The global economy is astoundingly complex [1] and no one can repeatedly correctly assess what course it will take. Nevertheless, well-trained and experienced people can attach probabilities to various outcomes that may or may not later turn out to be correct, but this does not imply that what ultimately transpires was destined to be.
Every single trading day, investors are bombarded with reems of economic data, which is exceptionally difficult to place within its proper context, is often later revised and is possibly irrelevant because it is backward looking. Nonetheless, economic activity has a direct bearing on financial market performance. The question therefore is whether a) investors should generally pay any attention to this data or b) if one is going to take heed of it, what should they really be focusing on.
Periodically, and of course with the benefit of hindsight, investors must subject themselves to the mandatory period of painful self-reflection, for example, ‘why did I not see that the US housing market was so overvalued in 2007’, or ‘I never imagined interest rates might not be zero forever, I wish I had kept a little more cash aside.’
Thinking of the economy as a complicated machine
What we are trying to avoid, or at least minimise, is this rather unpleasant exercise. In order to do this, we try to imagine the global economy as a car [2]. The dashboard is relaying to the driver (investors, central bankers etc [3].) various pieces of information which in isolation aren’t necessarily much use. For example, if your speed is 60Mph and the windscreen is obscured, or the brakes don’t work, you might be in trouble. You are not necessarily in any danger by simply driving at the speed limit, but it you are driving at 120Mph it might not matter if the brakes are in good order because you are just driving to damn fast.
Unfortunately, drivers tend to ignore the proverbial ‘warning lights’, which always seem to be on and if left unheeded can lead to serious trouble. The question is essentially this, if we ignore all the endless noise, is there some important economic relationship that is just way out of kilter. Ignore for a moment the AI euphoria (more about this later), the terrible state of US commercial property, whether the Fed is going to cut rates by 25Bps or 50Bps, or who ends up in the White House. These are of course important considerations, but to us, the Yen Dollar exchange rate appears to be very far from justifiable. The Yen is by some measures 45% undervalued versus the Greenback [4]. Anecdotally, Japan is now a relatively cheap holiday destination [5]. Who would have imagined that.
What is the ‘carry trade’ anyway?
Interest rates in Japan have been low for a long time. They still are, although they have risen a little recently. Not only were they low, but there was also near zero volatility. Put differently, they never really moved up or down by much. The latter point is important because it encouraged a certain type of financial transaction, known as the ‘carry trade’. The idea is simple, borrow money in a cheap currency, in this case the Yen, sell the Yen you have borrowed and invest the proceeds into something with the prospect of making money (no prizes for guessing what that is).
What could possibly go wrong. Well, several things actually. Just recently we got a taste of how fragile this situation is when the Bank of Japan raised rates unexpectedly. They immediately back tracked when the Yen soared against the Dollar, US Tech stocks plummeted, and the Japanese stock market fell by the most in one day for 37 years [6].
Does the carry trade explain the meltdown in US tech?
In an excellent analysis Dhaval Joshi at BCA Research makes a solid case for the hypothesis that the proceeds realised from the relentless selling of Yen has made its way into US superstar tech stocks [7]. As he correctly points out, correlation does not imply causation. Nevertheless, the evidence is compelling, and investors seem to be bidding up the value of these stocks, heavily represented in the NASDAQ, to the limit of what can reasonably justified by the likely trajectory of earnings. If Stock A has a forward multiple of 40x and the rest of the market trades on say 20x, there is a lot of good news baked into the price and little room for error.
The Bank of Japan (BoJ) has a clear mandate to maintain price stability [8]. In recent years, after decades of deflation, inflation in Japan is becoming more pronounced [9]. Perhaps inflation will subside and no further action from the BoJ will be required, but if it does not, the BoJ will be faced with the choice of following their mandate, or potentially perpetuating another episode of market chaos. With an exchange rate that appears to be very far from fair value a warning light regarding this aspect of the global economic machine seems to still be well lit.
[1] For a formal explanation of what constitutes a complex system see further: Complexity Economics Article via exploring-conomics.org
[2] We are not sure that a car is technically a complex system but bear with the analogy.
[3] Perhaps the investors are better thought of as passengers. Either way, we are all in it together and the information from the dashboard is available for everyone to see.
[4] See: https://www.bcaresearch.com/reports/view_report/40738/gis & https://www.economist.com/big-mac-index
[5] See: https://sg.finance.yahoo.com/news/why-it-feels-like-everyone-in-the-world-is-heading-to-japan-right-now-084434869.html?guccounter=1&guce_referrer=aHR0cHM6Ly93d3cuZ29vZ2xlLmNvbS8&guce_referrer_sig=AQAAAEgvdRymQvHX8V_Sb-ve1_DHRF3wddAU1Dm8hY7OKFbd9-53vFLNzPY15YEaztFhjm8r67gk_jWvS-Gd2WPtO6E4AbeYm5O3Z1qdFbhWELcAHmR4GoJsb_ifScdSVpx7kDidgm_RwocfNadwKgJ_ye2BEVN5aXL8iNktgKGGtcoq
[6] See note 4 above
[7] See: https://www.bcaresearch.com/reports/view_report/40689/cpt
[8] See: https://www.boj.or.jp/en/mopo/outline/index.htm
[9] See: https://www.reuters.com/markets/asia/japans-core-inflation-picks-up-july-demand-driven-growth-below-2-2024-08-23/
