Liquidity – noun: the fact of being available in the form of money, rather than investments or property, or of being able to be changed into money easily.
– Cambridge Business English Dictionary
If you took an extended summer break and have come back to look at the two-month results for July and August, you will be pleased to see that most equity markets delivered mid-single-digit gains and the FTSE Canada Universe Bond Index rose a solid 2.7%.
The market situation is positive, welcome, and in line with our base case of the global economy normalizing. We have a global economic backdrop where inflation is no longer the main worry, the U.S. economy is cooling as desired, and the rest of the world is poised to pick up some slack as many central banks are fully engaged in loosening monetary policy.
The bond market is on board with this scenario, and bonds offer fair value. Equity markets have priced in some of this encouraging outcome; gains are broadening out to more and more geographies, and more and more companies are participating in the rally. If you’re only interested in where things landed on August 31 then this can be the end of the story; nothing to see here – carry on. If you’re trying to extend your summer bliss, you should stop reading now.
However, for most investors a fully unplugged summer wasn’t our reality. We witnessed the summer somersault that markets took between mid-July and mid-August. Like Olympic and Paralympic athletes, the capital markets managed to stick the landing. The rest of this commentary will address why markets tumbled, what parts of that episode we need to be mindful of, and what isolated elements exacerbated the situation.
Softening economic data
The last two and a half years of tightening monetary policy were designed to deliberately slow economic activity and prompt a decline in inflation. Not surprisingly, investors are now leery and on alert for economic weakness that could upset corporate earnings growth, which was moribund for 2022 and 2023 and is now just getting back into broad-based growth mode.
The first two days of August brought a disappointing read on U.S. manufacturing and a weaker-than-expected (but not weak) U.S. jobs report that stirred up some recession fears. This employment report comes with two caveats: it reflects hurricane Beryl disruptions plus an uptick in the unemployment rate driven by additional people seeking work rather than job losses. Although the jobless numbers aren’t ideal, these caveats suggest we are not witnessing the kind of economy-wide layoffs that trigger a spiraling spending retreat associated with a recession. On August 5, a reading of the (much larger than manufacturing) services side of the U.S. economy surprised to the upside.
Indicators of consumer spending (that accounts for more than two-thirds of U.S. economic activity) were mixed. Some bellwether retailers reported weakness, especially in dining out and home improvement. Other retailers and overall retail spending showed resiliency.
Canada experienced many of these same themes: falling inflation, weak job numbers, and anemic retail sales. The idea that Canada’s economy is running hot sailed long ago, which is why the Bank of Canada started cutting rates three months back. Like other non-U.S. economies, Canada has been flirting with recession for two years. Although there has been some recent strength, sustaining that momentum will require ongoing interest-rate cuts. BMO Economics is calling for three additional 0.25% cuts through January, and then another 0.5% by mid-2025, taking the Canadian overnight rate down to 3.0% by next June.
Bond yields moved lower to reflect this reality; the FTSE Canada Universe Bond Index delivered a 0.3% return for August. Our loonie saw a nice one-month rally of more than a penny to US$0.741 or C$1.349.
Looking ahead, we see a combination of wage growth, falling inflation, and eventually lower borrowing costs driving real income gains that will keep consumers spending.
Messy earnings
Selling pressure began, and was heavily concentrated in, the large-cap technology names. Disappointing earnings outlooks from Tesla, Alphabet, Microsoft, Amazon and Intel had investors questioning the valuations of these stocks and the durability of the artificial intelligence theme. Concerns are being raised whether the billions the so-called Magnificent Seven companies are spending on AI research and rollout will pay off anytime soon. Many of these businesses are heavily represented on the NASDAQ Index, which was up around 25% on the year but fell 13% from its July 10 peak. It has since recovered a little over half of the decline, a healthy wake-up for the complacent. The S&P 500 downdraft was under 10%.
Beyond underwhelming earnings for selected mega-caps, earnings season has generally been fine, and earnings outlooks remain constructive. Markets less exposed to the mega-cap Magnificents reflected this. For the equal-weight S&P 500, the Dow Jones Industrial Average, and the S&P/TSX Composite, the drawdowns were in the 5% to 6% range, half as bad as the high-flying NASDAQ and run-of-the-mill stuff for stock markets. All these markets have fully recovered, and the S&P 500 sits a hair below a fresh high.
August’s tale of the tape: the S&P/TSX Composite rose 1%, the S&P 500 rose 2.3%, the NASDAQ rose 0.7%, the European Stoxx 50 Equity Index rose 1.8%, the U.K. FTSE 100 Index was flat, the MSCI China Equity Index rose 0.8%, and the MSCI Emerging Markets Index (USD) rose 1.4%.
Carry trade unwind
The unwinding of the Japanese yen carry trade exacerbated August’s abrupt market selloff. A carry trade is a strategy that involves borrowing funds at a low interest rate and investing the proceeds in assets that offer a higher rate of return. Japan has provided ultra-low, near-zero interest rates for decades, making the Japanese yen the most popular funding currency for the carry trade. Large investors, especially hedge funds, have borrowed heavily in yen and used those proceeds to invest in other assets, including U.S. technology companies.
