Weathering Market Storms: Lessons from the Caribbean
I have been living in the Caribbean for over 7 years. The weather conditions are near perfect all year round, whether you are looking for a pleasant morning of exercise or relaxing with friends on the beach at sunset. The warm temperatures can cause complacency that this idyllic weather is a permanent fixture. However, as many islanders are aware hurricanes can abruptly form and wreak havoc on livelihoods and property. It pays to have insurance and be prepared when potential disasters unexpectedly strike. Similar to Caribbean weather the US equity markets have been in a state of complacency all year. After going 356 days without a 2% daily drop in the S&P 500. We got two in short succession on July 24th and Aug 5th, in what amounted to a sizeable pull back in US equity market indices. The S&P 500 was down 9.7% and the Nasdaq down 15.6% at the worst moments of the day in early August.
In this way being prepared for a hurricane and being prepared in a market pullback have a lot of similarities.
John F Kennedy aptly put it: “The time to repair the roof is when the sun is shining.”
Market Pull Back
We do not believe this pullback is a harbinger for deteriorating returns going forward and have laid out our case below:
Volatility Reason 1: Weakening US employment data
Over the past two months we have witnessed the incremental slowdown in US employment data. The unemployment rate has risen to 4.3%, payrolls have been dropping and job openings falling. The triggering of the Sahm rule (an indicator for the start of a recession), flat retail sales and negative prints in inflation have investors worried that the economy is slowing too fast given the FEDs higher interest rates policies.
We listened to a lot of earnings calls over the last few weeks and there is indication that consumer is starting to pull back on their discretionary spending and the lower end consumer is having a difficult time. Airbnb mentioned slowing demand from US guests, Home Depot mentioned customers pulling back on renovation projects, Disney is seeing lower numbers at their amusement parks and Nike is still seeing reduced demand for its latest offerings. Visa, Wendys and Mondelez all commented on moderating spending from the lower income consumer. Consumer Discretionary sector as a whole has the lowest returns of any sector of the S&P this year, which highlights the concern.
Additionally, there is unease for the outlook of technology stocks with the AI theme in particular worrying investors. The main argument for overvaluation is there a huge amount of spending in AI model training and development and not a lot of impact on increasing revenues and profits for these businesses. Investors are worried there is no tangible evidence or “I-Phone product moment” that they can point to and that the AI spending is leading to a massive shareholder value destruction moment, similar to the early 2000’s Dot Com Era.
Why I would not worry.
I do not want to sound facetious, but one of the FEDs dual mandates is stable pricing or in this case to bring down inflation. The indirect effect of bringing down inflation is slowing the economy. We should therefore not at all be surprised given the highest interest rates in 20 years that the labor market is starting to slow. The FED has been aiming for a more flexible labor market and it has achieved its goal with labor market dynamics now returning to pre-pandemic levels. There is ample room to support the economy from the FED through interest rate cuts as the economy starts to slow from here.
One month’s data does not make a trend and the abnormally weak labor figures in July were offset by better than expected initial claims and ISM services data in August. Claudia Sahm (the inventor of Sahm Rule) has stated that although her early recession warning metric has been triggered. she agrees the US economy is not in recession due to the unprecedented level of labor force expansion from US immigration. Hurricane Beryl is also likely to have one time effects on labor weakness.
Despite this slowing in labor GDP (Gross Domestic Product) has held up very well. Consumer spending and business investment continue to perform well contradicting some of the company specific comments mentioned above. It is easy to blame the macro environment for underperformance and this may be the case here. We need to be careful not to extrapolate single company comments to the wider consumer heath situation. Bank of America looks at a wide spectrum of customers. They said on their call that consumer spending is now consistent with levels in 2017, 2018 and 2019 e.g. a more normal growth economy. As such, maybe what are seeing is just a normalization move rather than a slowdown.
Ironically the recent pullback in AI/Big Tech names, fueled by overvaluation fears and a FED making way to cut rates, led many market participants to diversify into companies that will benefit most highly from lower rates, namely industrial cyclicals, small caps and emerging markets. However, as recession fears grew these sectors got crushed along with Tech names. We believe this correction is a short term pull back in the long term secular trend for AI and we view it as a buying opportunity. Further, fundamentals are nowhere near as stretched as they were during the 2000’s dotcom era. Tech companies on the Nasdaq had a forward PE (price to earnings ratio) of 55 in 2001 before the bust whereas current forward PE for Nasdaq is 20.6. The S&P 500 has a similar overvaluation although not as pronounced with a rate of over 22.8 in 2001 and 18.05 today.
Some comments from the calls which enhances our conviction on the AI theme:
Google (GOOGL US) CEO: Sundar Pichai: “the risk of under-investing is dramatically greater than the risk of over-investing for us (in AI).”
Meta (META US) CEO Mark Zukerburg: “We had a strong quarter, and Meta AI is on track to be the most used AI assistant in the world by the end of the year,”
Palantir (PLTR US) CEO Alex Karp: “It may be easy to forget that only four years ago, we had 14 commercial customers in the United States. We now have nearly three hundred. Our growth across the commercial and government markets has been driven by an unrelenting wave of demand from customers for artificial intelligence systems that go beyond the merely performative and academic,”
ServiceNow (NOW US) CEO Bill McDermott.: “Our relevance as the AI platform for business transformation remains stronger than ever as CEOs are looking for new vectors of growth, simplification, and digitization”
Volatility Reason 2: Yen Carry Trade
The Yen Carry trade caused major volatility on world markets last week and contributed to the sell-off in equity markets.
The interest rate in Japan is exceptionally low as the Bank of Japan has tried for years to stimulate growth in their economy, whereas rates in the USA are at their highest in years to quell inflation. The Yen carry trade involves borrowing in the low interest rate economy, converting currency and investing in higher interest rate economy such as USA or other high yielding assets such as tech stocks. Investors benefit from the spread between low and high interest rate economies. This approach works well when currencies are very stable. However the risk/reward dynamic can change dramatically when currencies strengthen or weaken significantly. In this case the Bank of Japan raised rates to a punitive 0.25% which had the effect of strengthening its currency dramatically. Many investors who borrowed in Yen now have had their liabilities increase, causing margin calls and large unwinding of the trade for risk management purposes. This unwinding reverberated around the world causing the VIX (explained below) to spike to its highest level since the start of the Covid Pandemic, and the third highest in 30 years!
VIX Graph
The VIX index is a measure used to determine the expected 30-day volatility in the US stock market. It is calculated based on the prices of options on the S&P 500 index. When options are more expensive, it usually indicates higher expected volatility, as investors are willing to pay more to protect against unfavorable moves in the market.
Can you imagine in 2 years if you sold your assets because of the Yen Carry Trade Unwind, how foolish that would sound?
We always want to invest in companies with quality fundamentals participating in long term secular growth trends. The market is designed to test the emotional resolve of investors. I fully expect another pullback as the market panics around further labor market weakness, which will lead to the FED accepting it’s time to dramatically cut rates.
Just like hurricanes be prepared for next market pullback.
