Talking Heads – Caution after the market sell-off

This is an audio transcript of the Talking Heads podcast episode Caution after the market sell-off

Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week Talking Heads will bring you in depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing the current market turmoil and, probably just as importantly, what might come next. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Mark Richards, Head of Flexible and Absolute Return in our multi-asset team. Welcome Mark and thanks for joining me.  

 
MR: Hi Daniel.  

 
DM: So, I have to say I consider you quite brave, Mark, taking a stand when there’s this much volatility. I was looking at some of your comments and you talked about how the volatility of volatility – if that’s not too technical for our listeners – has reached levels we see only rarely. So, it has been a surprising several weeks given everything that’s happened. Let’s try to start with an understanding of what we think has gone on. And I’d like to break the question down into a regional grouping because it seems like there’s a lot of different factors. What seems to be happening in the US is different than what we’ve seen in Japan, for example.  

Let’s start with the US. We hear people talk about recession fears. Of course, we always wonder about bubbles and people draw parallels to the late 1990s, early 2000s,  with everything that’s happened with tech.  

So, Mark, what’s been going on on the US side.  

 
MR: Sure, from a fundamental perspective, we will try and look at growth and inflation.  

So, for the last two years, it’s really been the latter of those two, above-target inflation that’s been the focus of [the US] Federal Reserve and the focus of asset markets. In more recent times, , the focus has been more evenly split between growth and inflation. [In] the last three or four months we can see that there’s been enough progress in terms of inflation falling back to more comfortable levels for the Federal Reserve. More recently, there’s been more concerns about growth.  

We know that overall growth both in terms of real terms, so after inflation, or in nominal terms including inflation has been slowing for a couple of quarters. When growth tends to slow, there’s always a concern. Does it slow just [to] the average or does it slow more sharply and increase the risks of something more nasty happening that provokes a response from markets, [a] response from central banks? And in the last week or so, it’s been that risk of a more material, sharper slowdown in growth that has been concerning markets.  

Now we can talk about the details and some of the data prints that have come out. It’s my view, and it’s our team’s view, that some of the extrapolation or the market price action of the last couple of days has got far ahead of itself. So much so that the short-term interest rate market was pricing in a 60% probability that the Fed may have to cut interest rates even before their next meeting. It’s very unprecedented that they take intra-meeting decisions. It really happens in times of deep crisis, not after what one can describe as a couple of reasonable misses on some data prints.  

 
DM: Let’s turn to Asia because there it seems to be quite a different story. No one’s talking about a recession in Japan as what’s triggered the sell-off there. Of course, Japanese equities had been one of the best performing major markets so far this year. Things have turned around quite suddenly. Clearly, the currency seems to be the key behind all of this. I see people talking about carry trade. Could you explain for listeners exactly what people mean by that and why is that behind which seems to be going on in Japan?  

MR: So, there’s a macro angle and then there’s what I’ve described as more of a market technical angle. On the macro side, Japan has struggled with deflation or close to zero inflation for two-plus decades now. And through the course of this year, there’s been signs that the Bank of Japan was ready to start to just gently nudge up interest rates for the first time in several cycles. In terms of carry trades, what’s been quite a prolific feature of [the] market structure for many years is borrowing in low-yielding currencies to invest in high-yielding currencies or even to take leveraged positions across several asset classes.  

Now as the Bank of Japan maybe earlier than expected is  raising interest rates, the Japanese yen strengthened quite materially. For a couple of days, it didn’t really have an impact on markets. But then towards the end of last week, what we saw was quite aggressive declines in all sorts of currencies, all sorts of equity markets. W hat’s been transpiring in the last week or so is that yen-funded carry trades either across other [currency] markets or within equity markets have started to be called in.  

There’s also what we saw in [South] Korea. Now Korea’s equity market doesn’t get a huge amount of coverage, but it is a market that is exposed to a lot of leveraged trading structures. So, when we get these volatility events, it’s interesting to see how different markets are behaving. And what we saw was [a] 11 or 12% decline in the Korean equity market. It is related to an unwinding of structured leverage positions. 

 
DM: Thanks for that, Mark, it’s quite important to understand what’s happened and why, because the key question for you and for investors is: has this created opportunities?  

MR: So,  the volatility of volatility has rarely been this stretched. It’s only really in 2015 where the Chinese [renminbi] devalued and we had a large global growth scare in 2018 when we had a lot of unwinding of lots of leveraged structures, and then in the early onset of Covid. So, we have to ask ourselves, is this period of volatility appropriate?  If not, that creates some opportunities in markets. So, is the pricing of recession risk or emergency central bank rate cuts appropriate? I would say no.  

Is there more of this deleveraging process to go through? Perhaps, but the cascading we saw in equity markets doesn’t feel like it’s supported by any weakness in the fundamentals.  But yes, there’s opportunities. So, on a tactical basis, we have been removing some of our recessionary hedges that we have in the portfolio. Even though we’ve had a couple of data prints that are far less worrisome than [what] we saw in [US] payrolls, there is that momentum behind the slowing economy that we have to be mindful of. It’s not the case of we’re going to load the boat with a lot of risk-on trades. We’re going to opportunistically add to some areas of risk, but do so in a way that is sensible and quite tactical.  
 
DM: If I can summarise, Mark, your very useful characterisation of what we’ve been through recently. 

You pointed out that not so long ago the key worry that we had was inflation.  

Now we’re a bit more worried, I’d say perhaps equally about both the outlook for growth and inflation. We then got some data that pointed to that slowdown in growth. The market seemed to interpret that as highlighting a recession risk where you think the market kind of fundamentally has gone too far. By contrast, if you look at what’s behind the dynamics in Asia, particularly Japan, perhaps much more an unwinding of leveraged carry trades where the market seemed to have gotten quite stretched. When you think about where now the markets may have it wrong. You highlighted two areas. One, expectations that we’re going to see emergency cuts from the central banks – probably not that likely.  And then also fundamentally, if we think about the growth outlook, expectations of a recession in the near term in the US – probably overblown. Well, Mark, thank you very much for joining me. 

 
MR: Thank you. 

 
DM: That’s it for this week’s episode of Talking Heads.