Carry trades

We believe that the past few days of market declines can be attributed to low US employment numbers and the unwinding of Yen carry trades.

So what is a carry trade? A carry trade is a trading strategy where an investor borrows at a low-interest rate (Yen) and invests in assets offering higher return rates.

The correction in Japanese equities due to the unwinding of the carry trade exacerbated the Yen appreciation leading to further unwinding of the carry trade. This unwinding trade broke the goldilock scenario while the uncertainty arising from geopolitical risk doesn’t make investment easy. Such sudden and rapid market declines creates spill-over effects amongst asset classes and history tells us any rebound over the near term may not be sustainable until economic numbers continue to confirm a growing economy (US particularly) including getting past the geopolitical situation in the Middle East.

Position unwinding is always difficult to read as investors have varying degrees of staying power and risk appetite (are they leveraged or not?). Further downside is unlikely provided the Yen stabilises at current level and US growth continues (which is our base case scenario).

Chart 1: Nikkei past performance following similarly 3-day falls

Source: Yahoo.com, Avian Capital

What we can confirm is the market decline is due to valuation multiple contraction from a higher implied risk premium. There is little correlation with corporate fundamentals as recent corporate earnings and guidance were good.

In the words of Simon Sinek (an English born American) author, “Panic causes tunnel vision”. He introduced the idea of an infinite game in business, where success is not about winning or losing but about playing the game with a long term perspective and adapting to changing circumstances. This is one of those moment. We will wait patiently and look forward for Fed rate cuts as historically, Asian markets react positively (case in point, Kospi index).

Chart 2: Performance after Fed rate cut

Source: Yahoo.com, Avian Capital