From Bull to Bear: Understanding the Recent Stock Market Pullback

Stock markets often seem unstoppable during a bull run—until they aren’t. Recently, major indices like the S&P 500, Nikkei 225, and Nifty 50 soared to 10-year highs, thanks to strong economic data and controlled inflation in the U.S. and India. Even Japan saw encouraging signs of wage growth and consumer spending.

But markets can change in the blink of an eye. In just a week, we’ve seen the Nikkei, Kospi, Nasdaq, S&P 500, and Nifty plummet by 4% to 11%. What caused this sudden shift? A few critical factors converged to create a perilous cocktail.

1. Last week, U.S. stock markets saw a significant drop amid concerns of an economic slowdown, as the unemployment rate rose to a near three-year high of 4.3%. This increase raised worries that the U.S. economy is slowing down faster than expected and that the Federal Reserve has been slow to lower interest rates. In light of this, Goldman Sachs increased its likelihood of a U.S. recession occurring within the next year from 15% to 25%.

2. Next, let’s discuss the unraveling of the yen carry trade, which is somewhat technical, so allow me to explain in detail.

Until last year, Japan was unique in a world of rising interest rates, as it maintained negative interest rates. Commercial banks in Japan had to pay a fee to the Bank of Japan (BOJ) for holding funds above a certain threshold. This policy has been in place for decades in pursuit of economic growth. Institutional investors capitalized on this scenario by borrowing money in yen at near-zero rates. They would typically convert these funds into USD and invest in safe assets like government bonds and T-bills. Those with a higher risk appetite often ventured into stocks, commodities, and corporate bonds. Upon maturity of the bonds, the proceeds would be converted back to yen to repay the loan, allowing investors to pocket the interest rate differential. The strategy relies on earning this differential by holding assets from countries with higher interest rates.

However, there are inherent risks associated with this trade. An increase in interest rates by the BOJ or a decrease by the U.S. Federal Reserve can negatively impact profitability. Additionally, any appreciation of the yen or depreciation of the USD can also hurt returns. This is precisely what occurred recently.

In July, U.S. presidential candidate Donald Trump remarked that China and Japan were keeping their currencies weak, which was harming U.S. manufacturers. On July 31st, the BOJ decided to raise short-term interest rates to 0.25% from approximately 0.1%. These factors have led to an appreciation of the yen. This rate hike coincided with the U.S. Federal Reserve preparing to initiate a rate-cutting cycle. As noted earlier, this resulted in an increase in rates by the BOJ, a decrease by the U.S. Fed, and an appreciation of the yen.

Institutions have borrowed approximately $ 4 trillion in Yen and invested them in various emerging markets. If there is a disruption in the Yen-USD carry trade, these institutions will have to sell their investments to manage risk. This unwinding of positions will lead to ripple effects across all markets, which is what we have been experiencing. 

What does it mean for your investments though?

In 2023, the difference between the yields on U.S. 10-year and Japanese 10-year bonds was 417 basis points (with one basis point equal to 0.01%). Now, with the U.S. nearing a rate cut and Japan increasing its rates, this differential has narrowed to about 285 basis points. The unwinding of leveraged trades often poses a risk in financial markets, making equities and other assets vulnerable, but it has not yet reached a level that could lead to a market catastrophe. With a short-term adjustment to higher rates in Japan, markets are expected to stabilize due to the narrowing, yet still significant, interest rate differential between the U.S. and Japan.

Even as some analysts are arguing that the US is about to enter recession, note that US GDP grew by 2.8% during the April – June quarter of 24-25. In addition, with the US interest rates set to come down, markets will see an increased inflow of funds.  

In India, Deloitte’s Economic Outlook for August 2024 forecasts strong economic growth of 7.0% to 7.2% in FY25, supported by solid economic fundamentals. This prediction exceeds the Economic Survey’s estimate while aligning with the Reserve Bank of India’s outlook. Currently, support for Indian stock markets is primarily driven by domestic institutions. Since 2022, domestic institutions, led by mutual funds, have invested nearly ₹7.34 lakh crore in equities, whereas foreign institutional investors have sold shares worth ₹85,000 crore during the same timeframe.

The general expectation is that the current correction will just be that, “a correction” and not a big fall. Remember When investing in the stock market, you should be prepared for both possibilities. Large gains and considerable losses are typical in stock investing. Volatility is inherent to the equity investment experience. This holds true regardless of whether markets are moving up or down.

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