Insights into recent volatility trends
A combination of developments over the last week have driven heightened market volatility.
- Fundamental: Softening economic data.
- Geo-political: Increased tensions in the middle east.
- Technical: Speculation that investors are beginning to unwind their “Yen Carry Trade” exposure.
Fundamental
Last week, a culmination of economic releases reinforced the reality of a decelerating U.S. economy. Notably, industrial production as measured by the ISM Manufacturing PMI was softer than expected.
On the employment front, initial jobless claims (job layoffs) were slightly elevated, while net monthly job growth (net job hiring) was softer than expected. These labor market updates increased the U.S. unemployment rate from 4.1% to 4.3%.
Lastly, some of the recent market darling technology companies missed on their earnings expectations. These data points altered investor sentiment and began to weigh on the market, with most major market indexes trending lower last week.
Geo-Political
The conflict between Israel and Hamas has been on-going for some time but has recently intensified. The leading political Hamas figure, Ismael Haniyeh, was assassinated in the heart of Tehran in a government guest house. Iran now finds itself in a difficult position, wanting to retaliate to the assassination without escalating the conflict to a regional war that forces the U.S. military to get involved. Intensifying geo-political tensions create economic and political uncertainty, both of which cloud the outlook for investment markets.
Technical
If you have an internet connection, you’ve likely come across recent articles written about “The Yen Carry Trade”. This is a technical market position that involves borrowing yen at Japan's low interest rates and investing in higher-yielding assets in other currencies.
The investment profit comes from the interest rate differential. Key risks include exchange rate fluctuations and changes in interest rates, which can lead to significant losses if the yen appreciates, or global markets become volatile. Last Wednesday, the Bank of Japan increased their policy interest rate.
Over the last month, the Japanese Yen has appreciated relative to the U.S. dollar. In combination, these factors are causing investors who have benefited from the “Yen Carry Trade” to begin selling or unwinding their related positions.
As investment managers, our responsibility is to filter the noise, concentrate on the signal and focus on what’s within our control. At the beginning of 2024, our outlook for investment markets, which is driven by fundamental investment and economic factors, was for a 65% probability of a turbulent landing. This was coupled with probabilities, albeit lower, of a soft landing (more positive) and a crash landing (more negative). Here’s an excerpt from our baseline scenario.
Baseline scenario: A turbulent landing, wheels hit hard, bumps and jumps while the cabin rattles. Probability estimate: 65%
- The labor market deteriorates, albeit modestly. Unemployment rates move 0.5% to 1.0% higher, initial jobless claims increase to between 250,000 and 300,000, non-farm payrolls decrease to net monthly job growth of 125,000 to 150,000, only temporarily before leveling off.
- Industrial and service production remain in contraction territory below 50 but begin rebounding toward neutral in the second half of 2024.
- The Bank of Canada and U.S. Federal Reserve cut interest rates 4 to 5 times by the end of 2024, in line with current market expectations, playing defense against further economic deceleration.
- Earnings growth in the U.S. and Canada come in below expectations, ranging from -5% to +5%, disappointing investors. The level of earnings deterioration leads to greater market volatility, the equity market powers through a manageable mid-year correction of -10% to -15%, recovering through the latter half of 2024.
- North American GDP growth between -1.5% and 1.5%.
- Equity markets are volatile but end the year positive single digit total return, 0% to 9%.
- Canadian bond market total return 7% to 10%.
Although the above scenario is fairly accurate thus far in 2024, a couple of notions are worth mentioning. First, when positioning our investment portfolios, we never consider one singular scenario. This is critical. Although our experience and skill sets provide us with the capacity to understand economic and investment developments, trying to predict the future is an ill-advised endeavor.
Second, our focus is to manage robust investment portfolios through all market cycles. This means taking a long-term view, building diversified investment portfolios and being pro-active in managing risks that are being signaled by fundamental developments.
Translating this to portfolio management, from an asset allocation perspective we increased our allocation to the fixed income asset class in our Balanced Fund. This means an increased level of income and portfolio protection. These adjustments were made throughout 2023, predicated by the more attractive yields being offered by the fixed income asset class, the trend of decelerating economic data and the Matco Investment Horizon indicator.
Our Horizon Indicator is a tool that utilizes economic factors to indicate when a greater focus on portfolio protection or portfolio growth is appropriate. These pro-active decisions provide us with the comfort that when volatility strikes, our risk management framework is working for our investors, even when the market may be working against us.
The most critical factors for investment success are to take a long-term view, focus on fundamentals, and avoid emotional decision making at all costs. This approach might not lend to the most exciting dinner party conversations, but it allows us to manage risk and opportunity over multiple market cycles.
