What is behind the recovery in financial asset prices?

>> Reason for turmoil in risky assets

To try to answer this, Steve Barrow, Head of Standard Bank G10 Strategy, said there are a number of observations. The first is that there has effectively been a bubble in the yen-funded carry trade. Cheap yen has been used to finance not just positions in higher-yielding currencies but also other assets that investors want to fund cheaply. This bubble has popped, seemingly by a combination of BoJ rate hikes and currency intervention.

The question now is whether this bubble-burst is of the short-sharp variety that’s now over; or whether the deflation will persist for some time and so drag risk assets like stocks down for longer. The answer lies somewhere in the middle; that further carry-trade unwinding seems likely but the most significant and destructive part of this bubble-burst is now behind us.  

The second view is that the market has flip-flopped too aggressively and too quickly on the US economy. Not so long ago, the consensus seemed to be that a soft landing was the most likely outcome. But now, it seems to many that one weaker-than-anticipated employment report has lifted the odds of a recession significantly and left the Fed well behind the curve.

However, Steve Barrow said that they have Gerrymandered the US recession story to try to fit the facts of plunging asset prices, when the real reason for the slump has been the bursting of the yen carry-trade bubble. If the market calms its concerns about a US recession and the Fed being miles behind the curve, then we should see a positive influence on risk assets. In fact, as the Fed takes rates down, starting with a 25-bps cut in September, it might help embolden market sentiment.

A third observation is that many risk assets do appear to have been overvalued. Of course, this is always easy to say in hindsight. But it is not just a problem that risk assets such as stocks have been able to pile on more gains; it is that central banks have arguably been drawing air out of the lungs of the market through their quantitative tightening. Bond purchases by central banks in earlier years plied economies with cash, and part of that was used to invest in riskier assets such as equities.

>> What to expect from profitability of US companies?

But now these central bank asset piles are being reduced, and that presents a challenge for investors. We don’t deny that central bank asset depletion has been going on for some time without any significant retracement in riskier assets. But believing a liquidity bubble is bursting is one thing, and knowing when this will impact asset prices is quite another. In a sense, the yen carry-trade bubble just represents a smaller version of this much broader global liquidity bubble and that might be a warning that we have only seen the ‘little’ bubble popping recently; the big one is still to come.

If we put these three points together, we will be left with the following situation: Risk assets have seemingly risen too far and for too long and some sort of correction is necessary and healthy. The bursting of the yen carry-trade bubble might prove to have been the spark that caused these assets to burn. This correction could be over, but there are still some residual carry-trade exits that need to occur even if the really intense phase of this asset price weakness may be behind us.

“The hope that the worst is over could be compounded by the fact that US recession risks are overblown and the Fed has not fallen significantly behind the curve. But while this might provide some succour for the future, we do also have to bear in mind that there is a much bigger liquidity overhang that exists on a global scale and threatens to cause a much deeper and longer asset price correction than the one we’ve seen just recently,” said Steve Barrow.