From Tokyo to Wall Street: How Central Bank Decisions and Economic Data Shook Markets

Author: Anureet Saxena, CEO & Founder at Alignment Trio Management

Act 1: Bank of Japan (31^st July 2024)‍

Bank of Japan surprised markets with an unprecedented announcement to potentially raise interest rates and lend support to a weakening yen. BOJ announcement sent shock waves through capital markets across the world, and brought the USDJPY rally to an abrupt end.

Factors responded to BOJ with the expected alacrity. Figure 1 shows the currencies from the Barra risk model that had the highest return on 7/31/24 relative to their predicted one-day predicted volatility. As expected, Yen strengthened relative to USD. Exchange rates play a very complex role in international trade, and decisions by one central bank often have material second and third order effects on other currencies. Indeed, a stronger yen impacts the relative competitiveness of Japanese goods on the global markets, and that partly explains the reaction of other currencies and countries especially those in the Emerging Markets.

‍Figure 1: Currencies with outsized positive returns after BOJ announcement

BOJ also prompted a risk-off reaction from the market with investors rotating to focus on profitable companies that can generate free cash flows to support future growth and handle macro-economic uncertainties. Profitability and Dividend Yield had outsized positive returns relative to their predicted 1-day volatility while volatility and size factor had negative returns (Figure 2).

‍Figure 2: Style returns after BOJ announcement

Figure 3 shows style returns in Wolfe Developed Market risk model. While the overall direction of style returns is largely consistent with the Axioma model, large negative return on the interest rate factor is noteworthy. Wolfe’s interest rate factor measures the sensitivity of stocks to movements in long term interest rates (US Treasuries). Monetary policy is a multiple player game, and unexpected announcement from BOJ added another layer of complexity around predicting Fed decision at the next meeting. As expected, interest rate sensitive stocks underperformed their peers with lower interest rate sensitivity after the BOJ announcement (Figure 3).

‍Figure 3: Interest rate sensitive stocks under performed after BOJ announcement ‍

These events ended on an anti-climactic note on August 7^th 2024 when BOJ's top central banker retreated from his remarks and promised not to raise rates while the markets are unstable. The foundation for any central bank rests on three pillars, namely, credibility, commitment, and communication. BOJ announcement and subsequent retreat have demonstrated the fragility of two of these three pillars!

‍Act 2: US Macro-economic Data (August 2^nd 2024)‍

Since the Fed started raising interest, US markets have displayed all the characteristics of a classic bipolar personality vacillating between the dream of a soft landing and the nightmare of stagflation. The psychological predicament came to the fore on August 2^nd 2024 with the release of a rather lousy job market report. Job growth slowed sharply in July, and the unemployment rate rose to its highest level since 2021.

Markets reacted violently to the job market report with a classic rotation from cyclical to defensive sectors (Figure 4). The semiconductor sector suffered one of its worst days with the corresponding industry factor in the AXUS51-MH model down by almost 11%. Intel's underwhelming earnings announced the previous day sent the stock down more than 25%, one of the worst days in INTC history. Additionally, stocks in consumer discretionary sectors declined while defensive sectors had outsized positive returns. Markets moved into a risk-off regime with large-cap stocks underperforming small-cap stocks, and volatility factor registering outsized negative returns relative to its 1-day predicted volatility. These rotation trades need to be examined in the context of the high valuation of US stocks and the underlying uncertainty of employment numbers.

‍Figure 4: Style returns after release of US Employment Report ‍

First, US markets have been driven by the expectation of productivity growth propelled by advances in AI. For the past two years, investors have been an enthusiastic cheerleader of the hopes-and-dreams narratives that executives have woven around the AI theme. They have turned a blind eye to billions of dollars of AI-related capital expenditure with the hope for top-line growth or margin expansion, or preferably both. This had raised the valuation of US markets in anticipation of future growth prospects. The earnings season provided a reality check to these high valuations. High market valuations driven by AI gold rush combined with a lackluster earnings season that failed to provide tangible benefits from AI had created an unstable equilibrium. The lousy employment report released on August 2^nd provided the perfect catalyst to break the ice and offered an opportunity to market investors to recalibrate their fundamental expectations in general, and their bet on AI in particular.

Second, employment numbers tend to be extremely noisy and often undergo multiple revisions. The latest report released on August 2^nd restated numbers from a previous report being an excellent case in point. Investors need to examine these reports both in the context of their underlying variability, and their role within the mosaic of data points that the Fed is likely to consider while making its decision at the next meeting.

US elections are known to be anything but boring. What better way to mark 100 days to the election day (Nov 5^th) than a bout of market volatility, mixed macro-economic data, and a large central bank forced to eat crow by global markets!

‍Take Action

‍Volatile days following volatile days, aka Volatility Clustering, is a time proven concept in the investment profession. While the return impact of the past few days might have washed out, the volatility effect is likely to persist for the next several weeks. Factors such as profitability, quality and leverage that measure a company’s ability to generate copious amounts of operating cash flows and deploy them profitably are likely to be front and center of investor minds and drive market volatility in months to come. Furthermore, examining market movements through different factor models provides a multi-faceted view of risk that can both highlight investment opportunities and expose latent sources of portfolio risk.

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