August 2024 Market Commentary

August 2024 Commentary

In early August, we took advantage of a market disruption to reduce cash and increase client portfolio exposure to equities (for clients that have exposure to equities). In this month’s commentary, Quantitative Strategist Parker King discusses our thought process and some of the factors that we considered.

Was the Early August Market Sell-Off an Opportunity? 

The Triggering of the Sahm Rule

On Friday, August 2^nd, the July Unemployment Rate was released at 4.3%, 0.1% above the level required to trigger the Sahm rule. This rule, when triggered, indicates the early stages of a recession. The immediate response after the release of the unemployment number was a concern that the Fed had made a policy error, keeping rates restrictive for too long. Equity markets sold off, US Treasuries rallied, the Volatility Index (VIX) spiked to levels consistent with extreme risk aversion, and Fed Funds futures quickly shifted from an expectation of 32.9 to 49.5 basis points of cuts at the September 18^th meeting. Additionally, the US Dollar / Japanese Yen (USD/JPY) exchange rate fell to 144.18 by August 5^th and the unwinding of the Japanese Yen (JPY) carry trade was cited as one of the catalysts which drove the sell-off in equities.

Was this market sell-off an opportunity to extend equity exposure at better levels? Three things needed to be reconciled to answer this question:

• Does the unwinding of the JPY carry trade remain a concern?
• Was the rise in VIX consistent with observed economic and market data?
• Is the likelihood of a recession significantly higher?

What is the JPY Carry Trade and Does It Remain a Concern?

The JPY carry trade is analogous to buying equities (or other risky assets) on margin but with the additional complexity of exchange rate risk. Because interest rates in Japan have been near zero, it has been attractive to borrow JPY at a near 0% interest rate and then use the proceeds to invest in higher expected return assets (e.g. US Equities) denominated in other currencies (US Dollar).

As markets began to sell off in early August, the JPY carry trade began to unwind. Investors began losing on their risky asset (US Equity) exposure and were forced to sell those positions. These losses were exacerbated by movements in the exchange rate. To cover their short (borrowing) JPY positions investors had to convert their USD proceeds into JPY. This demand strengthened the JPY versus the USD and caused further losses on the exchange rate conversion. This unwinding of the JPY carry trade made the sell-off in US equities worse than it might have been otherwise. The question was whether the pressure from this trade was likely to continue.

Exhibit 1

Source: Bloomberg, AAFMAA Wealth Management & Trust

As a proxy for the total market short JPY position, we looked at the Chicago Mercantile Exchange (CME) outstanding futures contracts positions (Exhibit 1). We see that in the weeks prior to August 2^nd, the outstanding short JPY contracts were at an extreme, with nearly 200,000 outstanding short contracts. By August 6^th, the number of short contracts was near zero. So, we conclude that the most recent market movement significantly reduced short JPY positioning.

The recent strengthening in the JPY relative to the USD, rise in currency volatility, and reduction of JPY short positions lead us to believe that further near-term pressure from the unwinding of the JPY carry trade was unlikely.

Rising Risk Aversion

As assets sold off after the unemployment release, measures of risk aversion began to rise with the VIX Index spiking to 66 on an intraday basis and 38.57 on a closing basis. Exhibit 2 puts this in perspective. The level of the VIX after the unemployment number was more than 2 standard deviations above the mean level of the VIX and the two-day change of 20 points was something we have only seen 4 times since 2000. We were looking at levels and changes in the VIX consistent with September 11^th, the great financial crisis, and COVID-19.

Exhibit 2

Source: Source: Bloomberg, AAFMAA Wealth Management & Trust

Normally, an investor would begin selling risky assets (shift out of equity and into bonds or cash) as risk rises. As the VIX falls back to normal levels then the asset allocation returns to its previous state. The optimal time to revert back to the original asset allocation weightings is at the inflection point in the VIX, this would generally correspond to the point where assets had reached their maximum decline. The problem is that the inflection point is hard to identify with the VIX often declining for a short period of time before resuming the uptrend.

In this case, we felt strongly that we were at the inflection point and that the spike in the VIX was an overreaction and inconsistent with what we were seeing in markets and the economy. We saw no significant stress in credit markets and the remaining question was whether we should worry about recession given the labor market data.

Unemployment Rate and the Probability of Recession

To answer the question about the unemployment data and the probability of recession, we began by simulating the future path of the US Unemployment Rate (Exhibit 3). The expected path yielded an estimated July 2025 unemployment rate of 5.2%.

Exhibit 3

Source: Bloomberg, AAFMAA Wealth Management & Trust

The question is whether this unemployment path is consistent with a recession in the next year. Using the historical relationship between quarterly real GDP growth and changes in unemployment, we projected real GDP growth through July 2025 (Exhibit 4).

Exhibit 4

Source: Bloomberg, AAFMAA Wealth Management & Trust

The expected path of GDP growth has GDP at 1.7% in July 2025 with a low of 1.0% in Q1 2025. This estimated path of GDP growth is very much in line with Bloomberg analyst’s consensus forecast. When we look at all simulated paths and the instances of two or more consecutive quarters of negative GDP growth, we conclude that the probability of recession remains relatively low at 22.4%.

Conclusion

Although the recent unemployment rate data triggered the Sahm Rule, our analysis suggests that the probability of recession remains low. Additionally, other measures of labor market and economic strength are not consistent with recession. Positioning in the Japanese Yen carry trade appears to be close to neutral and the level of the VIX we observed was inconsistent with current economic and market data. For these reasons we used the early August market sell-off as an opportunity to extend our exposure to US equities across all portfolios.

Yours in trust,

Parker

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