Anatomy of a rout

0:05Pushkin. We've had a harrowing couple of days on markets. Friday and Monday were abysmal. It's Tuesday morning and things look a little bit better, but something has changed and something has spooked the market. On today's show, who was it? Or rather, whodunit? This is Unhedged, the markets and finance podcast from the Financial Times. I'm Rob Armstrong coming to you from Unhedged World headquarters in New York City. And joining me today, a special guest star, Nicholas Meagaw, the FT's Capital Markets Correspondent. Nick, thank you for being on the show. It is actually Meagaw. Like, Americans can't say it anyway.

0:53Meagaw! Yeah, I did go into high school, so... Yeah. All right. Nick, what just happened? A lot. A lot just happened. The longer I spend writing about equity markets, the more convinced I am that they don't always make a whole lot of sense. So trying to blame it on a single killer is probably a bit much better. Nick, you're never going to make it as a journalist if you don't learn to oversimplify. So start learning now. Please oversimplify. Okay. Economy, bad. Economy, bad. Japan, scary. Retail investors, dumb. Yeah. Okay, let's start with economy bad. We wrote in the newsletter that it's not necessarily as bad as people, certain hyperventilators in the punditocracy are making it out to be.

1:49But there's mixed signals, right? We got a bad employment report. We got like not great employment report. 114 ,000 jobs created against that kind of 200 ,000 jobs level that we've been bouncing around near. but there are a lot of temporary factors in there. Yeah, you've got like hurricanes, you've got just general summer. Yes. It's more complicated than it looks. And then we got a lousy ISM survey of manufacturing businesses and that spooked people too. That was actually the day before the jobs report, the day after the jobs report, the day before. And this is, you know, the most watched broadest survey of businesses and that showed manufacturing and contraction.

2:35It feels like that was the one-two punch. But a few days later on Monday, we had ISM services, same survey, different sector of the economy that did well. Yeah, I mean like the net picture is kind of, the economy is clearly less strong than it was. It's not that bad. Which in a way is what people have been pushing for for the last year and a half. Yeah, it's weird. You make a really good point there. What are Fed rate increases supposed to do? Slow the economy. What do we have? Slow our economy. Slow our economy. What's the best way to bring down inflation? Weaken the job market. Weaken the job market.

3:19And here we are. Inflation looks to be just about a target. But surprise, surprise, we have a slightly slower economy. But in the don't panic department, we just got the GDP figures for the second quarter, 2.8%, I think. So it's not like we've murdered the economy in the job market. We've just calmed it down a little bit. Okay, what was next on your list? We had economy bad and our conclusion is actually not that bad. We have Japan scary. Japan scary. So they really fell out of bed. Monday morning, the Nikkei was off 12 % or something like that. Yeah, it was the worst result in 37 years, something like that.

4:03Worse than that, it was extremely embarrassing for the unhedged newsletter because we've been quite bullish on Japan for quite a long time. They're finally getting deflation under control. They're very competitive. Many of their businesses are doing well. There are signs of improving growth, et cetera, et cetera. What happened there? I mean, even after the decline, to be fair, still doing better this year than, you know, U.S. small caps, which people have spent the last three weeks are saying is the next big thing. So you're at least not alone in being a terrible forecaster. Yes. But I mean, why Japan?

4:40We had this lousy day on Friday in the U.S. and then we wake up and Japan doesn't just mirror the drop in U.S. risk assets. It sort of doubles it. do we have a theory about why the reaction there was so violent a certain amount of it was a kind of rational timing point of like they it was their first chance to respond to what had happened in the u.s on friday so a certain amount of decline totally normal yes but the scale of it like you say was kind of almost unprecedented and i think more about the impact of the sudden interest rate increase. Yes. And the strengthening yen and it unwinding this whole.

5:23I think that sounds right. And just to catch our listeners up, Japan's rates have been incredibly low, roughly zero since the Middle Ages or something. And just in recent weeks, the Bank of Japan has edged rates up. So they're conducting a kind of experiment that they haven't done in a long time. The yen, which has been very weak, is strengthening. So there was already this kind of transitional thing going on there before the bad news from the US hit. Also, I wonder if we should add something else to our list, which is crowded trades bad. Maybe everybody was on the same side of the boat with Japan.

6:09You know, like unhedged, everybody was pro-Japan. This bad news comes along and everybody shifts to the other side of the boat and you threaten to capsize it. Yeah, because there's a rational bit, like you say, of the interest rates and yen impact, but also most of that was true on Thursday. And it was more just to kind of all of these things added up. There's a vibe shift and everyone runs away from the thing that they've been doing for the last six months. And as you know, of course, there is an added wrinkle, which is the so-called carry trade, which is borrowing in a currency that is very cheap to borrow and using the borrowed money to invest in a currency or some other thing that returns more than the small amount you paid to borrow the currency.

