The summer months between Memorial Day at the end of May and Labor (sic) Day at the beginning of September are supposed to be quiet - which is one reason for the mantra of Sell in May - traders, especially in commodity markets, would take time off and flatten their books before heading to the beach. Newspapers too would refer to the ‘Silly Season’ where in the absence of any lead from Politicians or the Courts (also on long Holidays), the newspapers would report on things such as sightings of the Loch Ness monster, or seeing the face of Jesus in a piece of toast. This year we have arguably seen a typical ‘Sell in May’ argument for a number of commodities (although we still see a bull market). However, we have not had much time for silly season stories - unless of course you count the weird opening ceremony for the Paris Olympics - as a sharp escalation in US Political drama has crashed into the news cycle several months early.
Thus from mid July, the market has struggled to price in some ‘known unkowns’ - a higher probability of a Trump win - and some previously ‘unknown unknowns’ - a Harris Presidency. Meanwhile it looks like as Equity, rather than Commodity, money is taken off the table, the Yen carry trade is unwinding - which we suspect is going to mess up August for a lot of people.
Short Term Uncertainties - US Politics and the Yen
The seasonality in Q3 is not great for equity markets even in normal times, but the dramatic twists in US Politics during July have added to the problems as they brought US Politics forward from Medium Term risks to Short Term Uncertainties. The gyrations in the markets, as first Trump’s prospects soared and then reset, as Joe Biden stepped down to be replaced with Kamala Harris and the Democrat propaganda machine swung into action to position her as the second coming of Obama, have thus given us an early insight into market attempts to price increased uncertainty.
A higher probability of a Trump win saw a sell off in tech and momentum stocks generally in mid July as well as in the $, and while the US media swung into action in the wake of Joe Biden stepping down to promote Kamala Harris as ‘the best ever’ the reassurance for markets that everything would remain the same was only temporary. The equal weight index has swung back versus the market cap weight, highlighting the concentration risk in ‘low risk’ passives and we note that around 70% of the S&P 500 stocks ‘outperformed’ in July.
Trump was a ‘known unknown’ in Rumsfeld speak that markets were planning to consider in great depth in the Autumn. Harris of course was an ‘unknown unknown’ and while the initial reaction appeared to be that it would be business as usual, the second order judgment has been to price in increased uncertainty. Hence the renewed sell-off in the opening days of August in the same areas - not because they market is judging likely Election winners and their policies, but because it is de-risking in the face of uncertainty.
It now looks like the Political Polls will replace the high frequency economic data in driving short term market behaviour
It certainly looks like traders are now deleveraging early and having ‘de-risked’, the naturally low liquidity in August is likely to create a lot of ‘noise’. However, to reference the famous Buffet quote - and perhaps appropriately for so many heading for the beach - now that the tide has gone out earlier than expected, we will now see who is missing their bathing suits. One place in particular this is being exposed is in the Yen Carry Trade.
The Yen Carry Trade unwinding
We have noted on a number of occasions recently that one of the biggest anomalies in financial markets has been the (low) value of the Yen and part of that we suspect has been the use of low cost Yen to fund carry trades into US equities. Low cost that is, until the Yen moves 7% the wrong way in the course of a month.
The point of a carry trade unwind is that it means the currency doesn’t follow the normal ‘rules’ of currency trading - the sellers, while not totally price insensitive, are ‘getting out’ and are thus distressed sellers with little pricing power, suggesting a momentum trade to the upside (stronger Yen) will appear. Some of those sellers have used a short Yen position to fund longs into Japanese Equities - a sensible hedge on the one hand, but only if you are long only. We have seen this previously in Japan where ETFs are bought in the hedged, rather than unhedged, version. However, to the extent that there are leveraged positions that are short Yen to fund Japanese equity positions, these are scrambling to unwind. Meanwhile, it appears some are using short Yen to fund long US Tech, where there is not even a natural hedge on the other side. This is a classic of something that works brilliantly until it doesn’t.
