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Dear Investor

General Market Overview

The end-of-July volatility and sell-off triggered by various disappointing economic releases was short-lived and markets, particularly the Japanese market, recovered relatively quickly (within a week) from a sharp drawdown.

The spike in volatility is evident when examining the movement in the VIX Index. Over the past year, volatility has been very muted, but early August saw option-implied volatility temporarily hit an intra-day peak of just under 66 and a daily peak of 38 before “recovering” once more.

One of the economic indicators that prompted the sell-off and a closely watched metric is United States (US) Nonfarm Payrolls. The July data, released in early August, added 68 thousand fewer jobs than in June, marking two consecutive months of fewer jobs.

A decline in payrolls raises the fear that the US economy may be slowing more than anticipated. While the Consumer Price Index (CPI) inflation index fell to 2.9% year-over-year (y/y), core inflation, excluding more volatile items like food and energy increased in July and remains above the Fed’s 2% target. The combination of slowing payrolls and inflation, which, while slowing, could still be considered “persistent”, caused a sell-off reaction as investors worried that the Fed may not begin to reduce interest rates.

These fears were, however, very short-lived, and just five days later, much of the losses were reversed entirely. Strong earnings reports were released, particularly by tech-sector companies. Several central banks “communicated” that they would enact policies that were supportive of growth if required (i.e. a reduction in interest rates), and stronger-than-expected ISM Services Index data was released in the US, indicating that a significant component of the US economy was still growing strongly.

Key economic data releases give market participants some sense of how the US Federal Reserve (the Fed) might react, given current data. The next Fed meeting is on the 18th of September. In evidence of a betting market for quite literally anything, the platform Kalshi allows market participants to place bets on a range of financial, political, social and economic outcomes. Based on the current “odds”, there is a 77% chance of a 25 basis point (bp) cut at the next meeting and a 26% chance of a “more than 25bp cut”. There is no expectation (based on Kalshi participants) of an increase in interest rates.

The actions of the Fed play a crucial role in shaping financial asset prices and investor sentiment globally. Financial mechanisms are interconnected, and the Fed funds rate is often the proxy interest rate used in valuing financial assets, not only in the fixed income sector. A commonly used valuation technique within equities is to discount future cash flows or earnings expectations to arrive at a present value. When a higher discount rate is used, the present value of those forecast future flows is lower, and conversely, a lower discount rate implies a higher present value. If the Fed does do as the market expects and lowers rates in September, this “automatically” implies a

higher present value of future cash flows, whether those cash flows are from corporate earnings, fixed income coupons or real estate rental income.

A lower discount rate also means that the cost of borrowing falls. At a corporate level, this might enable companies to raise more debt at a lower cost to finance expansion. It holds true for consumers, too; lower borrowing costs would allow individuals to borrow more to fund spending. Interest rates are a key driver of prices and behaviour, which is why monetary policy can potentially change the economic path.

In addition to the comments by the Fed, another chart that receives much analysis and attention is the Fed Dot Plot. Since 2012, the Fed has published the dot plot as part of a drive toward transparency, and it has now become another favourite image from which to seek clues about upcoming Fed policy.

Each dot represents the outlook of one member of the Fed’s policymaking group, the Open Market Committee (FOMC). This chart was published following the last June meeting and indicates each committee member’s outlook at year-end.

The “longer run” column indicates what a neutral interest rate level might be based on the expectations of the FOMC members. When interpreting the dot plot, it is helpful to examine the trend from year to year and how tightly clustered (or not) the dots are. On a trend basis, from 2024 to 2025 and into 2026, there is a definite downward trajectory showing that the committee is in broad agreement that rates will likely drop over the coming years.

When the dots are tightly clustered, it indicates consensus among the members, and while there are outliers in 2025 and 2026, there is a degree of consensus around the 4% level in 2025 and the 3-3.5% level in 2026. Of course, dot plots change over time as economic data unfolds, but as things stand currently, we are undoubtedly at the top of the interest rate cycle in the United States.

Several central banks have already started to reduce rates and market expectations across a range of countries show the pricing in of lower rates. The European Central Bank (ECB) and the Bank of England (BoE) have reduced their interest rates, and market expectations are for lower levels by year-end.

One central bank not currently at the top of the interest rate cycle and cutting is the Bank of Japan (BoJ). It is worth reviewing Japanese rates over a long time frame as the chart has essentially been a “flat line” for an extended period. In July, the BoJ raised rates to around 0.25% from the range of 0-0.1% set in March.

Japan has been in an ultra-low and sometimes deflationary environment for decades. Annual inflation was 2.8% (above the 2% target) in July and is “holding steady”, allowing the BoJ more leeway to continue increasing interest rates. The Japanese government also upgraded its economic assessment for the first time in more than a year on signs of improved consumption, and the Japanese economy expanded at a faster-than-expected pace of 3.1% y/y in 2Q24.

Despite some signs of strength in the Japanese economy, the Japanese market was particularly impacted by the early-August sell-off, falling over 20% in the first three days of the month and losing 12% in one day on the 5th of August. A trade that we’ve spoken of before is the Yen carry trade, which involves borrowing (shorting) Yen at low rates and investing in US Dollars, earning a much higher yield. In the days of concern about the strength of the US economy, many “risk-on” trades, including the Yen carry trade, were unwound. Investors reverse their positions by selling Dollars and buying Yen to unwind this trade.

The Yen is not a thinly traded currency; it is the third most active currency with a daily turnover over around $1 trillion, meaning that carry trade unwinding caused a sharp strengthening of the Yen relative to the Dollar and a rapid decline in Japanese equities. Of course, this came just at the BoJ raised rates, reducing the carry differential and making the trade slightly less attractive.

General Conclusion

As stated last quarter, central banks’ policies will shape market returns and sentiment. Several central banks, including the ECB and the BoE, have started cutting interest rates, which generally support equity market valuations and directly increase fixed-income prices.

The price action of equity markets in early August and the accompanying spike in volatility demonstrates how inter-connected global markets are and how sensitive market participants are to perception changes in the economic outlook. It reinforces the investment philosophy that while it would be easy to be “swept up” in the latest financial headlines, it is crucial to take a longer-term strategic approach to investing to avoid being overly reactive.

The September meeting and interest rate decision by the Fed will add more certainty to the likely path of interest rates over the remainder of 2024 and into 2025. However, we still have the US General Election to contend with in November, which comes with its own brand of global uncertainty.


06 September 2024


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