Five big things that have changed

Since we first grew more cautious on stocks in early July—particularly growth stocks and international—markets have entered a period of higher volatility, almost on cue. Then, as last week progressed, things seemed to stabilize. The services ISM was better than feared, implying a sharp economic deceleration was not underway. The Bank of Japan (BoJ) Governor apologized for spooking markets and promised to wait for more stable times before his next rate hike. And Fed Chair Jerome Powell assured us he is aware that the economy is softening and implied that rate cuts are coming, sooner or later. So, with the market now down 6% from its highs and large-cap growth stocks down 9%, is it safe to go back in the growth stock water?

We believe there is no rush to do so. We don’t think the last few weeks was simply “ordinary August volatility” you get when everyone is away on the beach. Some major forces that have shaped the investment environment over the last two years have shifted dramatically; investors need to position themselves accordingly. In particular, we think the so called “Great Rotation” trade, which evidenced itself briefly in the past few weeks, has legs. We’re maintaining our more cautious stance overall and will continue to limit our equity overweights to small caps, value stocks, and emerging markets. Here are the five big things that we see as changed:

1. The yen carry trade is ending. For the last several years, the BoJ has been running a loose money policy with sub-zero interest rates. For a while, the discount rates of the other G-7 economies were also very low, in some cases near zero, so the advantage of borrowing yen to fund investments in euros or dollars was not significant. This changed dramatically in the spring of 2022 when the Fed began to hike rates dramatically, even as the BoJ insisted it would keep rates below zero until inflation rose to its 2% target. As the Bank of England and the European Central Bank followed the Fed by hiking rates, this left the anomalous opportunity for opportunistic investors to exploit. A huge and deep government securities market in one of the world’s largest economies was offering borrowing rates at near zero, while all the other markets around the world were offering fixed-investment yields in the 4% to 6% range. To sweeten the bargain, as leveraged players from around the world began building positions in this trade, the yen began to depreciate, allowing yen borrowers to pay back their borrowed yen positions at lower levels than they borrowed them at. As the action heated up, these same leveraged players realized they could make even a greater spread by buying not government bonds but large-cap growth stocks, which my friendly Uber driver recently assured me “always go up and importantly, don’t go down.” Estimates of how big this trade, largely unregulated, grew are all over the map, ranging from $350 billion to $2.5 trillion. Although some experts assure us the trade has unwound, my guess is that it is not. In my experience, trades like this, built up over an extended period of time, take weeks to unwind properly—not three days. What gets unwound quickly are the positions closest to “out of the money” with very short-term expiration dates on them. The longer and intermediate dated positions are still out there, I’d guess. Unwinding them will take time, and likely be a source of pressure on dollar/yen as well as dollar assets that had previously benefited from the leverage, i.e., large-cap growth stocks and Japanese stocks in the EAFE Index.
2. The yield curve is dis-inverting. Another key feature of the investment environment of the last two years has been the sharply inverted yield curve, with short rates running 100 to 150 basis points above long rates at some points. We are now in the process of dis-inverting, and we think over the next two years we will be experiencing a more normal upwardly sloped curve, with the fed funds rate down from 5.5% (the upper bound) to around 3.0%, and the 10-year Treasury rate relatively stable around its present 3.75% to 4.25% range. Fed funds should drop to 3.0% or so, as labor markets have finally begun to soften and the Fed’s 2.0% to 2.5% inflation target is likely achieved. Absent a financial crisis (which we don’t expect given the current strength and high reserve levels of the banking system), a more historically normal term premium should re-assert itself; after 2022’s bond bear market, bond investors have been reminded the hard way that rates go up, and down. This means that long bond yields are probably roughly where they are going to end up this cycle. This matters a lot to long term investors. The 10-year matters because it’s the primary discount rate for valuing long duration assets, such as large-cap growth stocks. So when the 10-year rate shot up unexpectedly in 2022, those stocks took a beating. Short-term rates also matter for stocks, but in this case, mostly because financial stocks, asset heavy stocks, and small-cap stocks use shorter term funding to fund their balance sheets. So, when these rates rose from 0.25% in March of 2022 to 5.5% in July of 2023, the earnings of these companies, primarily in the Value and small cap indices, took big hits. As the yield curve dis-inverts, i.e., as short rates decline even as long rates remain stable, the same stocks that were hurt by rising short rates should now be helped. The long duration growth stocks, on the other hand, won’t have a similar, symmetric benefit because long rates are unlikely to move much.
3. The relative earnings growth advantage of large-cap growth stocks is declining. As if they already didn’t have enough going for them over the last 18 months, large-cap growth stocks enjoyed another big advantage over the rest of the market: they were growing a lot faster. In 2023, large-cap growth stocks’ earnings outgrew large cap value stocks by 9.5%, and in the first half of 2024, that gap increased to 23.6%. However, as we move through the second half of 2024 and into 2025, the earnings growth differential should shrink to 4.5%. This is a big shift that will, in particular, impact the momentum traders who have pulled into the large-cap growth stock trade, many on a leveraged basis. It’s likely to exert a continued downward pressure on these names.
4. The election is tightening and forward policy uncertainty is rising. Another issue for investors that’s news over just the last three weeks is that an election that back in May many, including us, were already calling for Trump has now shifted, with the replacement of President Biden for Vice President Kamala Harris on the Democratic ticket. Given the dramatically different policy outcomes of a Republican versus a Democratic government, we anticipate that an already softening economy could soften further in the coming months as corporates big and small delay investment and hiring plans, pending a clearer picture of the likely regulatory and tax environment ahead. Although this uncertainty will be removed as an overhang by mid-November, in the meantime it could add to volatility in the economic indicators that market watchers are focused on.
5. The labor market is softening. A final important feature of the post-Covid era has been the remarkably tight labor market—at almost historic levels of tightness. The U-3 unemployment rate stabilized below 4% for over two years (January 2022 through April 2024), and at its strongest had the lowest unemployment rate since 1969. Another metric of tightness, the number of job openings per unemployed workers, reached the highest level on record in 2022 (data collection began in 2000). This tightness has been a key factor in the sticky inflation data that has caused the Fed to delay the rate cutting cycle and has also buoyed the consumer sector despite the pressure on it from other sources, such as inflation. This softening of the labor market is likely to have both positive and negative impacts on specific companies, and we think could add to volatility in the markets broadly. Although we do not see any systemic risk in the banking system, which could extend and deepen labor-market softness into a broader recession, it could for a time create a “bad news is bad news” environment for stocks, which is something we haven’t experienced in a while.

In this business, sorting out the normal day to day noise from more dramatic developments is always difficult, given the daily news cycle and the tendency of all involved to over-dramatize at times the tale of the tape. And we won’t know till months from now whether the “Great Rotation” trade that began in early July, and then reversed partly last week, was the sign of a dramatic shift in the market’s fundamentals or was just a flash-in-the-pan. We believe it’s the former and continue to recommend portfolios tilt towards it as our balanced models are. Time will tell. Enjoy the rest of the summer and try not to stand under any tall trees.