7:00And the classic currency to do that with is the yen. And the thing about carry trades is when they start going the wrong direction and the borrowing costs go up and the returns on the other side of the trade start going down, you want to get out of there very quickly indeed. Maybe some of that happened, although it's hard to say how much. It's one of these things, it's really weird because it's like there was definitely some of that happening. Yes. But I sometimes wonder how much of the scale of the sell-off is because of people worried that it's going to happen. Yes. As much as it is. How big is the carry trade?

7:35Kind of hard to tell. Probably decent size, but it's not all in America. Yeah. You're also buying stuff in Mexico and Brazil, and you have to unwind those things as well. And they did also fall. But like the yen carry trade is not what was propping up the US stock market for six months. It's not the only thing doing it. So unwinding that is not going to explain the worst day for two years. Yes. But fear, You know, it adds to the environment of fear. I think there's also another phenomenon which we need a name for, which is that journalists and other pundits will seize on any explanation that contains a phrase that makes them sound intelligent.

8:14And I think carry trade is one of those phrases. So, like, because saying the word carry trade makes you sound like you know something, whenever there's a big event involving Japan, people leap up and down and say carry trade, carry trade, carry trade. Choking their chin and nodding sagely. Okay. So we've been through economy bad, Japan scary. And by the way, as of this morning, Japan's doing quite a lot better. We should mention that. Might not last, but there seems to be a bounce back there. What about retail stupid? Or we could maybe more politely say retail investors respond strongly to events.

8:56or something. Vulnerable to animal spirits. Vulnerable to animal spirits, precisely. Where do we see that? I mean, all the websites and apps kind of crashed on Monday morning, which is not a great sign. No. Considering especially that they are, from a kind of functioning point of view and a technology point of view, they're all kind of set up to fight the last worst case scenario. And so if you manage to crash like Vanguard's platform. So you're talking about brokerage sites. Yeah. Places where you trade stocks. And so if you manage to crash their platform, that suggests that the volumes were higher than in like meme stock mania.

9:39And we have been told that for at least some of the brokerages, that was true. Right. They may not have all been actually selling. Yes. But they're like people are seeing headlines and then getting scared and like wanting to open the thing. and everyone's rushing. It kind of just illustrates the climate of fear as much as any genuine selling action. I suppose this is as good a point as any to talk about the Magnificent Seven, which are, of course, popular, many of them popular among retail investors and which were some of the biggest fallers on the dreadful Friday and the dreadful Monday. Let me see if I can reel them all off in a row Alphabet, Apple, Meta, Amazon, Tesla, NVIDIA.

10:29One missing. Ah! The most valuable company in the world. Oh, God, Microsoft, of course. All right, so those seven have contributed, as unhedged listeners will know, a huge amount of the total gains in U.S. stock markets, not only in this year, but in recent years. And now they seem to be faltering hard. What, if anything, can we read into that? As with seemingly every bit of this, there is a starting point of rationality. Yes. And then it's been exacerbated by the kind of vibes. Because we're in the middle of earnings season and earnings have been not great. Yes. They haven't been terrible. And if you look at, say, like Alphabet's actual businesses, they did fine.

11:19Yes. It's just that they're still spending insane amounts of money investing in AI, and it isn't actually making money for any of them yet. That was true for all of the Magnificent Seven, I would say, except for Tesla, which had a plain old disappointing quarter, I thought. I mean, yeah, they've been kind of an odd inclusion in the Magnificent Seven the whole time. Part of it reflecting the fact that it's a retail thing. Yes. And retail guys love Tesla, and so they just lump it all in together. Yeah, but for Apple, for Amazon, for Microsoft, and for Meta, there is a pattern of the business is still thriving, but there's a huge amount of money going out the door basically to build data centers that will be able to deliver us all artificially intelligent friends in the near future.

12:10And hopefully somebody will pay for those, and maybe those spooked people a little bit. But again, I wonder if it was like, this was a great trade. It's been a great trade for a long time. Everybody made loads of money. The stocks are kind of expensive. And people are just looking for an excuse that a crowded, concentrated, old trade is just dangerous intrinsically. Yeah, a lot of people kind of on the institutional investor side kind of resented how much money they were making in those stocks anyway. Yes. They were like, this is nuts. Yeah. But I can't resist it because there's so much of the index.

