Unwinding Carry Trades & Over-Bought Investment Themes

Key Points

• Stock markets around the world reeled from a rapid unwind of the short-yen carry trade.
• Volatility spiked to alarming levels before receding Monday, while the S&P 500 neared correction territory.
• A technical correction is not a financial crisis, though highly concentrated and overextended markets are fragile and hyper-sensitive to bad news.
• The U.S. economy is slowing, leading investors to reconsider late-cycle bets on growth and momentum.
• The best remedy for investors is to avoid the frothiest parts of the market, namely momentum rallies that are prone to sudden reversal.
• Bonds and equities that are diversified beyond the “Magnificent Seven” remain attractive relative investments.
  
  

Stock market volatility is back, reaching levels last seen at the inception of the pandemic in March of 2020. The VIX, or “Fear Index,” hit a level of 65 intraday on Monday, up from about 17 last week. Though it has since cooled, this was, briefly, its highest level since early in COVID and among the highest since the financial crisis of 2008. This time the volatility spike is partly fueled by concerns about underlying weakness in the US economy as well as the unwinding of several massive trades.

The Federal Reserve’s monetary policy has been data-dependent for the past 13 months, as policymakers tentatively watch for progress along the “last mile” in the more than two-year battle against inflation. After the Fed’s meeting last week, Chairman Powell suggested that risks to employment were now on a par with those of rising prices. This neutral language opens the door for policy to begin to reverse the tightening cycle that began in 2021. Then employment data released on Friday showed a weakening US jobs market, activating a closely watched recession indicator.

Recession had been a widely anticipated culmination of inverted yield curves and regional bank stress last year—and remained in the year-ahead forecast of nearly a third of economists recently polled by the Wall Street Journal—but ebullient equity markets had, until very recently, all but written off the possibility of a hard-, soft-, or any sort of landing altogether.

Monday’s price action amplifies a growing concern about the extended valuations and equity market concentration in technology/AI stocks. Over the last month, the NASDAQ index of tech shares which has led most of 2024’s market rally, has underperformed the Russell 3000 all-capitalization index by over 6%. The kindling behind the large declines seen across global indices on Monday appears to be a rapid re-positioning known as the unwinding of “carry trades.”

A carry trade is one in which money managers borrow in the currency with the lowest interest rates (Japanese yen, in this case), and deploy that money in other assets—equities, bonds, commodities, currencies—that offer a higher return. According to one respected currency strategist, the carry trade at work in 2024 represents (in dollar terms) “the biggest the world has ever seen.” But when interest rates of the base currency start rising, the profits shrink, and the trades are liquidated. Last week, the Bank of Japan hiked rates by a modest quarter of one percent. The Japanese currency surged, while investment managers and the algorithms they use scurried to cover their positions. “Risk off” became the prevailing sentiment across most markets, with volatility in frothy-looking U.S. stocks the tip of the bullwhip.

The nature and timing of the recent market moves is hard to predict, but the underlying fragility that led to a wave of selling has been present for some time. The global equity markets have been dominated by US large cap growth stocks. More specifically, technology stocks. And, even more specifically, those tied to the Artificial Intelligence narrative (the “Magnificent Seven”). The narrowness of the rally has been as surprising as its magnitude. Market concentration in the S&P 500 has been at its highest level since 1970. The aforementioned seven stocks made up over 30% of the entire index as of the beginning of July.

This is not typically a healthy backdrop for the stock market, since comparatively so much is riding on so little. Concentration has a lot to do with momentum (the tendency for winners to keep winning and losers to keep losing). It’s a phenomenon driven by crowd behavior, not fundamentals. Echoing the generational extremes in concentration, stocks with the most momentum have outperformed by a larger margin than anything we have seen in the last 50 years, barring the very top of the dot-com bubble before it burst in 2000. The thing about momentum in markets is that, while it changes direction infrequently, it inevitably will reverse itself, and when it does, it reverses powerfully.

This is all detailed in a recent Research note provided here from the very folks whose data we rely on, S&P Dow Jones: Worth the Weight (spglobal.com). In this piece, S&P concludes that major market turning points have historically coincided after extremes in mega-cap performance and in the performance of momentum stocks. Through this perspective, the trades that reversed in the last few days have long looked overdue for a correction. Markets priced at nearly 35 times cyclically-adjusted earnings have embedded very rosy expectations indeed—with very little margin for error. Periods of low apparent volatility further entrench a dominant narrative (in today’s market, about only a handful of stocks) and sow the seeds of heightened instability.

A correction is not a financial crisis. What we observe in the market is technical and behavioral rather than primarily fundamental—though self-fulfilling prophecies are possible. Furthermore, despite the jobs number being a little weaker than expected on Friday, it is worth recalling payrolls are still expanding from a level close to or above most economists’ estimates of full employment. We believe that the Fed has been patient and will not want to admit an error, or risk causing panic, by cutting fed funds before its next meeting in a month. The situation for equity bulls has been deteriorating for most of this year, just as markets have been increasingly pricing certain stocks to perfection. Carry trades and AI hype may stretch equity markets to their breaking point, but they are unlikely to destroy the U.S. economy.

Our portfolios are intentionally diversified to limit these risks. We have been (frustratingly) underweight stocks with eyewatering recent momentum and invested in a broader basket of good companies at reasonable valuations. In public equity, fixed income, and private markets, we labor hard to find strategies that are not perfectly correlated to one another and are thus more inoculated to the fast-flowing rivers of global liquidity.

Unlike in the last market sell-off in 2021, which was driven by tightening conditions to fight inflation, bonds are today an attractive asset class for return and risk mitigation. With rates having reset to pre-global financial crisis levels, fixed income provides attractive yields and improved value. In our stock portfolios, we have embraced factor investing, also known as “smart beta.” For the low cost of a passive strategy, we lean modestly toward time-tested attributes of risk-adjusted performance such as smaller size, value, low volatility, and quality.¹ By combining these characteristics (a multi-factor approach), we further diversify our exposure to any single theme driving equity returns. Like turtles, it’s diversification all the way down.

Building truly diversified portfolios and fading the excesses of AI darlings, global carry trades, and other forms of investor euphoria can imply a short-term performance tax. Such a portfolio is almost guaranteed to lag the index whenever it becomes highly concentrated in the beneficiaries of anomalous momentum. But the practice of diversification helps us keep a disciplined eye on our long-term goals and not overreact to eddies and vortices of sensationalism generated by the media in our age of financial information overload. It does that by reducing some of the short-term volatility, helping us weather these kinds of storms without excessively worrying about our portfolio’s prospects for long-term success. We are not especially tempted to “buy” the dip; nor are we running for the hills. Fortunately, bonds are today a better investment than in recent memory. Over the next decade, smaller, reasonably priced equities are as well.

¹ And yes, when it is priced appropriately, momentum.

SEE IMPORTANT DISCLOSURES