Bumps in the Road

Key Points:

• Volatility has reappeared in markets after a period of calm. Japanese equities suffered their third largest weekly fall in 60 years.

• Markets tend to rise slowly and fall quickly however it is difficult to position for these events without avoiding markets entirely and often these episodes are good buying opportunities outside of recessions.

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After what felt like a relatively lengthy period of calm, happy markets, the past month has been more volatile. A combination of good, but not good enough, technology company earnings, weak manufacturing data and an unexpected spike in the US unemployment rate, pushed markets into correction territory, with the S&P 500 falling around 8% from the recent peak (though some of this has since been reversed). However, this volatility pales in comparison to the movements seen in Japanese equity markets, which fell nearly 20% in a week. In this month’s Market Insight, we explore violent market events, starting with recent movements in Japan and going backwards touching on some of the more classic examples.

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Unwinding the Carry Trade

Japanese equities falling more than 20% isn’t rare. Since the Financial Crisis, it has happened in 2016, 2018, 2020 and nearly did in 2022. The chart below shows how often Japanese equities have fallen more than 20% over a one-year time frame. Unfortunately for investors in Japanese equities (our portfolios don’t have a discreet allocation to this market), after finally recovering price losses from the ~75% collapse following the 1990s bubble, Japanese equities suffered their third largest weekly fall in sixty years between 29th July and 5th August, falling 25% in total and marking the fifth major decline in eight and a half years. Importantly, this came after a very strong rally and the Japanese market is currently sitting around where it was at the beginning of the year.

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So, what is to blame this time? Consensus seems to be pinpointing an unwinding of the Japanese Yen carry trade as the main culprit for the fall. A carry trade is borrowing cheap in one currency to invest somewhere you expect a higher return. With the cash rate in Japan close to zero, borrowing there to invest elsewhere has been cheap and caused the Yen to weaken substantially against major currencies as investors sold Yen to purchase foreign assets such as US equities. However, a rate rise in Japan followed by softer US data, increasing the number of expected rate cuts in the US, has triggered a huge reversal i.e. selling foreign assets to buy Yen and pay back the loans. The weak Yen had boosted the Japanese equity market given large global exporters such as Toyota benefit from a weaker currency. So, as the leveraged trades reversed, the equity market sold off rapidly also.

Now the carry trade has unwound in short order, more positive economic data has led the market to refocus on fundamentals and the market has subsequently begun to recover. The chart below shows the return of the US, Japanese and Australian equity markets since their recent peaks. The US is now down only -4%, Australia -2% and Japan -12%.

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These sort of major disruptive market events, driven by market mechanics or liquidity rather than market fundamentals entirely, are not unheard of. An unwinding of a Japanese carry trade is one instance of these kind of occurrences. Some notable other recent incidents are summarised below.

2022 Gilt Crisis: In September 2022, The UK government announced a "mini-budget" including £45 billion in unfunded tax cuts. This raised concerns about fiscal sustainability and saw a rapid rise in UK government bond yields. The spike higher meant leveraged trades held by defined benefit pension funds generated a large increase in their collateral and margin requirements. To meet these requirements, they were forced to sell more government bonds, pushing yields even higher. In the end, the Bank of England was forced to intervene in the market, implementing a £65 billion emergency bond buying program.

2020 Negative Oil Prices: Covid lockdowns amidst continued petroleum production saw WTI oil futures prices fall to nearly negative $40 per barrel in April 2020 as inventories rose very close to capacity. Investors were being paid to essentially take storage risk. Like negative bond yields following the Financial Crisis, negative oil prices were a new phenomenon.

2018 Volmageddon: A sudden rise in market volatility in February 2018 led to a one-day loss of more than 90% in the value of short volatility exchange-traded products (ETPs). These products derived an income from selling forward volatility. When the price of expected volatility rose, this created a value destroying feedback loop. To hedge risk in a rising volatility market where their assets were falling (because they are short volatility), the product issuers needed to buy volatility (VIX) futures, pushing the price of volatility higher and exacerbating the problem.

Swiss National Bank Peg Break: In January 2015, the Swiss National Bank unexpectedly scrapped its currency peg against the Euro. Immediately after the central bank’s announcement, the Swiss Franc soared by ~30% against the Euro and Swiss equities fell around 10%.

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Flash Crashes: There have been many instances of flash crashes in the past decade, often with mysterious causes:

• In May 2022, many European markets fell 5% - 7% after a very large accidental sell order placed on market.

• In October 2016, the British Pound fell 6% against the USD in 2 minutes, before quickly recovering most of the loss.

• In August 2015, the S&P 500 declined 5% in minutes after the open, with little to explain the fall.

• In October 2014, US bond yields round tripped around 1.6 percentage points, again with no discernible cause.

• In May 2010, alleged market manipulation by a participant (rapidly executing large S&P 500 futures sell orders) drove a flash crash of around 10% in US markets.

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Black Monday: Of course, the most infamous market dislocation continuous to be Black Monday. On October 19, 1987, US markets fell more than 22% in one day after algorithmic trading drove a negative feedback loop, building upon fundamental weakness already present.

History is littered with market events which in the moment feel very threatening, but in the end turn out to be a flash in the pan. More often than not, the sell-off is recovered extremely quickly (see below). That’s not to say that serious market drawdowns don’t occur – they certainly do. However, they are generally tied to fundamentals, which are more predictable than out of the blue market crashes. As a result, they are easier to position portfolios for.

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Portfolio Positioning

The only way to be positioned for a left tail market event is to not participate in markets. The fact that these events occur is one of the reasons why investors get paid more to invest in markets rather than cash. Ultimately, flash crashes and liquidity-driven market dislocations tend to be quite temporary. Opportunistic market participants quickly fill gaps. Indeed, Japanese equities recovered around half their fall in the two days after the event. Investors are better placed to focus on the fundamentals of markets when building portfolios with long term time horizons.

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