Rate cut expectations have varied significantly over the course of this year. We started the year with high hopes and a strong likelihood of up to 5 rate cuts within this year. The likelihood then fell to as low as 1 rate cut. Now, we are back to the possibility of 5 rate cuts, potentially lowering the current rate from 5.25% to 4.00%.
The US Fed has a dual mandate, pursuing the economic goals of maximum employment and manage inflation or price stability. Essentially, the Fed is constantly attempting to balance these two goals.
To achieve high employment, the Fed has to boost demand and stimulate economic growth. Conversely, to maintain price stability and keep inflation around its 2% target, it has to taper demand when inflation is high, so as to slow economic growth.
In the recent FOMC meeting statement, the Fed says it is attentive to risks on both sides of the mandate, a change from the previous text that said it was focused on inflation risks.
It also said that in recent months there has been some further progress toward the 2% inflation goal, compared to the modest further progress reported previously. The Fed views inflation as somewhat elevated while the economy continues to expand at a solid pace, job gains have moderated, employment rate has moved up but remains low. The Fed also repeats that it does not expect to cut rates until it has gained greater confidence that inflation is moving closer to the 2% target.
Labour market conditions
The US unemployment rate jumped to nearly a three-year high of 4.3% in July amid a significant slowdown in hiring, heightening fears the labour market is deteriorating and potentially making the economy vulnerable to a recession.
The increase in the unemployment rate from 4.1% in June marked the fourth straight monthly increase. It has risen from a five-decade low of 3.4 per cent in April 2023. So far, the labour market is slowing, driven by weak hiring, rather than layoffs.
The Fed also said that the latest snapshot of the labor market is consistent with a slowdown, not necessarily a recession.
Fed Chair Jerome Powell also commented that while he viewed the changes in the labour market as broadly consistent with a normalisation process, policymakers were closely monitoring to see whether it starts to show signs that it’s more than that.
US Stock performance
The US stock performance has declined over the past month. As of the Monday 5th August close, DJIA, S&P500 and Nasdaq are down 1.71%, 6.84% and 11.73% respectively.
The widely agreed definition of a stock correction is a 10% decline, while a bear market is defined by a 20% decline.
However, all indices still remain in the green when looking at the 1 year time frame.
Bond performance
The iShares 20+ Year Treasury Bond ETF (US TLT) seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years. The price of US TLT increases when interest rates decrease and the price decreases when interest rate increases. As the Fed hiked throughout 2022 & 2023, the price of US TLT crashed. On Friday, with higher hopes of interest rate cuts, the US TLT increased by 3%, while the Nasdaq recorded a -2.5% decrease.
Japan carry trade unwinding?
The Japan Nikkei index recorded its biggest one day drop since 1987, plunging 12.5% on what investors refer to as another Black Monday since the last one in 1987.
The index however swiftly recovered by 10% at the opening bell on Tuesday. This leaves the index at 20% lower than the all time high recorded in mid July. The USD/JPY also fell from a high of 161 to a low of 143 before recovering to 146.
This extreme volatility is a sign that recent market news may be more significant than what investors believe and Market watchers think the crash was due to a rapid unloading of “carry trades”.
Carry trades refer to operations wherein an investor borrows in a currency with low interest rates and reinvests the proceeds in higher-yielding assets elsewhere, whether in Japan or overseas.
A continued weakening of the Yen boosts carry trade in a foreign currency and a strengthening Yen diminishes this.
Additionally, The Bank of Japan raised interest rates on 31 July to 0.25%, making the carry trade more expensive to execute and also caused fears that interest rates would continue to increase in Japan, currently the only developed country with near zero interest rates.
Buffett sold Apple to buy bonds
Warren Buffett’s Berkshire Hathaway sold $75.5 billion worth of stock and halved its Apple stake as part of a massive 2Q24 selling spree that sent Berkshire’s cash pile to a record $276.9 billion, up from just under $200 billion the previous quarter. Market watchers have assumed that Buffett believes that a substantial correction is coming.
Buffett has also significantly pared down its Bank of America’s stake, its biggest bank bet. Berkshire has trimmed that position by $3.8 billion since mid-July. Banks tend to earn a lower net interest margin in a lower interest rate environment which may not be offset by volume growth in their loan book.
Buffett has struggled to find ways to deploy its mountain of cash as share prices soared and deal activity stagnated. Yet he has continued to pare its stake in these key investments.
At the May shareholder meeting, Buffett remarked that Apple was an even better business than two others Berkshire owns shares in, American Express and Coca Cola. Yet he has sold 50% of his stake in Apple. There has been debate on whether Buffett is avoiding a crash or whether Apple is losing its shine due to competition. Regardless of your view, the fact remains that Buffett recorded net sales of stock in 2Q24.
Buffett also likes to park the bulk of Berkshire’s cash in ultra-safe U.S. Treasury bills, which stood at $235 billion on June 30, compared with $129 billion at year-end. Berkshire has been getting a 4% to 5% plus yield on its T bills and is now one of the largest T-bill holders in the world.
End of run for Singapore banks?
The Singapore banks have done fairly well this year, even after the crash on Monday. DBS is still up 10% for the year to date while OCBC and UOB are up 8.5% and 5.5% respectively. Including dividends, the banks have all delivered more than 10% in total returns to shareholders.
The banks have all made new record profits in recent years off the back of the higher interest environment and fairly strong growth in South East Asia. However, the outlook has now turned bearish as a compression on their net interest margin may happen in conjunction with lower loan book growth should the US and the rest of the world enter a recession in the near term.
Singapore banks have been an attractive dividend play, providing for yields spreads that are above the prevailing benchmarks and even yielding more than many blue chip S-REITs. With the banks unlikely to cut dividends in a gentle downturn, the banks maybe even more attractive to investors at a cheaper price.
What should you do??
In a volatile market, being nimble is key to survival (or success). Keeping cash is always the safest and most nimble option. T-bills are shorter term bonds with maturities of up to 1 year, while bonds have maturities of at least 1 year and up to 30 or even 50 years.
Shorter term T-bills tend to be less sensitive to interest rate changes and in the worst case, should interest rates move significantly, investors can hold them to maturity. Longer term bonds are more sensitive to interest rate changes and investors in longer term bonds are likely in it for capital gains as well.
We think the reason Buffett invests in these shorter term T-bills is because he wants to have the financial flexibility when an opportunity arises.
Clearly, he also thinks the market is overvalued and he does not see any opportunity if he is selling such large quantities of Apple without switching to another investment at the same time.
However, given the state of the economy and the Fed’s unwillingness to commit to substantial rate cuts, we could continue to be in a “higher for longer” interest rate environment. Investors could do well by exercising patience and first either getting into these t-bills or longer term bonds (depending on your risk appetite) and subsequently switching to stocks after locking in a profit from T-bill/bonds and after stocks fall to more palatable levels.
The Japanese market is being hit by a confluence of major macroeconomic factors such as the unwinding of the carry trade, the possible start of a series of rate hikes and swings in the USDJPY which makes investing in the Japan market somewhat challenging as evidenced by the substantial volatility in the Nikkei.
The Singapore banks are probably on the minds of many local investors who are keen to buy these banks at cheaper prices given that the likelihood of dividend increase is more likely than the likelihood of dividend cuts. Should the Singapore banks correct further, the lower prices and potentially higher dividends could make the Singapore Banks even more attractive than Buffett’s T-bill plays.
Is the current selloff a correction or a crash? Join Alvin and Chris tonight as they share their market outlook for the rest of 2024, including what to avoid and consider for your investment portfolio and how to best navigate this year’s turmoil.
