When will the selling end? Watch the dollar-yen exchange rate
From Standard & Poor's Equity ResearchLiquidity flowing from the yen carry trade was one of the factors fueling the strong global equity performance of recent years. Speculators took advantage of wide interest rate disparities between the yen and other currencies by borrowing money in yen and investing the proceeds in higher-yielding currencies or asset classes. The yen carry trade flourished during the period of record-low risk aversion.
But over the course of an uninterrupted eight-month rally, global equity markets became priced for perfection, leaving limited room for further gains - or for anything that challenged either the "Goldilocks" fundamental outlook or continuing global economic and earnings growth.
Since Feb. 27, however, volatility has soared as investors priced in potential risks that may derail the global economy and jeopardize a long-running streak of record worldwide earnings growth. The chief risk stems from the fear the world economy may be slowing. That fear has taken hold in recent weeks, based on weaker-than-expected U.S. economic data, the Chinese government's push to cool down the country's red-hot growth, and a weak start to the year in Europe.
And the Japanese yen is rallying as greater uncertainty in the capital markets spurs a rush to unwind the carry trade. As this important source of funding dries up, the pressure on equity selling intensifies.
Not surprisingly, as investors reevaluate their risk appetite, asset classes that stood to benefit most from steady growth and enjoyed the largest gains in recent years are now proving to be the most vulnerable. These include less liquid, lower-quality areas such as U.S. and international small-caps and emerging market equities, which have fared worst in the current sell-off. Conversely, global large-cap blue chips have performed slightly better.
For equity investors seeking a safe entry point amid recent stock market gyrations, S&P Equity Strategy recommends focusing on the carry trade, specifically the dollar-yen exchange rate. With risk aversion rising recently, the yen has rallied as speculators cover their short yen positions and close out their carry trades. An end to the recent yen rally may indicate that the worst of the current global bout of risk aversion has run its course, signaling an imminent equity rally.