After the turmoil.
Financial markets have been experiencing turbulence over the last couple of weeks, most especially over the last few days. The U.S. tech sector has faced a notable downturn (dropping more than 15% from their peak on 11 July), leading the rest of the market in a market correction. Within this, Japanese equity markets have caught the worst of the headlines after a sharp sell-off of over 12% in a single day, while the Japanese yen has appreciated more than 10% since early July. These market developments have been influenced by a complex interplay of factors. In this blog, we explain what we think is going on and the implications for investments and your portfolios.
Macroeconomic and Geopolitical Developments
Economic Trends and Policy Shifts
In the United States, the Federal Reserve recently maintained the current level of interest rates (at 5.5%) but gave the surest indication yet of imminent future rate cuts possibly as soon as September. On the other hand, the Bank of Japan has taken a hawkish approach, raising interest rates to the highest level in more than 15 years (from 0.1% to 0.25%) and signalling further tightening. This divergence in central bank interest rates has been a key driver of the yen’s appreciation, while the softer US labour market data in early August spooked some investors.
Market Sentiment
Market sentiment towards the bellwether US tech sector has been hit hard by mediocre earnings from some of the major companies which included cautionary words about ongoing investment and how this could be a headwind for future profits.
Couple all this with a time of year when markets usually have less trading activity (given most people are on holiday!) and growing tensions in the Middle East and one quickly starts to see the magnitude of some market moves, especially in Japan, as increasingly irrational.
Specific Market Developments and Their Primary Causes
US Tech Sector Decline
The U.S. tech sector has seen a significant correction, driven by several factors. The initial surge in tech stocks earlier this year, fuelled by excitement around artificial intelligence (AI), has lost momentum. The recent earnings season revealed that some tech companies failed to meet lofty expectations while highlighting the need for ongoing investment in systems. In other words, these companies that had large cash stockpiles and large profit margins are now spending lots and expecting to earn less in the immediate future. But importantly, for the first time in a long time they are now investing for future growth rather than just buying back their own shares. As long as one believes in the ability of those company management teams to make successful investments, then this could be positive for future growth.
Japanese Equities and the Yen
The strengthening yen has compounded the issue, as many investors unwound “yen-funded carry trades”. In international markets, investors can borrow money in one currency to make investments in other higher yielding currencies (a carry trade). The most logical way to do this is to borrow in the currency that charges the least amount of interest. For decades, that has been the Japanese yen but with inflation in Japan now in line with other developed markets (at about 2.5%}, the Bank of Japan is raising interest rates at the same time as other central banks are embarking on rate cuts. This reduces the attractiveness of borrowing in yen.
The sharpness of the move in the yen has led many to believe it is the result of many investors being forced out of various carry trades at the same time.
Japanese equities have been particularly volatile, driven in no small part by the sharp appreciation of the yen, which hurts export-oriented companies. As the yen strengthens, Japanese goods become more expensive abroad, putting pressure on the country’s exporters. The yen’s rise also reflects broader global concerns, as investors seek safe-haven assets amid market uncertainty.
Investment Implications
Long-Term Perspective
For investors, the current market environment presents both challenges and opportunities. Despite the short-term challenges, the reasons for optimism continue. The recent market corrections have created buying opportunities, particularly in sectors that have been oversold. As always, a diversified portfolio and a long-term investment horizon are crucial for navigating market uncertainties and capitalising on potential opportunities.
