A Cross Pacific Current

The pullback in global equity indices at the beginning of August left many investors racing to understand what had caused such outsized volatility. Amid this market turbulence, there were two seemingly unrelated economic events that occurred on different sides of the globe. On July 31, the Bank of Japan surprisingly announced that it would raise its benchmark interest rate from 0.10% to 0.25%, continuing its transition from the ultra-low rates that had been commonplace in recent time. Later that week, the July U.S. nonfarm payroll employment data, which many use to gauge the health of the domestic labor market, came in below estimates. This report led investors to question the strength of the U.S. economy and whether the Federal Reserve had waited too long to cut its policy rate. Simply put, equity markets reacted negatively. The Nasdaq, which is a growth-oriented U.S. large-cap stock index, exhibited a particularly sharp drop during this time, falling by roughly 7% in less than one week. The speed and severity of this sell-off left many asking if one poor labor report alone was solely to blame. As it turned out, the Bank of Japan’s interest rate decision earlier in the week may have been just as important as it relates to what had occurred in U.S. markets.

A “carry trade” is a strategy wherein an investor borrows in a low-yielding currency (in this case the Japanese yen) and invests the borrowed funds in a higher-yielding asset. While it is difficult to assess the size and scope of these trades, certain statistical relationships can emerge that may shine light on how borrowed funds are being invested. To that point, the chart above shows the year-to-date changes in level of the Nasdaq index and the value of the U.S. dollar (USD) relative to the Japanese yen (JPY). Interestingly, on a rolling 30-day basis since the start of the year, the movements of the NASDAQ and USD/JPY have been moderately correlated with a coefficient of 0.46 (a coefficient of 1 would indicate a perfectly positively correlated relationship). While indeed moderate, this relationship does indicate that as the dollar has weakened relative to the yen, the Nasdaq has weakened in a similar fashion. What might be driving this relationship?

While we cannot draw definitive conclusions based on correlation alone, the carry trade strategy may be partially responsible for the emergence of this relationship. In the first half of this year, U.S. large-cap stocks notched strong performance while the dollar steadily strengthened against the yen, which kept yen borrowing costs low. That said, when the Bank of Japan raised its policy rate (and the cost of borrowing yen) in late July, many carry trade investors were forced to sell assets to pay back the funds borrowed in yen, which was now rapidly appreciating against the dollar.  For those who had been investing borrowed funds in U.S. stocks, harvesting gains from these positions would be a logical move in order to post collateral. It is important to point out, however, that this process can snowball. Specifically, higher demand for yen drives up the value of the currency, which prompts collateral calls for more investors who have borrowed in yen, which leads to further selling of risk assets like U.S. stocks. This feedback loop can be observed in the shaded region of this week’s chart, during which the correlation coefficient between Nasdaq and USD/JPY jumped to more than 0.9.

While this chart highlights one relationship to provide insight into the recent spike in equity volatility, a broader conclusion readers should draw is that changing dynamics within global markets and the opaque nature of certain trades can make risks faced by investors difficult to identify and measure. As a result, it is important for investors to maintain well-diversified portfolios that can weather various market environments.

The Emergence of Argentinian Equities

Argentina has faced myriad economic headwinds in recent time, including hyperinflation, currency-related difficulties, and a series of defaults on its sovereign debt. As the country headed into a presidential election year in 2023, Javier Milei, a member of the Argentinian Libertarian Party, emerged as a front-runner in the race, as many viewed his laissez-faire approach to economic policy as having the potential to correct the nation’s trajectory. Milei ultimately won the presidential election and assumed office in December of last year.

Over the last several months, President Milei has enacted a series of unique and controversial economic policies aimed at making the nation’s currency more competitive, reigning in excessive inflation, and stabilizing Argentina’s economic footing. These policies include the devaluation of the Argentinian peso by more than 50% and the introduction of a crawling peg, which is designed to further depreciate the peso. Additional initiatives by the Milei government include lifting capital controls, slashing state subsidies, and scrapping hundreds of government jobs and regulations. This austerity program, while certainly creating its own set of complications for the Argentinian people, has been largely well received by investors. To that point, the MSCI Argentina Index has returned close to 200% on a cumulative basis over the last two years, which is far in excess of the cumulative returns of both the MSCI Emerging Markets and MSCI Frontier Emerging Markets indices in that time. This performance is a sign of investor optimism related to the country’s economic prospects under Milei’s leadership, and Argentina’s status as a world leader in lithium and copper reserves could provide additional support from market participants. Marquette will continue to monitor the progress made by Argentina on the economic front.

