Charlie Jamieson, Chief Investment Officer

Well, that certainly escalated quickly!

The recent sell-off in equities, coupled with a significant market rally in fixed rate government bonds, indicates that despite periods of subdued market volatility, the interconnected nature of global markets can still pose ongoing challenges for investors.

This also addresses any doubts about the negative correlations of government bonds as protectors in times of stress. If defensive allocations aren’t providing the liquidity or capital protection you anticipated, it might be worth reassessing your options.

Markets can be very humbling at times; these moves are only partially based on economics, but also by the changing nature of financial factors driven by heavy and crowded positions and changes in expectations around those themes.

It is important to understand the relationships fostered by policymakers since the Global Financial Crisis. Any disorderly unwind could have a damaging psychological impact on an already fragile economy, which is teetering close to a tipping point.

When I started my career, folks were trained to study the economy and reflect those outcomes in financial market pricing. That still occurs, but a new element has been added.

Since the Global Financial Crisis, policymakers flipped this relationship somewhat to encourage animal spirits. By pumping up financial markets using quantitative easing and relaxing financial conditions, they are able to drag economies higher in a mirror image of the traditional relationship and generate confidence and wealth effects in the process.

In doing so, a generation of “buy the dip” investors was born and, quite rightly, they have made a fortune. They have thrived as market conditions have rewarded their approach.

Yet, much like Pavlov’s dogs salivating at the sound of a bell or a turkey anticipating its daily feed, these investors might face abrupt setbacks if market dynamics shift unexpectedly.

In an ordinary market cycle, sell-offs are a normal occurrence – they are welcomed and necessary for markets to function. They create price tension as buyers and sellers compete for the clearing price.

Prior to the recent corrections, the S&P had not had a 2 per cent correction for 356 days. Markets were simply too calm.

Recent market movements saw wholesale liquidation driven by observable forces, catching investors off guard.

Those heavily invested in the improbability of a US recession, and likely holding crowded leveraged positions, were particularly affected.

A combination of weaker US employment, a rotation away from the Magnificent Seven stocks – Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta Platforms, and Tesla – and questions about AI valuations, combined with the changing landscape in Japan, have caused havoc in markets.

US economic data has been as exceptional for its weakness in the second quarter of 2024, as for its strength in the first.

The average monthly inflation rate has slowed to 0.1 per cent, down from 0.33 per cent in the first quarter. On this realisation interest rate cuts are expected in September, (aligning with Canada, the European Central Bank and Britain). However, the US Federal Reserve’s delayed action might leave it behind the curve as growth stalls.

This has investors questioning their confidence about a “no landing” scenario for the US economy and threatens a deeper interest rate cutting cycle, a topic we’ve explored previously in this column.

The real nitroglycerin is Japan’s positioning. Global investors have been borrowing cheap yen to buy leveraged assets elsewhere. With the Bank of Japan raising its interest rates and with US recession risks increasing, the income differential between US dollar and yen moved violently. The cheap yen rallied, catching unhedged investors off guard, causing margin calls and a death spiral of selling leveraged assets. The position size is hard to estimate, ranging from $US3 trillion to $US20 trillion, the impact of this shift is substantial and far-reaching.

Japan is now facing its first domestic inflation in decades, with the Bank of Japan expected to hike interest rates further.

If the US federal funds rate reaches 3.5 per cent as suggested, the yen could head back to pre-pandemic levels, around 107. This recent market volatility was triggered when the yen dropped from 160 to the low 150s and further squeezed to 141. If the yen heads towards 110 or 100, the impact could be severe.

Recent asset market moves have been highly volatile.

French bonds lost five years of income versus German bonds in just five days, the Mexican peso devalued 15 per cent following elections, and Indian equities collapsed post-election.

Now Japan is in focus. Consider the assets in your portfolio that could reprice violently – low-quality credit, for instance, might be a particular candidate.

Perhaps it isn’t different this time after all. As the saying goes, nothing is as permanent as a temporary solution. Quantitative easing and more central bank manipulation to the rescue.

That could be great for all assets markets (except floating rate bonds) but sadly we might have to experience the sickness before we get the antidote.