Summer Turbulence Once Again

In keeping with a long-standing tradition in financial markets, the month of August has seen rising levels of stress, exacerbated by fewer participants, reduced liquidity and increased price volatility. Whereas some years have spared investors these anxieties, 2024 will go down in history as a year in which surprises have been served up to catch investors and fund managers unawares. This said, even surprises might contain elements that should and could have been foreseen or, at least, recognised by seasoned investors as potential alarm bells.

The key to August’s global turbulence lay in the unexpectedly weak US weekly jobs figures that aroused suspicions of a slowing economy, one in which the inflationary pressures of the last two years were firmly at the back of market concerns. These came amid lacklustre quarterly US earnings figures in which the reaction of share prices to disappointment were, in some cases, ruthless. The Federal Reserve quickly transpired as the fall guy, as a central bank once again behind the curve as others had already embarked on a program of cutting interest rates.

Markets were swift to react, pushing the volatility (or fear) gauge towards new highs as share prices fluctuated wildly, sometimes violently exacerbated by that regular party-pooper, the unwinding of the carry trade. At the centre of this international storm lay the Japanese Yen, an unlikely perpetrator.

The past two years have been a period of some concern in financial markets. Although inflation rates had begun to subside for several reasons, plentiful were the commentators, observers and, to a large degree, experts who begged to differ from what bond and other markets were observing and predicting. As of today, many of these actors have gone silent as central banks in more or less financially important regions have embarked upon monetary easing, usually through monetarist but sometimes through exchange rate policies. An example of the latter has been Japan.

For decades, Japan has been viewed as the combination of a country on the verge of a deflationary bust as well as a bastion of stability and soundness. In times of stress, the Japanese Yen was seen as one of the ultimate safe havens, despite perennially low interest rates (thereby quashing the argument whereby the external value of a currency largely depends on its interest rates relative to other currencies). Turbulence usually resulted in a strengthening of the Yen, coupled with an inability of an export-dominated Japan to embark upon the sort of bull market enjoyed by other countries.

Yet this time was different. Increased tensions had resulted in a weakening Japanese currency, thereby placing competing countries (such as China) at a disadvantage. It further reawakened the carry trade in which countries with low interest rates are used to finance speculation in higher-yielding currencies around the world. Traditionally, Yen-related carry trades were attributed to so-called Mrs. Watanabe, the epitome of the local, unsophisticated retail speculator seeking a superior return to the one obtainable at home. The most recent wave, however, saw international players seize this opportunity to jump on any number of momentum bandwagons, the most important of which was the rush to participate in the relentless rise of Magnificent Seven share prices on the US stock market. Other targets were the Mexican Peso, as well as further hand-picked emerging markets currencies in Asia; hedge funds were, as usual, important players who also bore the brunt of the ensuing margin calls that always occur in times of stress and can result in the wipeout of profits for the entire year. And the resulting massive increase in volatility has been the culprit in increasing the perceived risk to investors, according to those who equate volatility with risk (which is not the case with this author).

As the Bank of Japan increased its key interest rate at the end of July for the second time in four months (March marked the first time in 17 years), the Japanese currency turned and its external value bore the brunt of the carry trade unwinding. This saw the Tokyo stock market shed 12 per cent of its value in a single session. The last time this happened, around 35 years ago, it was labelled a stock market crash. Indeed, this is what it was on 5^th August 2024. (Old-timers will remember a similar situation in 1987 when the perpetrator of unexpected monetary tightening was the now-defunct Bundesbank. But the causes and its effects were the same as today).

2024 has been characterised by massive momentum in share prices generally involved in artificial intelligence (AI) and its gigantic perceived future potential. As with all momentum-driven share price gains, potential risks were superseded by return expectations, based on inordinate amounts of capital expenditure but whose fruits are expected far in the future, if at all. At the same time, the dominant market positions of the small number of leading AI players also reflect their vulnerability. As fear took over from greed in the marketplace, wild gyrations in share prices replaced the no-brainer mentality of investors who had chased seemingly ever-higher levels. At their peak, the market capitalisation of the Magnificent Seven had reached more than half the value of the United States’ gross domestic product. In the end, all that was required was the announcement by Intel that it was shedding 10 per cent of its workforce for the mood to change overnight.

The combination of reasonable and falling international rates of inflation, and expectations of its trajectory, caused stock market turbulence to point investors to the safety of fixed income markets, especially, once again, in the US. The result was an unusual, short-term decorrelation of share and bond prices which was entirely attributable to heightened tensions and share price volatility. But it raises serious questions about what the future will bring for investors, and why.

As investors sought to point a finger of blame for their losses, the Federal Reserve suddenly became the villain. Quite clearly behind the curve, the Fed should have eased monetary policy some time ago and should even consider an emergency cut to calm the nerves of investors, according to many observers. Dovish Fed comments would conclude that the first rate cuts could come in September and be followed by others as the current year closes.

More important, as usual, is the behaviour of bond markets. For those who believe in the long-term correlation of share and bond prices and who acknowledge that the rising interest rates of last year have taken time to be felt in the economy, an important page in central bank behaviour has been turned. Furthermore, US money supply has recently tracked inflation numbers, cementing the impression that disinflation is back and talk of persistent inflation outmoded. China is a case in point. The country is now grappling with deflation and falling bond yields as the Chinese Communist Party interferes with local banks’ investment programs, urging them to buy into local short-term bonds to forestall an inverted yield curve.

But as August unfolds, the carry trade-related turbulences have receded and given way to renewed share price rises. A modicum of calm has returned from what may have been a storm in a tea cup.

However, the world’s geopolitical picture has taken a turn for the worse. Bearish commentators have used Middle East tensions as an argument for shrinking globalisation, tightening supply chains, higher oil prices and, of course, a heightened risk of all-out war involving super-powers. In the event of a fully-fledged war in the Middle East, its severity and duration will not go unnoticed by the oil market. That quantity is unknown. Meanwhile, however, the oil price has fallen back to levels last seen in January 2024.

Amidst this murky geopolitical and macroeconomic picture, this year investors have continued to be influenced by AI. As the share prices of such companies surged, long-term investment criteria took a back seat, irrespective of the qualities of traditionally sound and growing businesses, such as those who enjoy the label of Quality Growth. At times, fears of future embedded inflation rates were giving rise to “higher for longer” rates of interest, as well as bond yields. This sometimes clouded the otherwise clear and sound outlook for companies who have long enjoyed an outstanding position in their market. It is thus time to go back to basics.

The Ten Golden Rules of Quality Growth investing, often described in detail in these newsletters, have served to contain otherwise unquantifiable risks for investors in financial markets. This is largely because such investors concentrate on the business at hand, without too much fixation on its share price. This has produced the expected results, whereby business activity drives forecastable earnings which, in turn, drive share prices. This is difficult to assess when looking at businesses whose share prices are the object of momentum buying, irrespective of their long-term outlook. Forecasting the earnings of companies involved in the largely nascent space of AI cannot be the serious and fundamental background against which risk is measured. The long term is less important in the reasoning of investors whose time horizon is not only short but, furthermore, almost irrelevant.

The somewhat skewed investment background prevalent in 2024 might have pulled the shares of Quality Growth businesses out of the limelight for many players. But this does not apply to investors whose time horizon is unlimited and whose convictions concentrate on where the true risks to a business lie, as well as its true value.

As we have long argued, the ability of Quality Growth businesses to grow into perpetuity represents the long-term opportunity that serious investors will continue to recognize – and seize.

P. Seilern,

August 19^th, 2024

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