MARKET NEGATIVE SWING IS SYMPTOM OF UNWINDING CARRY TRADE:  BUYING OPPORTUNITY?

What to do with my money?  Give into my emotions and rush out of stocks?  Or put emotion aside and look at explanations for the recent down turn?  Values will not always go straight up but 100% in cash is likely not the answer.   Let’s explore recent volatility:

What is this Carry Trade?  It’s a strategy when an investor sells one country’s currency which has a relatively lower interest rate and uses the funds to purchase a different country’s currency which has a higher interest rate.   If the investor uses leverage (borrows against other securities such as stock) the difference captured between the two rates can be substantial.   However, when the support of lower rates changes, such as the Federal Reserve reducing (tapering) the amount of money that it’s pumping into the US economy, the Carry Trade can reverse and result in wide swings in currency prices.    Moreover, as a currency drops in value, the investor may have to sell stocks that were used to borrow against to make this investment.   As these stocks sell off to generate cash, prices come down which may lead to buying opportunities because structurally, there is no real immediate change in positive economic outlook.

We just had the first leg of this unwind and the initial fall out can be the largest swing in market prices.  The countries with the weakest fundamentals such as Argentina, Turkey and other emerging countries (Russia, Venezuela, Chile, Brazil, Turkey, etc.) will experience the largest downturn in their currency values.  Likewise, emerging market countries tend to be very dependent on exporting their goods to China; when China slows and imports less, these countries are negatively affected and get a double whammy as interest rates are just starting to go up in developed nations such as the U.S. and the U.K.   As discussed above, these rate increases change the value of currencies.  For the most part, our clients are not invested in these economies- generally, it’s noise to understand but to put into context. 

The markets have been overdue for some correction and the Federal Reserve is past due in reducing its spending to support the US economy.  The U.S., China, Japan and Germany –the 4 largest economies- are growing.   Moreover, this coordinated global economic recovery should require growth in inventories which will result in an acceleration of economic growth.   Companies have been too cautious and conservative to meet this demand.    Corporate guidance reflects this caution by reducing expectations and then exceeding analysts’ target returns. 

Expect some further volatility anytime China reports slowing growth or problems with their banking- the Shadow Banks – smaller banks that use unregulated methods to raise capital.  China has massive government reserves to stabilize their economy and banking system which should “fence in” these concerns.   Also expect more headlines about currency and the weaker emerging market countries.  Look for more market volatility to result from these currency changes. 

All of this is and was expected as the global recovery continues.  It’s a normal phase and current global condition; historically this has been viewed as opportunity within the cycle of the markets.  Emerging economies are important- some more than others.   Their pain will continue as the balance moves back to developed countries.  As emerging economies slow, we will be looking for the effects on the global recovery.

Steve Erken, CFP
Principal

January 27, 2014