The unwinding of a decade-long carry trade on the Japanese yen, the weakening US economy and a lack of rate cuts from the US Federal Reserve have caused August’s market turbulence, according to ARK Invest CIO Cathie Wood (pictured), who says volatility has created buying opportunities.
In a note published yesterday afternoon (20 August), Wood noted that capital gained from the popular yen carry trade – or the shorting of the Japanese currency in favour of reinvesting in other areas of the market – was put back into mega-cap tech names.
Now, however, these stocks have shown “genuine vulnerability” due to disappointing economic data from the US among other factors, meaning investors “may have faced margin calls forcing them to unwind their yen carry trade”.
She writes: “While these types of sell-offs are sparked by market fear and risks to consensus positions, they often create pockets of opportunity. Historically, these condensed bouts of volatility lead to a market rotation that can favour a broadening out away from the contributors of this volatility.
“In our view, though disruptive innovation may be susceptible to volatility in this climate given its relatively high beta nature and the unknown length of this market shock, it may benefit from a resultant, more receptive Fed, a general broadening out away from the prior consensus, and a light being shed on the shift of inflation to disinflation.”
Three interrelated factors
According to estimates obtained by ARK Invest, investors have piled some $20trn into a yen carry trade over the last decade or so, which equates to 15% of global equity market capitalisation.
As Japan begun to increase interest rates and reduce its stimulus package for the first time in 17 years, at the same time that the Fed decided to hold interest rates, investors have been unwinding this trade.
“The markets reverberated violently as a result, and it appears that unsuspected areas of the financial markets, namely broad indices highly concentrated into the Magnificent Six, may have been buoyed up by this leverage, creating a liquidity spiral as forced sellers unwound this carry trade,” Wood says.
The unwinding of this carry trade has “provided a new case in point” surrounding the concentration risk this handful of stocks presents across major indices, according to the CIO.
“Japan’s stockmarket saw its worst single-day crash since 1987 on 5 August and the Magnificent Seven stocks [including Tesla] erased close to $1trn in market cap in a single day. The market is now trying to understand how much debt still needs to be unwound and who could be left holding the bag.”
Meanwhile, US economic data has been weakening, with unemployment rates increasing by 20 basis points month-on-month to 4.3% in July, while the Institute of Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI) Report on Business fell by 3.5% over the same period.
This, combined with weakening commercial and multi-family real estate, falling car sales and capital spending, and a general decline in consumer confidence, means the US economy “has been tiptoeing through rolling recessions”, says Wood.
“The Fed has been hung up on persistent inflation and the idea that inflation has been the key economic problem may have been misplaced. Those looking beyond core inflation figures would have seen that prices have come down dramatically across wholesalers and retailers, while ARK’s concerns of potential disinflation appear to be coming to fruition.”
While leading economic indicators in the US keep weakening, Wood says the Fed “isn’t just late to the rescue, it hasn’t even responded to the call yet”. “The market turbulence is showing how dire the economy may be and how any procrastination in rate cuts can be detrimental.”
While markets are pricing in a 60% chance of an emergency interest rate cut next month, the CIO wonders whether this would be “too little, too late”, or whether it could bolster ailing markets.
“One thing is for certain, this bout of uncertainty has underscored risks to the latest consensus bets and clients are reassessing their exposures in light of updated short- and medium-term market outlooks.”
Buying opportunity?
Wood points out that previous market shocks have almost always presented buying opportunities. During the throes of Covid lockdowns in 2020, for instance, there was a “rapid V-shaped” reversion for many companies.
Now that investors will likely be thinking twice about their exposure to the Magnificent Six Stocks, according to the CIO, markets could offer “compelling upside potential”. In particular, she believes ‘disruptive innovation’ stocks – which will remain volatile over the short term due to their high beta – will benefit over the medium-to-long term.
See also: “Choosing ‘picks and shovels’: Managers look beyond Nvidia for AI plays“
“Today, pricing is coming down across the world as corporate margins face pressure,” she explains. “This is an example of ‘bad deflation’, where companies are forced to lower prices to deplete inventory gluts and to meet consumer demands, as opposed to ‘good inflation’ where technological improvements drive down costs that can be passed onto consumers that sparks demand.
“Technology – such as the potential for a dramatic productivity uplift through artificial intelligence – may step in to help offset the effects of price declines, and we anticipate many of our portfolio companies to benefit in this scenario, similar to how technology stepped into solve issues relating to Covid.
She adds: “In our views, clients should diversify risk in their portfolios away from concentrated, consensus bets, which tends to benefit performance following a market shock. The markets may broaden out in both a ‘catch-up’ scenario, and – more topically – a ‘catch-down’ scenario that we have observed over the last week.”
