The Carry Trade Recovery and Slowing Growth Ahead

Hey folks,

It’s Terry Gardner from C.J. Lawrence coming to you on Tuesday evening, the 6th of August, on the back of what has been a really wild ride in the equity markets in just the past three weeks. I thought I’d share some thoughts, a little unscripted tonight, and just reflect on what has happened and how the market narrative and sentiment have changed dramatically in a short time.

Think back to the 13th of July, the date of the assassination attempt on Former President Trump’s life. We saw a subsequent groundswell of belief that Trump would win another term in office. What that meant for the market, based on perhaps lower taxes and deregulation, was perceived as somewhat bullish. A couple of days later, the market hit a record high, and we were off to the races. That was less than three weeks ago.

Then, the Sunday after President Biden announced that he was leaving the race and abdicating his position as the Democratic nominee supporting Vice President Harris, the market cooled. The following week on Thursday, July 25th, the initial read on second quarter GDP was released and came in hot. If you remember, the estimate for quarter-to-quarter was for 1.9% growth, but the quarter-to-quarter actually came in at 2.8% growth. On a year-over-year basis, the estimate was 2.9% growth forecast, and it came in at 3.1%. Naturally, the narrative changed dramatically. It became all about rotating to cyclicals because the economy was stronger than everyone had anticipated. Again, that was just two weeks ago.

On July 29th, the Fed released its policy statement, more than hinting that they would begin to lower interest rates in September. Once again, the market started to shift, thinking about a reducing and declining rate environment and where to be positioned for that. For three or four days, it became all about buying small caps because we anticipated rates going down. Then, just last week on Friday, August 2nd, nonfarm payrolls and unemployment came out lower than expected. Unemployment was 4.3% versus an estimate of 4.1%, and nonfarm payrolls came in well below expectations. Once again, the narrative changed. All of a sudden, we were reintroducing the R word, recession. Small caps went out the window and everything started to sell off because growth was slowing precipitously and we were heading towards recession.

Cap that all off on Monday with this yen carry trade phenomenon, which many people hadn’t even heard of up until this week. I don’t want to go into much detail on this, but investors were borrowing money in yen because the currency and interest rates were low. They were taking that money and investing in US equities. When the Bank of Japan raised rates and the currency spiked, those investors were caught in a bad position. They had to sell US stocks to pay back the banks from which they borrowed. There will be some currency traders who will say my characterization is incorrect, but that’s a short summary. The bottom line is, that really added to the selling pressure that came on the back of the soft employment numbers and the higher than expected unemployment rate.

This carry trade story is probably the crux of the challenge for the market, or at least it has been over the last couple of days. We decided to take a look back at past situations where there were major currency fluctuations that upset global capital markets. To be honest, there aren’t that many parallels to the Japanese yen carry trade, because this particular situation doesn’t accompany a credit crisis or a credit issue or sovereign defaults as a lot of previous currency crises have. They’ve all been accompanied by some type of a credit issue, a country default, an emerging market growing issue, etc.

The only parallels that we can point to appeared in 2015. In January of that year, the Swiss currency was de-pegged from the Euro, and the markets for the most part shrugged that off. Then in August of 2015, China changed the way they were setting the trading range for the renminbi, and that came as a surprise to global markets, with China being the second-largest economy in the world and a large consumer as well. That shook capital markets globally, and stocks here in the US traded off 11% on the back of that, only to recover that 11% in the following four weeks, making it a relatively short-lived downdraft.

In December of 2015, the expectation was that Mario Draghi, who was head of the ECB at the time, would deliver a stimulus package, which he did not do. That surprise sent the Euro higher and caused sell-off in European markets that also found its way here to US markets. That month, the US stock market measured by the S&P 500 sold off 9%. Those are two parallels where a currency issue and a rise in interest rates, a rise in a currency versus other trading partners, caused some ripple that put pressure on US stocks. It looks like on average stocks trade down about nine or 10% on the back of those events, and that’s about where we are today.

Is this carry trade for selling over? It’s tough to tell, but probably not. I think the point is that this sell-off we saw going into yesterday was probably driven more by that than a “growth scare” that was precipitated by the unemployment figures and the nonfarm payroll results. To take a look at growth and see what’s happening, the interesting thing is that in the midst of all this, we’re in earnings season. Companies are reporting second quarter results; at this point, about 80% of the S&P 500 has reported. The nice thing is we can get a read from company management as to what they’re seeing, and this growth scare isn’t being reflected by company managements, nor is it being reflected in earnings expectations for the rest of this year.

If you look on the edges, there is some softening. The consumer is starting to slow down in certain pockets, right? We can see that in the results of certain consumer goods companies, but we would see it in a more widespread way if there was something underfoot that was challenging growth for the balance of 2024 and 2025, and we’re not seeing it. In fact, I was looking at the earnings growth forecast going out for the balance of this year and for next year to see if there had been any change over the last couple of days or weeks. What I’m seeing is that growth is actually coming in better than expected, and in some cases being ratcheted up rather than down.

The message from the research analysts that cover the 500 companies in the S&P 500 is that growth is slowing in some sectors, but not in others. For instance, in communication services, which contains companies like Meta and Alphabet and Disney and others, growth for this quarter was expected to be about 16%, and it’s coming in around 23%. Same thing for technology, which everybody cares about. Growth was expected to come in at around 14.6, and we’re seeing it come in at about 18% growth. Those numbers will be reflected in the outlook for the calendar year 2024. Growth estimates are being ratcheted up, same for 2025.

We’ll watch these numbers carefully, since they’ll be a good barometer as to whether or not the economy is slowing. We’ll start to see earnings expectations come in, so we’ll watch to see whether or not they actually get ratcheted up at all. So far, earnings look pretty good, and that’s a positive sign for the stock market.

I want to leave you with a couple of thoughts regarding this narrative about growth slowing. I don’t think it’s a surprise to the markets or to investors that growth is coming in a bit, that inflation has been coming down, and that unemployment probably will rise. We’ve had a series of rate hikes that have taken us to the fastest rate hike growth in decades so there should obviously be some impact from that.

We probably are heading into at least a lower growth scenario. Credit spreads aren’t suggesting there’s a recession imminent. Other economic metrics, such as the ISM services numbers that came out yesterday, didn’t suggest that there is a contraction ahead. In fact, that figure was still an expansionary territory. I think it’s fair to assume that we could be going into a slower growth situation, but not into a recessionary situation.

First of all, if that’s the case, in a slow growth environment strong companies get stronger. There’s a big question about large capitalization stocks. They’re growing fast and they’ve got huge balance sheets, so I think those probably deserve a second look.

Secondly, lower rates, which are coming, are good for stock valuation. There’s this concern that stocks are overvalued. Valuations could actually climb if rates come down.

Third, as growth becomes scarce, as fewer and fewer companies are demonstrating double-digit earnings growth, those that do get rewarded.

Finally, as we mentioned in our last video, talking about capital spending, growth CapEx is a competitive advantage. It widens the competitive moat between leaders and followers. Don’t be concerned, don’t be afraid of owning companies that are strategically investing in the future through higher levels of capital spending.

That’s all I’ve got for you. If you have any questions, give me a call at (212) 888-6403 or shoot me an email at tgardner@cjlawrence.com.