One week / one topic: Karen vs Godzilla

What happened?

Karen (the average US consumer) and Godzilla (the Japanese financial system) have been trading blows.

But who are they? And why does this matter?

Meet Karen, representing the US consumer:

• Key features: Collectively responsible for 34% of the world’s household consumption and 69% of US GDP. Used to high quality and convenience, she’s not afraid of borrowing vast sums

• Weapons of choice: $60k disposable income per capita, high salaries, 401K’s

• Vulnerabilities: Low savings rate (3.5%), questionable job security, exposed to drawdowns in stocks and housing

• Special move: Federal Reserve magic monetary spells

Enter Godzilla, i.e. the Japanese financial system:

• Key features: Finally coming out of its malaise after three lost decades, as of late Japan can boast strong equities performance, shareholders-friendly corporate reform and the Bank of Japan finally raising rates

• Weapons of choice: Top creditor nation in the world ($3.3tn), high savings rate (29%), cash-rich corporations

• Vulnerabilities: The Yen is the funding vehicle of choice for carry trades globally, demographics are deeply challenging, GDP per capita has stagnated for 30+ years

• Special move: Ability to quickly liquidate assets held abroad and repatriate massive amounts of cash

After Karen had been enjoying a smooth ride in the form of protracted economic growth accompanied by sizable asset appreciation, Godzilla struck with a strong one-two punch: Japanese stocks crashed -20% over three days, and the Yen surged 12% in less than a month.

Since being long Japanese equities (blue) and/or short the Yen (white, inverted) had been a very popular trade, forced liquidations quickly led to widespread panic. US Treasuries also soared (red) as fear took hold among investors and ‘emergency rate cuts’ from the Fed (!) were also invoked.

Goodbye, ‘immaculate disinflation’… Hello, systemic crisis?

The US consumer however was not to go down without a fight, and on August 8th unemployment data came in (marginally) better than expected – yet enough to allow many asset owners to breathe a sigh of relief: things are ok after all, no need to panic… Yay!

That said, after everything was said and done, global equities are still down 5% vs mid-July and US 10yr yields 35 bps lower, in a sign that investors’ assessment of the underlying distribution of potential outcomes has indeed shifted away from ‘everything is fine, just buy more AI stocks’ to ‘watch your back’.

(The Nasdaq is indeed lagging as of late, and is now 10% down from the peak)

Investors have been caught in the middle of these developments, and (perhaps) unwillingly cast in the role of referee. Nonetheless – even in the absence of a clear knockout punch from either side – we seem to have entered new territory.

So – now that things are ‘in play’ – what else might be looming in the shadows? Opportunity or risk?

Our observations

• Fundamentals: With positioning-driven moves, the main concern about fundamentals was (and is) negative feedback loops. While valuations might have become more attractive, the risk of a Minsky moment suddenly came to mind. Also, there are reasons to be concerned about the US job market.

• Price action: The shock reverberated very quickly across global markets, as many investors were long Japanese equities and short the Yen. While positioning should be less extreme by now, this was a good reminder that momentum – while very powerful – ultimately can’t last forever.

• Investor beliefs: In hindsight, depending on what’s next, these events will obviously look like either ‘the beginning of the end’ or ‘just a bit of noise’. Investors’ reaction to upcoming developments might give us some clues as to what’s the prevailing narrative, but there is palpably more nervousness across markets.

So what?

After witnessing our holdings in US 30yr Treasuries soar by ~6% in short order, we took comfort as – in the presence of a potential deflationary shock – they did once again provide portfolio insurance. The age of diversification is not dead, after all.

Also – while rebalancing alpha is real – we decided not to take profits here as we keep observing a less rosy macro backdrop, which had also already led us to reduce exposure to equities before the recent sell-off.

Going forward, market pricing of a recession in the UK or Europe seems too low vs the US – yet, any temptation to shift US Treasuries into Gilts or Bunds should take into account that, in a true crisis, you can’t really compete with a $27tn-liquid market backed by a military superpower…

As for Godzilla, the Bank of Japan does have an ominous track record of beginning to raise rates just before the start of a recession…

Will this time be different?