Merlin Weekly Macro: Stock markets get the jitters

Global stock markets are suffering a bout of the collywobbles. Although sometimes dramatic, these are not unusual, especially after prolonged periods of strong gains as we have seen in the US. Unless there is a specific catalyst (e.g. a war, a pandemic, a global event etc), as is so often the case, what creates such a sell-off is often difficult to pin down precisely: reasons this time include worries precipitated by weakening jobs data and business confidence indicators that the US economy may yet fall into recession rather than gently decelerating towards a soft landing; Europe, particularly Germany, remaining economically sluggish; speculation that China’s reported growth rate may be an invention of the Chinese Communist Party and it is not growing at 5% at all; as regular readers of these columns will recognise, all of these have been talking points among investors for some time.

The Bank of Japan and the battle for the yen

However, what has changed in the past several days, and which is important, is a potentially significant divergence in central bank monetary policy between the Bank of Japan (BoJ) on the one hand and the US, European and British central banks on the other.

For many years, by way of achieving its target of 2% inflation (a common goal shared with the US, the eurozone and the UK) the BoJ has pursued a policy of leaving its interest rate fixed, instead deliberately using bond purchases to manage (in any other terminology, ‘manipulate’ or ‘control’) its key 10 Year Japanese Government Bond¹ (JGB) to a specified target yield (for the US Federal Reserve, the European Central Bank and the Bank of England, such actions are forbidden in their constitutions, not so the Bank of Japan). Through this policy the BoJ has come to own over 50% of all the JGBs in existence; over several years the BoJ has also been active buying shares in the country’s biggest companies, equivalent to around 7% of the Japanese stock market. Following a change of Governor at the BoJ last year, his successor made it clear that the long-running strategy would gradually be changed towards a more normal approach of using interest rates as the principal monetary policy lever.

Having in March moved from negative interest rates to positive (from minus 0.1% to plus 0.1%) what we experienced at the end of last week was the BoJ unexpectedly raising its interest rate again from 0.1% to 0.25% and beginning to wind down its bond purchases, almost simultaneously with the Bank of England reducing its base rate by a quarter-point from 5.25% to 5.0% and the Federal Reserve indicating it would most likely begin cutting interest rates from September, with some investors speculating that possibly a half-point reduction from 5.5% is required as a starter to avert a US recession.

While the Bank of England and the European Central Bank have already begun loosening policy in the belief that the worst of the inflation threat is over and some economic stimulus through reducing borrowing costs should be beneficial, and the Federal Reserve is proposing to do the same, the Japanese central bank is actively applying the brakes at a time when its own economy is already flirting with recession. It seems a counter-intuitive strategy; however, the BoJ’s principal worry is that at 2.8%, the inflation rate is too high and remains enduringly so thanks to the persistent weakening of the yen against the dollar since the end of 2020, in which time it had lost 36% of its value up until 8ᵗʰ July (a weakening currency makes imports more expensive). The BoJ has deliberately decided to take active steps to try to make the yen stronger; a further product of adopting such an exchange rate strategy is that Japan’s exports will become more expensive and less competitive; Japan has a current account surplus (meaning that it exports more than it imports) of around 3.6% of GDP², so a stronger yen is also likely to cause the economy to slow further, again reducing the inflationary pressure.

Think of the interest rate situation like two jousting knights: if one charges at another which is stationary, the crunch is bad enough; if both are charging at each other head-on, the pace of events accelerates double-time and the impact is colossal. The effect of the BoJ and its western counterparts coming at each other from opposite directions simultaneously is considerably greater than had Japan been acting alone.

If Japanese monetary policy is changing, the programme of corporate structural and governance reforms enacted by the Japanese government and the stock exchange authorities remains firmly on track, specifically designed to help unlock value from Japanese companies and to attract foreign investors.

To which add Trump and Tehran

As we discussed a couple of weeks ago, Trump’s comments about not unconditionally protecting Taiwan (the source of 90% of the world’s semi-conductor chips) should he win the White House sent initial shivers through the technology sector. Today, geopolitically we have a further heightening of tensions in the Middle East as Iran, through Hezbollah, and Israel confront each other in the Golan Heights and Lebanon. And from a macroeconomic perspective we have the factors discussed above. The coincidence of all these has caused jitters in equity markets, exacerbated by the usual seasonal reduction in stock market trading thanks to the August holidays and many traders being on the beach.

Stop; consider; assess; proceed

All sell-offs are uncomfortable; old adages start being muttered that tumbling share prices are akin to ‘catching a falling knife’ and ‘if you’re going to panic, panic early’. However, seasoned long-term investors tend to use such periods of more pronounced drawdown to see whether price setbacks afford good buying opportunities for favoured shares at a more advantageous price. Many perceive volatility in share prices as being the definition of risk. We take a different view: for us ‘risk’ is the permanent loss of capital (i.e. selling at a lower price than the investment was made and crystallising a loss). But key in weighing everything up is to step back and dispassionately consider what has changed; if it has changed, is that change significant and what is to be done about it.

The Jupiter Merlin Portfolios invest in other funds rather than directly buying shares in individual companies. However, it is important for us to understand the investment process of each of the managers in whose funds we invest and what it is they seek when they are investing in companies. To us, when appraising the risk and opportunities in equities in the current circumstances, we believe there is a broad distinction between ‘value’ and ‘growth’ investments.

‘Value’ companies tend to be those which are more directly economically sensitive, whose profits and earnings are more geared into the economic cycle (examples include the industrial sectors and retail); here we are looking to see if the economic outlook has changed such that business fundamentals might be impaired according to the global economic outlook.

Prospects for the ‘growth’ sectors (e.g. technology, media, biotech etc) while not completely immune tend to be less directly sensitive to the economy; success is more linked to secular developments, innovation and research. ‘Growth’ valuations are typically much higher than for ‘value’. ‘Growth’ share prices have a habit of attracting momentum buyers: company fundamentals are important but here the debate is more about what is the most appropriate valuation to pay. A good basic valuation example is the price/earnings ratio: it is the company’s share price calculated as a multiple of its annual post-tax profits expressed on a per share basis; if a company has 10p per share of earnings and a share price of 100p, it has a P/E ratio of 10x. What it in fact means is that were the profits to remain static, it would take the company 10 years to generate the equivalent earnings in pence per share that the investor has paid out today in the share price; the faster the company’s earnings grow, the higher the multiple the investor is prepared to pay, and vice versa. However, the higher the multiple the shares attract (known as multiple expansion, running the risk of getting ahead of what the company’s fundamentals can reasonably sustain), the further the share price is likely to fall if anything happens that derails the company’s prospects: it’s a balancing act, a judgement that is predicated upon the investor’s personal appetite for risk and a realistic appreciation of what the company’s business growth rate is, combined with the sensitivities of the profits to changes in business inputs and outputs.

While equities are in flux and in the headlines, bond yields are still falling as investors perceive lower interest rates in prospect. The corollary of a falling yield in the fixed income sector is that the price is rising.

Not everything is falling at the same time! 

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.

¹Government bonds are issued by governments.  Bonds are a type of fixed interest investment, in which a company, government or other institution borrows money and, in most cases, pays a fixed level of interest until the date when the loan is due to be repaid.

²GDP = gross domestic product. GDP measures the monetary value of final goods and service produced in a country, and can represent the size of an economy.