Schwab Market Perspective: Spinning

Market action signaling recession?

Elevated market volatility has exacerbated some of the recent economic fears, not least because of U.S. stocks' sharp selloff immediately after the release of the July jobs report—which culminated in a week that saw the S&P 500's worst and best daily gains of the year thus far. While some of the elevated recession fear is justified, we don't think the market is sending a recessionary signal.

Since the S&P 500's most recent all-time high in mid-July, there are only two sectors underperforming relative to the index: Consumer Discretionary and Information Technology (tech). The latter had been the top-performing sector this year and (perhaps unsurprisingly) saw the strongest inflows on a rolling one-year basis. That coincided with a remarkable rise in its forward 12-month price-to-earnings (P/E) ratio. As shown in the chart below, tech's forward P/E—before the recent selloff—rose to its highest in more than 20 years.

The tech sector houses many of the market's heavyweight names and was the worst performer in the recent drawdown. Given that, as well as the fact that traditional cyclical sectors like Financials have fared much better, the market's message is that a popular theme has unwound in a rather dramatic and quick fashion. For now, investors' profit-taking in tech shouldn't be conflated with the market sending a recession signal. Of course, that can change if the labor market weakens at an aggressive pace, but for now, market signs of a downturn aren't yet abundant.

Fixed income: Volatility picks up

Bond yields dropped sharply in the past month, reaching the lowest levels in over a year amid high volatility. A weaker-than-expected August unemployment report pulled yields lower and raised concerns about a potential recession on the horizon. Market expectations for the timing and depth of Federal Reserve rate cuts accelerated. That news collided with a surprise interest rate hike by the Bank of Japan (BoJ). Investors in a popular strategy, the "yen carry trade" were shaken out by the rapid turnaround.

A "carry trade" describes when investors borrow in low-yielding currency to invest in one where expected returns are higher. Over the past several years, it has been profitable to borrow in Japanese yen with rates near zero and invest in U.S. stocks and other assets that have been rising. With the change in outlook, many of these trades were liquidated as the value plummeted.

The good news for U.S. bond investors is that Treasuries assumed their traditional role of a perceived safe haven asset during the market turmoil. Treasury bond prices soared, helping to offset declines in other parts of balanced portfolios.

Now that the dust has begun to settle, we look for yields to stabilize in a lower range than earlier in the year. In the Treasury market, intermediate- to long-term yields have already fallen to levels consistent with weaker growth, low inflation, and several rate cuts by the Federal Reserve. Ten-year yields reached our year-end target of 3.8% and fell even further before bouncing back. We expect the Fed to lower the target range for the federal funds rate by 75 basis points, or 0.75%, in incremental steps from the current range of 5.25% to 5.5%. More rate cuts are likely in 2025, with the potential for the federal funds rate target to fall to 3% to 3.5% in this cycle.

Although yields have fallen sharply, we still see opportunities in the fixed income markets for investors. In the Treasury market, yields for two- to five-year notes will likely fall further, lifting prices and producing positive returns. For investors with a longer time horizon, investment-grade corporate bond yields are in the 4.5% to 5% region. Although there is somewhat more credit risk there than in Treasuries, the risk/reward may be reasonable for investors wanting to capture those yields for a longer time period.

In the months ahead, there are likely to be more bouts of volatility, given the uncertainty about the economic outlook and the potential for more unwinding of leveraged trades. Fixed income can play its traditional role in a portfolio—providing income, capital preservation, and diversification from riskier asset classes.

Global stocks and economy: Is the great unwind over?

Going long on tech and short on the yen have been two very popular trades in recent years. With the yen the cheapest major funding currency—meaning it has been possible to borrow at the cheapest rate in yen—and since tech has tended to be consistently profitable, it's not hard to imagine a good portion of the short yen trade flow has gone into U.S. tech. The chart below of the similar movement in the dollar-yen exchange rate and the tech-heavy Nasdaq highlights the likelihood of carry trades funding investments in tech, but the trade likely funded buying in other markets as well.

After last week's dramatic moves, is the unwind of the carry trade now over? While it is impossible to say exactly how big the carry trade is, there are some indicators we can look at to see how far the unwind could still go on a short-, medium-, and long-term basis.

• Short-term: To look at the size of a potential for a short-term reversal, we can examine yen contracts tracked by the Commodity Futures Trading Commission. On July 2, speculative investors, like hedge funds, were holding a net 190,000 contracts betting on a weaker yen (worth about $15.6 billion). By July 31, the day of the BoJ meeting, those positions were halved and were nearly back to the flat line by Tuesday, August 6th. While positioning could further unwind and perhaps even turn long, we feel that most of the extreme short position is unwound.

• Medium-term: A proxy for the medium-term carry trade magnitude is to look at Japanese banks' foreign lending in yen. This type of lending is often to non-banks, like asset managers, and has been on the rise since 2010 and accelerated in the last couple of years as rates rose outside Japan while remained very low in Japan. According to the data released by the Bank of International Settlements, the loans totaled $1 trillion (145 trillion yen) as of March 2024. Unlike investors in futures that are subject to margin calls that can force urgent selling, asset managers may look to reduce any carry trades and pay back yen loans over the medium-term, dependent upon their outlook for currency and rate moves. This means an unwind of this exposure could unfold over the coming months.
• Long-term: For the longer-term carry trade size, we look to Japan's long-term net investment position. Japanese investors are the biggest non-U.S. investors in U.S. Treasuries and among the top five in ownership of non-Japanese stocks. According to the International Monetary Fund, decades of current account surpluses have accumulated, giving Japan the world's largest net international investment position with $3.3 trillion of investments held abroad as of March 31, 2024. The potential for a reversal of more than a decade of outward flow of capital may be felt by investors worldwide. It is unlikely all of the outbound investment from Japan will reverse given the scope of investment opportunities outside of Japan, yet the size of the position suggests the potential for a trillion or more in capital might be repatriated to Japan over the coming quarters.

The global stock market sell-off of August 5th saw a turnaround the next day with when markets rebounded, but the recovery doesn't guarantee the risk has been eliminated. We believe that the most dramatic moves tied to the unwinding of the short-term yen trade may have passed, yet the unwind could remain a market drag and prompt more volatility over the medium and longer-term. The markets' panicky moves offer a reminder about how portfolio diversification and a review of risk-exposures is prudent.

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