Mind the Gap

Any ride on the London Tube reminds riders to mind the gap: Beware the space between train car and platform as you board and depart the train. A recent trip to London brought this phrase back to me and it seemed like a perfect description of how to look at financial markets this year, with the “gap” serving as the difference between expectations and reality, most particularly in terms of interest rate cuts.

In our market preview, we identified the Fed pivot as a primary driver of financial markets this year, most especially how expectations of cuts would line up with actual Fed policy. Going into the year, the market had priced in at least five cuts, which helped fuel a furious fourth quarter rally and investor optimism for 2024. One quarter in, however, those expectations have been turned on their head. Hotter than expected inflation and jobs reports in March have created a “higher for longer” narrative with the market expecting no more than two cuts during the second half of the year. Some economists have taken an even more bearish stance, suggesting there will not be any cuts. Overall, rates rose across the curve during the quarter as current U.S. debt levels sustained the long end of the curve while the short end was relatively unmoved.

Intuitively, many investors would expect such a big change in rate expectations to weigh heavily on markets, both equities and bonds. In that sense, equity performance was surprising during the first quarter, as the upward trend from 2023 continued. Predictably, bonds suffered as rates rose, but below investment grade sectors were profitable. To be fair, though, it should be noted that equities have endured a difficult start to this month, down 4.6% through April 22 as the higher for longer narrative has gained momentum.¹

Going forward, what should we watch for from asset classes as we venture into a market environment that looks much different than what we were expecting only three months ago?

Japan: This Year’s Vacation Recommendation

Foreign investment isn’t the only thing streaming into Japan. In 2023, the number of travelers to the country surpassed long-term average levels, though that figure still sat below pre-pandemic highs. That said, last year was a clear sign of recovery for Japan’s beleaguered tourism industry, and this trend has continued into 2024. Through the first two months of this year, the number of visitors to Japan is already close to 22% of last year’s total, with tourists coming from surrounding Asian countries and the Western world as well. To that point, nearly 150,000 U.S. citizens visited Japan in the month of February alone. A major driver of Japan’s appeal to tourists is the weak yen. In April, the yen hit a low not seen in over 30 years relative to the dollar, thanks in part to disparity between the policies of the Federal Reserve and the Bank of Japan. These dynamics have allowed U.S. travelers to enjoy more “bang for their buck.”

Earlier this year, Japan slightly curtailed its long-running accommodative monetary policy with the goal of addressing the country’s chronic deflation problem and spurring economic growth. The influx of tourists described above might also provide these desired effects, with several industries, including transportation, restaurants, entertainment, and hospitality potentially standing to benefit. For instance, there has been a material increase in average daily hotel rates in Japan, which recently hit highs not seen since the late 1990s. Although this is just one example of travelers having an impact on Japanese price levels and growth, it is illustrative of what could happen more broadly to industries directly tied to tourism. While the outlook for economic growth and future tourism in Japan is uncertain, it is encouraging to see certain data reflect the pre-pandemic environment.

3Q 2023 Market Insights Video

This video is a recording of a live webinar held on October 26 by Marquette’s research team, featuring in-depth analysis of the third quarter and themes we’ll be monitoring for the remainder of the year. Our Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real estate, infrastructure, private equity, and private credit, with presentations by our research analysts and directors.

Featuring:
Greg Leonberger, FSA, EA, MAAA, FCA, Director of Research, Managing Partner
Evan Frazier, CFA, CAIA, Senior Research Analyst
Frank Valle, CFA, CAIA, Senior Research Analyst
Catherine Hillier, Research Analyst
David Hernandez, CFA, Associate Director
Chad Sheaffer, CFA, CAIA, Senior Research Analyst
Griffin Gildea, Research Associate
Hayley McCollum, Research Analyst
Brett Graffy, CAIA, Associate Director

 

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Portfolio Trick or Treat

Coming into 2023, investors were cautiously optimistic about 2023 market returns; cautious considering the broad losses across asset classes during 2022 but optimistic about more attractive valuations and the inherent upside potential stemming from these price points. Nine months into the year, which of these opportunities have been “treats” for investors, and which have been “tricks”?

