The first week of August is a period when the only screen most in the market were concerned with was sunscreen, but those who did sneak a peek at their portfolios would have been greeted by a sea of red as equities sold off.
A number of factors contributed to the sell-off that saw the S&P 500 fall by around 8 per cent, with concerns around the health of the US economy and disappointing profit numbers from several of the large technology companies that had largely driven the gains made by global equities over the past year.
Uniting a number of those themes was the volatility caused by the unwinding of a long-standing strategy deployed by investors, known as the yen carry trade.
Stephen Jones, chief investment officer at Aegon Asset Management, says: “The yen carry trade meant investors could borrow very cheaply in Japan, where interest rates have been very low for years, and use that money to buy, for example, US technology shares that have risen sharply in recent years.
"When they have to repay the money they borrowed in Japan, they sell the shares bought in the US, and keep the difference between the low interest rate and the rise in the value of the shares."
Problems with this strategy emerged at the start of August as a result of the Bank of Japan – the country's central bank – lifting interest rates and also signalling to the market that rates were likely to rise by more than previously expected, says Guy Miller, head of macroeconomics and chief strategist at Zurich.
This increased the future borrowing costs when borrowing yen made refinancing the debt more expensive, and led to investors who previously might have refinanced the loan and continued the trade deciding to close the trade.
Closing the trade involves selling the technology shares, most likely at a profit, and repaying the yen.
With investors already anxious about the outlook for the economy, and the potential of the large technology companies to continue to grow profits, there was a wave of selling pressure within equity markets, just at the time the yen carry trade was being unwound by many investors.
Miller says: “The yen carry trade was massively extended and had been running for a long time. But when the BoJ spooked markets, selling began. I would say that it was also exacerbated by people just wanting to close out their positions in markets before they went on holiday.”
Dorian Carrell, head of multi-asset income at Schroders, says the effects of the initial unwinding were amplified by many hedge fund strategies having to close out their positions when certain technical events occurred.
He says: “Trend-following strategies have to sell when the trend is broken, and they sell immediately. The other factor is that many retail investors in Japan were spooked and sold equities and all of it was exacerbated by very thin trading volumes due to people being on holiday.”