The Bank of Japan (BoJ) surprised markets with a 0.15% increase in its primary policy rate, which sparked a sharp strengthening of the yen against the U.S. dollar. That in turn spurred a mass unwinding of the yen carry trade. These investors were forced to unwind their positions thanks to higher yen borrowing rates plus stock prices already under pressure from the U.S. recession scare and poor AI-related earnings.
Higher collateral requirements for the yen loans and margin calls against falling stock prices set off a “death spiral.” Prices fall for assets being force-liquidated (stocks), assets appreciate when they are force-purchased (yen to cover loans), begetting more margin calls… and so the spiral goes. The result was a 26% peak-to-trough drop in the Japanese Nikkei stock index, including a one-day plunge of over 12%.
Despite all the volatility, the unwinding of the trade seems to be over, helped by the BoJ’s pledge to be mindful of market volatility and financial stability going forward. Talk about an “oops, my bad!” The Nikkei is back to its June level – up 15.5% for 2024. For August, the Nikkei was down 1.2%.
Fed fudge
An additional concern was the U.S. Federal Reserve (the Fed). Messaging from its June meeting was hawkish. The bank left rates unchanged for the seventh consecutive meeting – at the highest target rate in 23 years. Still worried about inflation, the Fed displayed cursory regard for rising unemployment and only mildly softened its tone.
Investors are acutely concerned that the Fed is waiting too long and should cut interest rates without delay to stave off economic weakness. We believe the Fed should have begun its rate-cutting cycle in June. This tone deafness despite market weakness made things worse. Like the BoJ, the Fed then quickly moved to change its tune. Fed Chair Jerome Powell’s late August speech made it crystal clear we can expect an imminent rate-cutting cycle.
BMO Economics has adjusted its forecast, calling for an aggressive U.S. rate-cutting campaign to start in September, with 0.25% cuts expected at each of its next five meetings and a total of 2.25% of easing by January 2026, a year earlier than previously projected.
Our strategy: Balanced, with an equity bias
We are overweight equities, specifically Canadian and U.S. equities. We are neutral weight to international developed markets (Europe and Japan) and underweight emerging market equities. Within fixed income, we are overweight investment-grade corporate bonds and underweight the lowest-quality borrowers in high yield.
We are well positioned; throughout 2024, our discipline saw us selling stocks into strength to add to bonds as a hedge against a growth scare.
Outlook
We can’t rule out a repeat of the growth scare we just weathered. When the world’s largest economy is slowing, its second largest is sputtering, and everyone else is somewhat fragile, the ice gets a bit thinner under our base case scenario of cooling-not-collapsing economic growth.
We believe recession dynamics are not firmly in play, or if they are, they could be quickly reversed by rate cuts from the Fed (and other central banks). The U.S. labour market is slowing but is not a source of downward momentum as some currently fear. We’ve seen other soft-to-stable economic data, with pockets of resilience still to be found. Overall, the indicators are more consistent with a soft landing than an impending recession.
We are coming off weak corporate earnings from 2022 and 2023 and belt-tightening on many fronts. Business spending, housing and manufacturing have all been restrained by global central banks’ lengthy and sharp rate-tightening cycle. We foresee a rebound and some release of pent-up activity in these areas as likely in the quarters ahead. So far in 2024, capital markets are driving solid results in anticipation of this outcome. They are pricing in (bond yields lower, stock prices higher) the expected response to an environment of post-inflation, easing monetary conditions where economic growth stabilizes – an environment we see as favourable to investors.
The last word: Liquidity and mark-to-market
Good liquidity in financial markets is the ability to transact efficiently and transparently without significantly impacting the current price of the asset. Prices can tank when large groups are forced to sell (typically due to contractual obligations involving some debt), and few buyers are available, or buyers recognize the counterparty’s desperation. The yen carry trade unwind we described above is a classic example.
Why is this relevant? We live in a mark-to-market system. The last recorded transaction sets everyone’s closing price for publicly traded stocks and bonds. In poor liquidity conditions and impaired transaction prices, investors who own some of the traded stocks will see their values reflect the panic-selling prices. That can happen even though there is nothing materially wrong or changed with the companies in question. In fact, the sellers being squeezed may unload high quality assets simply because they can, or have little else to sell to meet obligations.
For long-term investors, good management of your time horizon and cash flow needs is the best strategy to navigate situations where poor liquidity is creating problems in the markets. For investors in this category, other than managing the emotional response to seeing your investments temporarily worth a lower amount, no action is required.
Our point is that early August’s violent reaction in some equity markets was a collision of several events. If one or more of these events hadn’t happened simultaneously, or if liquidity conditions had been better, the magnitude of the market response might not have been as severe. The swift bounce back for equity markets demonstrates why panic reactions are never advisable. Capital markets oscillate for many reasons. If poor liquidity is one of them, being able to weather those (often brief) adverse conditions is well rewarded.
Capital market dislocations triggered by forced selling are the most violent upheavals. However, they generally represent a washing out of internal market imbalances, not a major shift in macroeconomic dynamics. Just because equity markets did a summer somersault doesn’t mean markets have fallen off the beam.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
You should not act or rely on the information contained in this publication without seeking the advice of an appropriate professional advisor.