In this edition:

  • The biggest trick of them all: Investment grade fixed income
  • But not all of fixed income has been a trick…
  • Tricks come in all sizes: U.S. small-cap equities
  • Trick, treat, or both? U.S. growth stocks
  • Currency movements still tricky
  • More treat than trick: Emerging markets
  • If you’re not surprised, it’s not a trick: Commercial real estate

Fitch Downgrades U.S. Credit

Fitch Ratings unexpectedly downgraded the U.S. government’s credit rating one notch from AAA to AA+ on August 1, 2023. This is only the second downgrade in history, after S&P Global Ratings, then Standard & Poor’s, made the same adjustment shortly after the 2011 debt ceiling crisis; S&P has maintained the AA+ rating since. Moody’s — the third major U.S. rating agency — still has the U.S. at its highest Aaa rating. Fitch noted the downgrade reflects expected fiscal deterioration over the next three years, the country’s high and growing debt burden, and an erosion in governance over the last several years, marked by bipartisan standoffs and last-minute resolutions. The downgrade and timing have drawn criticism from the Biden administration and economists, citing economic strength and the minuscule risk of the U.S. actually missing any debt payments.

While in practice the downgrade will likely have minimal impact, with the U.S. government broadly considered one of the safest borrowers, markets are reacting. Treasuries initially rallied on the news, anticipating the same flight to quality seen in 2011, though that sentiment reversed this morning, with yields at one point breaching a key resistance level of 4.1% — a level last seen in November 2022. Also likely contributing to the move today is the Treasury Department’s announced plans to sell a higher-than-expected amount of longer-dated securities next week, as it works to replenish the Treasury General Account (reference Marquette’s recent newsletter for additional context). The U.S. dollar initially dipped on the news but has since rallied and is up on the day amid higher yields. U.S. equities, after a steep run, are down modestly today, with growth equities leading the group lower.

Print PDF > Fitch Downgrades U.S. Credit

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Halftime Adjustments

For anyone who regularly reads these letters, recall the market preview edition opined on the outlook for asset classes in 2023, particularly the likelihood of each delivering positive returns for the upcoming year. Given that we are halfway through the year, we would like to use this letter to make “halftime adjustments” to our outlook; with NFL training camps set to open later this month, we couldn’t resist the urge to borrow a football term. We hope this is a quick beach read as you enjoy your summer vacations and prepare for the second half of the year.

This edition re-assesses the outlook for fixed income, equities, and real estate for the second half of 2023.

Read > Halftime Adjustments

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

More Bang for Your… EM Local Currency?

Local currency emerging markets debt has been one of the standout fixed income asset classes this year. The J.P. Morgan GBI-EM Global Diversified Index — which tracks local currency bonds issued by emerging market governments — is up nearly 5% year-to-date.¹ This compares with the Bloomberg US Agg up 2.5% over the same period. Yields for the emerging markets index peaked in the fourth quarter of 2022 and remain near multi-year highs. Local currency EM debt could stand to benefit for three reasons: higher starting yields, proactive emerging markets central banks, and emerging versus developed GDP growth differentials.

  • Real yields in EM local currency debt are at attractive levels relative to history as well as relative to developed markets. As of June 26, GBI-EM yields were 6.28%. This compares with the U.S. 10-year Treasury yield at 3.72%. This yield differential compensates investors for the higher risk and positions them to benefit from yield compression if global macro headwinds start to abate.
  • Several EM countries such as Brazil and Mexico began their rate hiking cycles much sooner than their developed market counterparts. To the extent that positions these emerging central banks to cut policy rates sooner than the rest of the world, yield compression could benefit total asset class returns.
  • EM local currency debt should benefit from higher GDP growth than is expected in developed markets. Based on projections from the International Monetary Fund, EM economies are projected to grow approximately 4% per annum through 2024. This compares to advanced economies, where real GDP is projected to grow roughly 1.5% through 2024.

In sum, a number of tailwinds could continue to position EM local currency debt for strong relative returns as the year progresses.

Print PDF > More Bang for Your… EM Local Currency?

¹Through June 26, 2023

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

1Q 2023 Market Insights Video

This video is a recording of a live webinar held April 20 by Marquette’s research team, featuring in-depth analysis of the first quarter of 2023 and themes we’ll be monitoring in the coming months. Our Market Insights series examines the primary asset classes we cover for clients including the U.S. economy, fixed income, U.S. and non-U.S. equities, hedge funds, real estate, infrastructure, private equity, and private credit, with presentations by our research analysts and directors.

Featuring:
Greg Leonberger, FSA, EA, MAAA, FCA, Director of Research, Managing Partner
Jessica Noviskis, CFA, Associate Director
James Torgerson, Research Analyst
Catherine Hillier, Research Analyst
Evan Frazier, CFA, CAIA, Senior Research Analyst
Chad Sheaffer, CFA, CAIA, Research Analyst
Josh Cabrera, CFA, Senior Research Analyst
Hayley McCollum, Associate Research Analyst
Brett Graffy, CAIA, Associate Director

 

Sign up for research alerts to be invited to future webinars and notified when we publish new videos.
For more information, questions, or feedback, please send us an email.

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. Marquette is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Marquette including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request.