The Market Turmoil From Early August Might Not Be Over, Says Socgen Edwards

The potential for tighter monetary policy in Japan, combined with fading optimism around U.S. tech earnings, suggests that the market turbulence witnessed in early August may not be over yet. This perspective comes from Albert Edwards, a typically bearish strategist at Société Générale, who emphasized in a recent note that global investors should keep a close eye on developments in Japan, as the country often signals major market shifts before they occur elsewhere.

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Edwards pointed out that Japan has historically been a harbinger of significant market movements, citing the late 1990s tech bubble that began to burst in Japan before impacting global markets. He stressed the importance of monitoring Japan closely, especially now, as recent events have once again put the country at the center of investor attention.

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Just a month ago, Japan was thrust into the spotlight when its markets were hit by a dual shock: the collapse of the yen carry trade and growing concerns about the U.S. economy following a weak jobs report. The yen carry trade involves borrowing in the low-yielding Japanese currency to invest in higher-yielding assets elsewhere. The unwinding of this trade, coupled with fears of a U.S. economic slowdown, led to significant market volatility.

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Since then, market sentiment has somewhat recovered. Stronger U.S. economic data has helped to ease recession fears, and the extreme market positioning that contributed to the earlier turmoil has been largely corrected. However, Edwards warns that investors should not become complacent, as two fundamental shifts could reignite market instability.

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The first shift concerns the diminishing optimism over the earnings of major U.S. technology companies. Edwards noted that this declining confidence in tech earnings is undermining the primary driver of the U.S. bull market. The tech sector, which has been a key engine of market growth, is now facing increasing scrutiny as earnings forecasts are revised downward. This change in sentiment could have far-reaching implications for the broader market, as the tech sector's performance is closely tied to overall market health.

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The second shift involves Japan's potential return to more conventional macroeconomic policies. After years of deflation, Japan appears to be moving towards a period of inflation, which could allow the Bank of Japan (BOJ) to continue raising interest rates. Edwards cautioned that any normalization of Japanese interest rates would have a significant impact on global markets. In the short term, higher rates could lead to a further unwinding of the yen carry trade, as investors abandon their yen-funded positions in favor of higher-yielding assets. Over the longer term, rising Japanese interest rates could reduce the outflow of investment capital from Japan, altering global investment flows.

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Indeed, the yen strengthened on Tuesday following comments from BOJ Governor Kazuo Ueda, who reiterated his commitment to raising borrowing costs if the economy and inflation continue to meet expectations. This yen appreciation reflects the narrowing yield differentials between the U.S. and Japan, a trend that could lead to further carry-trade unwinding.

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Edwards provided a chart in his note showing that Japan has reached a significant milestone: for the first time since the 1990s, Japan's underlying wage growth, a key inflation measure for central banks, has converged with that of the U.S. This convergence suggests that Japan is no longer an outlier in global economic trends, which could have important implications for global markets.

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However, Edwards also highlighted the uncertainty surrounding the yen carry trade, noting that it is unclear whether the trade has fully unwound. He suggested that the recent sharp rally in U.S. technology stocks may have temporarily stalled the unwinding process. This creates a precarious situation where risks to the yen carry trade could emerge from multiple directions. A sudden strengthening of the yen could trigger a sell-off in U.S. stocks, while a decline in U.S. tech stock prices could also lead to a further unwinding of the carry trade.

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In conclusion, Edwards emphasized the need to closely monitor the other side of the yen carry trade, where developments in U.S. tech stocks could have a significant impact. He advised paying close attention to declining earnings-per-share optimism in the U.S. tech sector, as this could be a key indicator of future market movements. With these shifts in mind, investors should remain vigilant, as the potential for renewed market turbulence remains high.

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