It’s been anything but a quiet summer so far this year. In the last week alone, we have seen Donald Trump select J. D. Vance as his Vice President, a global outage following a flawed CrowdStrike update and President Biden withdraw from the upcoming US election.
In markets, after a softer-than-expected US CPI report earlier this month raised hopes that the Federal Reserve will cut interest rates sooner rather than later, we saw a notable market broadening and an aggressive rotation from US large cap stocks to US small caps. In fact, July witnessed the largest single-day outperformance of the Russell 2000 Index over the Nasdaq since the Russell's inception in 1979.
This has been further complicated by rising expectations that Trump will win the US Presidential election in November. A Trump victory, among other factors (chiefly heightened geopolitics), is regarded as reflationary and we have consequently seen a rally in cyclical stocks, as well as yield curve steepening.
Market concentration and the heavy skew towards momentum have been dominant themes in equity markets for some time. Market gains have been extremely narrow and tech centric and valuations have reflected this. These factors combined to exacerbate the pace and magnitude of the rotation, with heavily-owned, mega- and large-cap names materially affected to the downside last week, although we saw the S&P 500 Index rise and tech shares rebound on Monday.
Whether the rotation persists after a pause on Monday remains to be seen. In the short-term, a rotation would likely be a headwind for many investors. Looking out over a more meaningful timeframe, periods of volatility such as that we witnessed last week creates opportunities. Further, a move away from a narrow market would be a welcome – and arguably overdue – development.
USD/JPY unwind?
One-way bets in financial markets typically become sources of real pain eventually. The peg of the Swiss franc (CHF) to the euro (EUR) at 1.2 until January 2015 was one such example – the Swiss National Bank ran negative interest rates, meaning that investors were effectively being paid to borrow in CHF to fund investment in other assets. When the CHF was revalued on 15 January 2015, funding conditions changed, a few high-profile hedge funds blew up on CHF losses, and industry de-grossing played out in a tough subsequent period for cross sectional momentum, and measures of crowding: the Goldman Sachs Hedge Fund VIP Long/Short fell approximately 5% in the following days and Morgan Stanley’s US Long/Short momentum basket fell 13% over the next month, for example.
For the last three years, the one-way trade du jour has been US dollar/Japanese yen (USD/JPY), propelled by a widening spread of US treasuries over Japanese government bonds (JGBs). That relationship began to break down from the second quarter of this year (when some large foreign exchange (FX) hedges associated with a portfolio of fixed income losses were unwound). Then, it snapped back earlier this month with a large appreciation of JPY versus USD after the softer-than-expected US June CPI print, and with some evidence of the Bank of Japan intervening to support JPY.
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Tracking carry trades accurately is not straightforward, but some indicators suggest that there is plenty of capital deployed on the assumption that the JPY will remain weak: Uridashi issuance – bonds issued in a foreign currency for Japanese households – is on course for its largest volume in Australian dollar (AUD) for at least 15 years, illustrating household demand for high-yielding carry trades; and reported net speculative JPY positions are close to the largest ever short.
What happens if the rug is pulled?
So, with a large stock of capital deployed on the basis of the JPY staying weak, the question is what happens if the rug is pulled as the spread of US Treasuries over JGB continues to contract? The dramatic rotation in markets earlier this month perhaps gives us a clue that the withdrawal of easy money rapidly upends momentum – in other words, prior winners become losers. One clear representation of this is the relationship over the last year of the long-short spread of crowded trades and JPY shown in the chart below.
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In contrast to the CHF experience a decade ago, it’s worth emphasising, however, that any JPY move would likely be much more benign because JPY is not pegged. CHF appreciated more than 20% against the EUR and 18% against the USD on the day it de-pegged, which created catastrophic leveraged losses. JPY is very cheap and could ultimately revalue materially in time, but it would not happen in one day.
With contributions from Nick Wilcox, Managing Director, Discretionary Equities, and Ed Cole, Head of Multi-Strategy Equities, Solutions at Man Group.
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