Near-term Shock to Equities
Broad equity indexes recently peaked in mid-July and have traded off since that time. This decline was recently accelerated this past Friday, August 3. While many of the “smart-money” crowd opined on this, we felt it worthwhile to look through the noise of the crowd.
What Happened?
Interest rates have been front-of-mind for most investors. The Bank of Japan (BOJ) raised its key lending rate as of July 31, surprising most investors to a level not seen in 15 years. This was the second rate increase since March 2024, which at that time ended eight years of negative interest rates. In general, interest rates within Japan have remained low relative to other economic regions.
A result of this was an increase in the value of the Yen relative to other currencies, specifically the United States dollar.
Near-term Equity Volatility
Most major equity indexes had exhibited a degree of exuberance during 2024 up until mid-July, at which time valuations peaked only to falter going into the month of August. It appears that a “perfect storm” followed the BOJ’s announcement which accelerated the downturn in equities.
One key driver is a concept called the “carry trade” in which one borrows at a low interest rate (e.g., in Japan) and uses the proceeds to invest in assets perceived to offer a higher rate of return (e.g., in the United States). This trade can expose one to various forms of risk, including currency or exchange-rate risk.
A driver of near-term equity market volatility has been attributed to institutional investors closing their carry trades, as the resulting increase in Japanese interest rates, coupled with the appreciation of the Yen to the United States dollar, raised the cost and the associated risk of carry trades which diminished the prospective return of these trades.
Another facet of volatility is attributed to the unwinding of “crowded trades.” We have written about the concentration of domestic equity indexes within certain sectors and a limited number of companies (e.g., the Magnificent 7, for instance). A result of this phenomena is the concept of “crowded trades” where index funds are compelled to propagate this concentration further exacerbated by individual investors feeding into this loop due to FOMO (Fear of Missing Out).
Overall, through this tempest domestic equities, as measured by the Russell 3000, declined 8.6% from their mid-July highs through August 5, while foreign equities as measured by MSCI All‑Country World Index ex-USA (ACWI ex-USA) fell 7.7%. Each index rebounded on August 6 in that year-to-date returns for the Russell 3000 Index and ACWI ex-USA are 9.4% and 2.6% respectively.
Focus on the Fundamentals
Within the United States we have a very fluid economic environment coupled with an election later this year. At BTC Capital Management, we take a long-term view of the markets. From a macro perspective, inflation continues to abate and while unemployment may have recently surprised to the upside, the economy is expected to continue to plug along.
More so, earnings for domestic and foreign companies are expected to grow. Earnings growth, coupled with the expectation the Fed will cut interest rates, promote a “cautiously optimistic” outlook for investors.
We recommend investors review their investment objective and corresponding asset allocation regularly during the ebb and flow of the capital markets. This monitoring will ensure their goals, time horizon, and level of risk tolerance is in line with their preferences.
Sources: BTC Capital Management, FactSet, LSEG
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