Why US & Japan are causing a gold rush

Investors back from their summer holidays may have a bad case of whiplash. A panic sell-off in early August set alarm bells ringing across markets, but losses had been recouped just a few weeks later amid a semblance of calm. So, was it just a case of August jitters? Or could it be a harbinger of more September mayhem? Are you prepared for either eventuality? 

Sparking panic – What caused the sell-off? 

At the end of July, markets were initially buoyed by hints from the Federal Reserve that US interest rates would be cut soon. But a weekend to stew on the health of the US economy coupled with weak jobs data primed markets for a Monday morning rout. Add to the mix the raising of Japanese interest rates which stoked fears of a financial meltdown from all the investors who have been using cheap Japanese loans to finance higher interest investments elsewhere (the carry trade), and panic was triggered.

The conflagration of a potential US recession and the impact of a sudden shock to the global financial system from higher Japanese interest rates sent the Nikkei index in Japan down 12% at one point. US stocks also fell on Monday morning, with the S&P 500 down about 4% and the tech-heavy Nasdaq dropping more than 6%. However, markets began to recover their losses quite quickly, and climbed back to pre-panic levels within a couple of weeks.

So, now that the dust has settled, was there really nothing to worry about? Is the state of the US economy or the possibility of a Japanese Yen-related financial meltdown still cause for concern?

Outlook for the US economy – the Sahm rule

US economic data is complex and there are many moving parts, so economists and investors often use indicators to gauge the underlying health of the economy. In late July one of those indicators started flashing red. Specifically July US jobs data, which were softer than expected, soft enough to trigger the ‘Sahm rule’, an economic indicator that helps identify the early signs of recession (because it can take many months to collect enough data to declare an official recession). 

The Sahm rule has reliably detected every recession since the 1970s, although it can only detect them once they have started rather than predicting them far in advance. 

So how does it work? Simply put, if the percentage of people without jobs suddenly rises by half a percent or more over a short period, this rule suggests that the economy might be slowing down significantly. The possibility of a US economic slowdown is enough to create substantial market uncertainty, hence the sell-off. 

But the market has recovered since, and it’s because many experts and investors don’t think the situation is as bad as first indicated. Even economist Claudia Sahm, the originator of the rule, says her rule was meant to be broken and doesn’t believe the US is in a recession right now.

JP Morgan said in a note in early August: “We do not think a recession is imminent. Recent volatility will likely lead the Fed to deliver cuts faster than initially anticipated, but that does not mean the economy has fallen off the rails.”

It also doesn’t mean there’s nothing to worry about. US job growth for the last year has been revised down recently, painting an even bleaker picture of the state of the economy, and experts aren’t so sure of the near-term outlook. In late August, investment Bank UBS increased its odds of a US recession from 20% to 25%,calling the outlook ‘cloudy’. 

The Japan carry question

As if US concerns weren’t enough, investors are also worried about the state of the markets in Japan. The Japan carry trade was one of the triggers for the early August stock slump, and even though the markets have recovered, the issue is still there. 

The Japan carry trade is a financial strategy that involves borrowing money from Japan, where interest rates are very low, and then using that money to invest in other countries where interest rates are higher. Borrow cheap, invest it in another country where the bank gives you a higher interest rate on your investment, and profit from the difference. 

Interest rates in Japan have been so low for so long (half a percent or lower since 1995), and the carry trade is a popular strategy among global investors, which means there is a lot of money tied up in it. Estimates vary widely but Reuters suggests that some analysts use Japan’s foreign portfolio investments, nearly $4 trillion, as a rough gauge. 

There are two main risks to the carry trade – that interest rates in Japan will rise meaning borrowers of cheap Yen will have to pay more to service their loans, eating into profits, or the Yen will strengthen against other currencies, meaning it will cost borrowers more to pay back their loans when converting back into Yen. 

At the end of July, Japan raised interest rates for only the second time in 17 years, and the Yen appreciated in advance of and subsequent to the rate rise. Higher interest rates and a stronger Yen impelled some investors to ‘unwind’ their carry trades, which means selling higher interest assets in one country and they repaying Yen-denominated loans. 

The pace and volume of reversing these trades caused the sharp slump in the stock market. 

So, has the danger passed? Not likely when there are still billions invested in carry trades, the Yen is still so volatile, and the Bank of Japan’s Governor could continue to raise rates. Some investors are convinced the Japan carry trade will lead to another major financial crisis, while others expect the trade to resume once volatility has tempered. Someone is right, but who?

Preparing for every eventuality

Investor whiplash is not uncommon. Uncertainty in markets is inevitable, so it’s prudent to plan for this eventuality. The best way to protect your assets is diversification, which means ensuring a range of assets that add balance in both calm and torrid times. Most investment portfolios are a mix of stocks, bonds, cash and safe-haven assets like gold. 

Gold has a long and venerable history of retaining or increasing its value during times of instability or uncertainty. It is called a safe-haven asset for good reason, and it is recommended as part of an investment portfolio because it often rises when other assets like stock are falling.

Meanwhile, gold has also been rising alongside stocks over the last year, growing 25% in value in the past 12 months. So the investors looking to benefit if the markets turn and lead to safe-haven assets increasing in value have also been benefiting from the gold market in the meantime.

It’s possible the US economy will go into recession, but equally possible that the world’s largest economy will side-step any downturn and return to robust growth. It’s possible the Japan carry trade will trigger another mini meltdown, or something even further reaching across the global economy, or it could quietly return to the stasis of the last 20 years. For prudent investors it shouldn’t matter. A balanced portfolio of assets, including safe-haven gold, can support any eventuality.