japan conversely is embarking on a path of raising interest rates. Having raised rates for the first time in 17 years in March 2024, the Bank of Japan raised interest rates again on 31st July. The prospect of divergent paths of interest rates resulted in a sharp strengthening of the Yen.
The stronger Yen may be impacting other asset classes due to the consequences of the ‘carry-trade’. The carry trade, a popular strategy in the currency market, involves borrowing in a low-interest-rate currency to invest in higher-yielding assets. For years, the Japanese Yen has been a cornerstone of this strategy due to Japan's persistently low interest rates. However, when market conditions shift this strategy can unravel, leading to a ‘carry unwind’, which has profound implications for the Yen and global markets.
Carry trades can be highly profitable in stable market conditions, but they are vulnerable to shifts in risk sentiment or changes in interest rate differentials. When investors anticipate a downturn or escalating geopolitical risks they become risk-averse and unwind these trades by selling higher-yielding assets and buying back the funding currency, in this case, the Yen. This sudden demand for Yen can lead to its sharp appreciation. As the Yen appreciates, other traders may also decide to unwind their positions to avoid further losses, creating a feedback loop that accelerates the Yen's rise.
With the fall in US bond yields relative to Japanese bond yields, we wonder if the Yen’s rise may have further to go?
Given the correlation seen in recent months of the Yen and other asset prices, we wonder if the impact of the Yen sell-off is being seen in other asset prices too. Large US technology shares (as measured by the Magnificent 7 index) have fallen 5% in July whilst US small companies (as shown by the Russell 2000 index) returned 10% over the same period.
US and Japanese bond spreads have started to close, with US yields falling relative to Japanese bond yields which supports a stronger Yen relative to the US Dollar
Source: Artorius, Bloomberg
July 2024 saw small caps outperform after a long period of large cap dominance in US equity markets, a pattern that may be linked to the rise of the Yen versus the US Dollar
Source: Artorius, Bloomberg
Earnings fundamentals matter
These short-term moves may evolve into something more sustained if the fundamentals justify it. The current reporting season, where companies provide updates to investors, suggests a mixed backdrop for US companies, with the overall outlook being downgraded when looking at guidance for Q3 2024.
The likes of McDonalds commentated on the weakness of the US consumer, especially in the low-income bracket. Even amongst technology giants the updates have been varied. Microsoft indicated that growth was moderating, Alphabet (Google’s parent) reported good growth, but analysts wondered about the profitability of their investment into AI.
In Europe, companies have, in general, disappointed investors with their updates. Earnings have underwhelmed expectations. We would suggest that given the weakness in the European economy, the backdrop has been challenging for companies to grow revenues and profits, but the downgrades to analysts’ forecasts is a headwind for investors seeking to diversify out of US companies. One sector with robust profits delivery has been the banks. Both in Europe and in the US, higher interest rates have resulted in impressive profit margin expansion. However, there are risks to the sector when profitability is high. A recession could result in bad debts (and loan write-offs) that could hurt profits. The other risk is that with elevated budget deficits governments may see the profitable banking sector as being ripe for a windfall tax. Unlike taxing households, taxing banks wouldn’t come with any electoral damage, indeed the average person on the street may actually applaud windfall taxes on banks.
Gerard Lane
Chief Investment Officer
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Conclusion
Whilst higher interest rates in Japan shouldn’t normally trouble investors, the consequences of those higher rates, and the prospect of lower interest rates in the US may be rumbling through asset markets. Company earnings have generally been quite poor especially in terms of guidance for the outlook. There are signs of a weak consumer and some expressions of doubt about how profitable AI investment by companies might be. The poster company of AI, Nvidia, reports at the end of August, which may be key in signalling the direction for the wider AI investment thesis and the overall direction for US equities in the shape of the S&P 500.
Important Information
All expressions of opinion reflect the judgment of Artorius at 2nd August 2024 and are subject to change, without notice. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete; we do not accept any liability for any errors or omissions, nor for any actions taken based on its content. The value of an investment and the income from it could go down as well as up. The return at the end of the investment period is not guaranteed and you may get back less than you originally invested. Past performance is not a reliable indicator of future results. Nothing in this document is intended to be, or should be construed as, regulated advice. Artorius provides this document in good faith and for information purposes only. Reliance should not be placed on the information contained within this document when taking individual investments or strategic decisions.
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