12:47Yeah, exactly. And so people were waiting for any excuse. They got enough of an excuse. It starts falling. And then the kind of more momentum driven people and like, which I would include probably most retail traders in. See it, panic, sell everything, makes it all worse. There's another strand here. I really am not sure what I think about this. but we've heard the argument from several experts that the structure of the market is somewhat different now. We have a lot of passive products. We have a lot of algorithmic products. We have a lot of momentum-chasing products, multistrat hedge funds, all of these things that sort of chase trends, and then when the trend breaks, they go running the other direction.

13:31So there's this theory that the market has been designed to be very volatile in a certain way. Do you buy that kind of – it has a slight conspiracy theory flavor to it. But I wonder what you think. Yeah, it's a really interesting one. At the margins, it might have done – they're really interesting. And maybe I have fed this sometimes because I've written stories about how these CTA funds and vol control strategies, which are these types of hedge funds that, like you say, kind of chase momentum, can exacerbate moves. But actually, honestly, if you look at the overall number of assets they manage, they're not that big.

14:11And I feel like they alone cannot be causing massive shifts in the market, even when you add leverage onto it. All right. That's interesting. To nuance it is that it's not that the market has been designed at the moment to be volatile. In a way, it's designed to be not volatile and then suddenly very volatile. out. Yes. Which is kind of what has happened. Yeah. The VIX went bananas. Let's talk about that for a second. Yeah. It's been at like 12 for most of the year, which is insanely low. And everyone was like, oh, the VIX is broken. And then it went to 65. Yes. Which is just for our non-nerds.

14:45The VIX is an index that basically tracks how much it costs to hedge the S &P 500 against high volatility in the short term. So as the VIX goes up, you're paying more for insurance against big market moves. So they call it the fear gauge because it shows you how worried people are about big moves in the near future. Yeah, it's kind of a proxy for expectations of a swing in the next month. The only thing that I don't like about the fear gauge term, which is impossible to avoid, and I still end up using it in every article. Carry trade, fear gauge. It's like, it's not just fear. It swings in either direction.

15:31In theory, if you think the stock market is going to swing massively positive in the next month, that is also volatility. Yes, and that would drive VIX up. Yeah, yeah. And I think, in a way, that's the rational bit of the VIX being high right now. It's hard to tell whether things are going to keep falling or keep going up, but it's probably going to be choppy. It does feel like we have entered a new stage. You talked about this kind of process by which market structure seems to favor smoothness interrupted by moments of turbulence. Whatever the next move in the market is, it does feel like we are in one of these turbulent transition points.

16:12Yeah, at least for the near term because we haven't even finished earnings season. And we've got some of the biggies to come. Yes, Walmart. Walmart, Target, I think, still to come. Nvidia. Yes. Who is so big that even if they didn't move every other stock in the market, they can drag the index on their own. Yes. And they will move every other stock in the market. So that's going to be a fun day. All right. So let me close this way. A friend of mine suggested that you could structure the question we've been talking about as an Agatha Christie novel. Who done it? Who made the market go bananas? Do you have a prime suspect?

16:51I mean, I think it might be a bit of a murder on the Orient Express. Mm. Tell me what do you mean by that? You all did it. Ah. Spoilers. What? Great. Now we can't read that novel. So it's a conflagration of events. I myself, I really think the fact that there's been one trade and that it's super concentrated in a small number of tech stocks, that finally that became frightening and unstable. The bad news elsewhere was enough to tip those. And once those wobbled, the Microsofts, NVIDIAs, Apples, et cetera, then it was kind of on. So if I had to send one factor to jail, it would be big tech. But you are a more rational person than I.

17:40I mean, I feel like you're right. But also that was true in March. Yeah, it could have been. The same thing could have happened. And the results were the same in March. They were still doing good business and spending shed loads of money on AI. It's just they needed something to push them over the edge. And I think that was the getting spooked about the economy. All right, listeners, we'll be right back with Long and Short.

18:15Welcome back. This is long and short. That part of the show where we go long things we like and we go short things we don't like. Nick, do you have a long or a short for us? I have a long. Advertising revenues on CNBC. Yes, they are back, baby. They're back. People are going to have to watch it at like nighttime. Yes. Actually pay attention to a small island off the coast of China. Yes, exactly. Taiwanese stocks suddenly matter. And Japan. Yeah, yeah. Like, I don't want to watch it when I get home. Yeah, but you've got to now. I'll see. Yeah, I was watching the news like 11 o 'clock last night.

18:53I myself am long Google in the following specific sense. Just been a big U.S. court result finding that Google is a monopolist and my long experience of covering legal challenges to big tech tells me this stuff never matters in the end. Nick, thanks for being on the show. Listeners, we will be back in your feed on Thursday.

19:43Just go to ft.com slash unhedged offer. I'm Rob Armstrong. Thanks for listening.