With such fabulous weather, I hope you had a great long weekend. Unfortunately, news on the stock market front isn’t as steady as the weather we just experienced. Both bond and stock markets experienced a lot of volatility this past week with interest rates going down (and bond prices up) and equity markets experiencing the most difficult week in almost two years.

In my opinion, the three culprits are:

1. Good but not great earnings from the Magnificent 7 technology companies. Over the past two years in particular, stock market gains have been driven by the Magnificent 7 (Microsoft, Apple, Google, Meta, Nvidia, Amazon and Tesla) to the point where these companies were trading at earnings multiples that were well beyond their 5-year average. Over the past two weeks however, these companies started reporting uninspiring earnings. Not only did the companies just meet expectations but the forward guidance of future earnings was disappointing. Meta and Apple were the exception with earnings ahead of expectations. The problem is that when you are trading at lofty valuations, investors expect to be wowed for the share price to advance further. Since there was very little wow factor, some investors began trimming positions. Because these companies have such an influence on the US stock market (these 7 companies represent 31% of the S&P 500,) the overall market started to turn down over the past two weeks.

2. Weakening economic data. At the start of the year, investors were expecting to see six rate cuts in 2024 by the US Federal Reserve based on expectations that inflation would decline dramatically (below the Federal Reserve target) and the economy would weaken. Since the economic data did not weaken as expected and inflation remained sticky, investors began ratcheting down expectations and as recently as a few weeks ago, the expectation dropped to one, maybe two rate cuts in the US by the end of the year. In the past week however, something else started to materialize – the economic data started to weaken, and recession fears began materializing. The unemployment number on Friday really spooked the market. The unemployment rate last month picked up to 4.3%; 117,000 jobs were created but 249,000 people were put on temporary layoff. If people start losing jobs, a recession can become a reality very quickly in this environment. Although inflation has declined to 3.3% (from 9% in 2022), consumers don’t feel a benefit; a basket of goods is still 15-20% more expensive now than it was a few years ago. High prices and rising unemployment mean less spending. Recessions lead to lower earnings which lead to lower stock prices. This makes bonds attractive and stocks less so.

3. The unwinding of the Japanese Carry Trade. Japan has been in a deflationary cycle for decades brought on by the property collapse in 1990 combined with an aging population and lack of immigration. The thing about a deflation cycle is that it's very hard to unwind. If you think prices are going to be lower for goods next year, there is no incentive to buy the item this year. If your population is not growing and in fact is aging, the demand for goods further declines exasperating the problem.

To try and stimulate growth, the Japanese central bank brought rates to zero hoping that consumers would spend instead of keeping money in their bank account. Japan has also been using quantitative easing for quite some time. They print money to buy bonds which drives up the price and drives yields to zero. They have had zero interest rates for a long time and concurrently a weakening currency (the Japanese Yen has weakened by about 40% versus the USD in the past 10 years). Recognizing this pattern, speculators and hedge funds borrowed in Yen (at close to zero rates), converted to US dollars, and invested in US growth stocks like the Magnificent 7 above. This is the "carry trade." This seemed to work until the Japanese decided to raise interest rates last week to combat inflation in their country. Suddenly, borrowing rates rose and more importantly, the Yen began to appreciate.

So, what happens if you are in the carry trade and are leveraged? You unwind it. You sell your stocks, convert back to Yen (which sometimes can cause the Yen to rise, making the problem worse) and pay back your loan. This is exactly what happened, and the US equity markets responded dramatically on Friday and Monday. How long does this last? Hard to say and I don't know if there's an easy fix. I believe if the US suddenly drops rates to support the equity markets, this can make the Yen strengthen further. I think it will take a bit of time. There will be indiscriminate selling which will create opportunities. When your kids are in high school, it's easier (albeit sometimes more expensive) to plan vacations because there are set times where you can go on vacation.

When your kids are in university, their lives, work schedule, and social calendar seem to take precedence over my desire to spend time with them. Determined to go on a family vacation this year, Kris and I managed to find time to go away earlier this summer with our kids. We planned on a trip to Kauai for eight nights. In booking the flights I noticed that there was a significant difference in price if we came back on Sunday versus Saturday and that included spending an extra night at a hotel. Armed with this knowledge, I thought it was a great learning opportunity for the kids to talk to them about how pricing can be dramatically different. Maya's response: "oh great, so we made money." Perplexed, I asked her to explain, and she said, you were going to spend more, but now you're spending less, so you made money. Pretty easy Dad. Somehow, I didn’t see it that way!

Ashit