With other central banks starting to cut and hold, there is an increased expectation that the Fed will soon follow, but we remain unconvinced that it will be a function of the short term data. Indeed, with the political opinion polls shifting to replace traditional ‘noise’ like the Non Farm Payrolls, we suspect it’s going to be US politics and polling that drive things in the short term.
Medium Term Risks - US Government spending
US Politics is important, not only for the Hollywood-like drama, but also the sheer size of the spending undertaken by the US Government. The US Budget expenditure in fiscal 2023 was $6.13trn . Around half of that is mandatory, leaving the amount of so called discretionary spending equivalent to almost the whole of UK GDP. Meanwhile, of the discretionary part around 40% is spent with the private sector, meaning that an economy the size of the Netherlands is maintained through access to the US Government. Now wonder there is so much lobbying.
The US Government Discretionary spending Budget is the size of the UK Economy
In this context, the aligning of Elon Musk and Peter Tiel (both tied heavily to the US Government via Space-X and Palentir) behind Trump and his new VP, JD Vance, along with fellow former Pay Pal Mafia member David Sacks, is interesting, especially as another alumnus, Reid Hoffman of Linked in, is aggressively backing Harris, alongside many of the traditional Media and big Tech companies in Silicon Valley. Just as there are different factions within Democrats (Obamas v Clintons) and Republicans (MAGA v never Trumpers) so it is in Silicon Valley. To the extent to which this election will be ‘influenced’ by Twitter and Tik Tok, rather than just YouTube or the MSM, the barrage of mis-information, dis-information and fake news (depending on your viewpoint) is going to be huge, making markets, usually dependent on a constant flow of ‘data’ likely to feel very confused.
Meanwhile, to the extent that the President can impact the favourites at court, as implied buy these alignments, this is obviously important for Earnings in the NASDAQ and is likely one factor behind the tech wobble in mid July. Whoever gets in, somebody, somewhere, loses while someone wins.
Long Term Trends - Dollar re-alignment and shifting of currency pegs
Another key factor emerging from the US Government is the crowding out effect from the sheer size of the Budget and its need to be funded by selling bonds. Neither side look set to cut spending - the solution to increasing political polarity seeming to be bread and circuses. Moreover, with Net Interest Payments on the debt heading to $1trn a year its difficult to see what can be cut to compensate. This makes it difficult to see how US Bonds can escape a bear market - they can be traded, in the manner that the Japanese Equity Market delivered periodic strong returns during its multi decade slump - but the ongoing value proposition continues to look strained.
Flattening the yield curve by cutting at the short end and managing the long end is one option to reduce the burden of interest payments and the Bond markets appear to be pricing that in right now, but equally the US authorities don’t want to stimulate the economy too much and cause inflation, so any cuts would likely be modest enough not to trigger a round of mortgage re-fi . Don’t forget that the US has the, almost unique, advantage of having fixed rate, refinanceable mortgages, which is why higher rates don’t slow activity in the same way that they do in, say the UK or Australia. Anyone who remortgaged in 2021 for example locked in 2.3% for 15 years, so not only do higher short rates have no impact, but they would have to drop a long way to do anything for anyone but new buyers.
If the world’s short term leverage is in Yen, it’s short term lending is in $s. A cut in US rates may trigger an excess move in the $ as a result
A small cut might not then be inflationary, and of course other central banks have already cut a little, but we suspect that any move by the Fed may be seen as a reason to sell the $ - which is where a lot of the world’s short term cash is sitting.
One option that we have discussed previously is to allow the $ to depreciate against a basket of currencies. For all the talk of a need for a Yuan depreciation (a macro meme we don’t understand, rather like the apparent Fed pivot), the case for a reset of the US$ looks much more interesting and may indeed be starting with the move in the Yen. Nobody said the Yen was expensive at 120, but somehow a move from 160 to below 150 is wrong? Japan is ultra-competitive at the moment and to the extent that China trades against a basket of Asian currencies (which it does) we would expect it to appreciate against the $ too.
Of course, should that happen, then there would be a very interesting case to peg the Hong Kong $ to some Trade Weighted basket (coincidentally around the time that the HKG achieved parity with the Rmb. More known unknowns.
