Will there be a second round of adjustments for US and Japanese stocks?

1. Focus One: Reasons for the Adjustment in the US Stock Market, the US Economy is Key, and Earnings Reports of US Stocks also Have an Impact

Regarding the adjustment in the US stock market since mid-July, it is influenced by the weakening US economy, concerns over the earnings reports of the seven US tech giants, and the seasonal patterns of the US stock market.

Firstly, the trend of the weakening US economy is intensifying. On one hand, US employment data fell short of expectations. In July, the non-farm payrolls in the US increased by 114,000, below the estimated 175,000, with the previous value showing an increase of 206,000. The US unemployment rate in July was 4.3%, hitting a new high since October 2021, with an expectation of 4.1% and a previous value of 4.1%. On the other hand, the US manufacturing sector's business activity significantly declined. The US ISM Manufacturing PMI in July was 46.8, marking the largest contraction in eight months, further exacerbating market concerns about the US economy.

Secondly, the market is concerned about the earnings reports of the seven US tech giants. Since late July, the seven US tech giants have gradually started to disclose their interim financial results. Due to the high stock price gains of US tech stocks in the past year, the market is worried that the earnings growth may fall short of expectations, making it difficult to support further stock price increases.

Thirdly, there is a noticeable seasonal pattern in the US stock market. By analyzing the monthly ups and downs of the US stock market since 1990, it can be observed that the probability of a rise in the US stock market in August and September is relatively low. This is because August and September are often the time when US companies release their semi-annual reports, and the performance of these reports becomes the market's focus, which can easily lead to market fluctuations.

2. Focus Two: Reasons for the Adjustment in the Japanese Stock Market, Influenced by the US Stock Market Adjustment and Yen Appreciation

The Japanese stock market has a strong correlation with the US stock market, while the volatility of the Japanese stock market is higher than that of the US. In addition to the adjustment in the US stock market, the recent significant adjustment in the Japanese stock market is also affected by factors such as the Bank of Japan's interest rate hike, yen appreciation, and carry trades.

First, the Bank of Japan's interest rate hike has intensified the adjustment of Japanese stocks. Reviewing the history of interest rate hikes in Japan, except for 2006, the Japanese stock market has experienced adjustments after the end of each interest rate hike cycle. On July 31, 2024, the Bank of Japan announced a 7-2 vote to raise the short-term policy interest rate from 0.1% to 0.25%, leading to a 8.9% decline in the Nikkei 225 index within a week, a deeper decline compared to previous adjustments.

The reasons behind this adjustment can be attributed to the Bank of Japan's first dual interest rate hike within the year in 2024, which exceeded market expectations in terms of rate hike magnitude and pace. Additionally, since 2024, the Bank of Japan has implemented several measures to promote the normalization of monetary policy, including ending the Yield Curve Control (YCC) policy, announcing the cessation of ETF purchases, and halting the purchase of Japanese Real Estate Investment Trusts (J-REITs). Therefore, the recent adjustment in the Japanese stock market reflects the cumulative impact of these monetary policy changes.

Secondly, under the backdrop of interest rate hikes, the rise in the Japanese yen interest rate has put pressure on yen carry trades. Due to the difficulty in directly quantifying the exact scale of yen funding arbitrage trades, we use the net yen foreign exchange position to reflect changes in carry trades. According to Bloomberg data, we track the overall net yen position by calculating "leveraged fund net positions + non-commercial net positions + actual currency net positions".

Since April 2023, the size of net short yen positions has continued to expand, while the Yen Carry Index has reached new highs. The Yen Carry Index is a USD/JPY interest rate differential return index, reflecting the return obtained by borrowing yen to buy dollars, thus indicating the profitability of yen carry trades and influencing the scale of such trades. However, since the Bank of Japan's unexpected interest rate hike, the size of net short yen positions has contracted, and the Yen Carry Index has rapidly retreated, indicating that the rise in Japanese yen interest rates under the backdrop of interest rate hikes has reduced the profitability of yen carry trades, putting pressure on the scale of such trades.

Thirdly, under the background of the appreciation of the Japanese Yen, the Japanese economy may be affected. Since 2023, signs of recovery have emerged in the Japanese economy, with the nominal GDP growth rates for the four quarters of 2023 reaching 5.0%, 6.0%, 6.7%, and 4.9% respectively. Breaking down the structure, according to the contribution rates of different industries to the nominal GDP as announced by the Japanese Cabinet Office, the tertiary industry on the production side and net exports on the demand side significantly contribute to GDP growth. Therefore, looking at the three major sectors of the Japanese economy, the main driving force of this round of recovery is the export sector in the tertiary industry, with goods and services trade exports being the main driving factor.

On one hand, assuming a weakening of the U.S. economy, under the backdrop of the appreciation of the Japanese Yen, it will affect Japan's export sector; on the other hand, the contraction of the Yen carry trade scale will indirectly drive the appreciation of the Yen, thereby increasing the uncertainty of Japan's economic recovery.

3. Focus Three: Will there be a second round of adjustment in U.S. and Japanese stocks, with the third quarter being a critical observation period

Regarding the adjustment of U.S. and Japanese stocks, it can be observed that the subsequent performance of the U.S. economy is a key variable. On one hand, the U.S. economy directly affects U.S. stocks, and the adjustment of U.S. stocks will also lead to the adjustment of Japanese stocks; on the other hand, assuming a weakening of the U.S. economy, the logic of Yen appreciation may be further strengthened, thereby affecting the liquidity of the Japanese stock market.

3.1. The U.S. economy is the most critical variable

Looking ahead to the third quarter and the second half of the year, we believe that the uncertainty of the U.S. economic outlook remains high.

Firstly, according to the Sam rule, if the average of the current three months is 0.5 percentage points or more higher than the lowest three-month average of the past 12 months, this will mark the early stage of a recession in the U.S. The U.S. unemployment rate in July was 4.3%, with an average of 4.13% over the past three months, exceeding the lowest three-month average of the past 12 months by 0.53%, basically meeting the threshold of the Sam rule.

Secondly, U.S. residents' excess savings turned negative in the second quarter of 2024. The main pressure of inflation in the U.S. this round is in the service sector, and one of the reasons for high service sector inflation is the distribution of a large amount of cash subsidies to residents, leading to residents having more excess savings for consumption. However, according to estimates from the Federal Reserve Bank of San Francisco, as of May 2024, U.S. residents' cumulative excess savings were approximately -$263 billion

Thirdly, after the inversion of the yield curve of U.S. Treasury bonds ends, the U.S. economy usually enters a recession phase, with the recession criteria defined according to NBER. Specifically, short-term interest rates of U.S. Treasury bonds are often determined by monetary policy, while the yield spread is influenced by economic expectations. Based on historical data, the end of the inversion of the 10-year and 2-year U.S. Treasury bond yield spreads often signals an upcoming recession in the U.S. Starting from July 2022, there have been clear signs of inversion in the 10-year and 2-year U.S. Treasury bonds. Recently, the degree of yield curve inversion has significantly converged. According to historical experience, after the inversion ends, there is a high probability of a recession in the U.S. economy.

3.2. Assuming the U.S. economy continues to weaken

If the further weakening of the U.S. economy is confirmed, it is highly likely to trigger further adjustments in the U.S. stock market. Historically, there is a high correlation between the trend of the U.S. stock market and the fundamentals of the U.S. stock market. Taking the S&P 500 as an example, the trend of the S&P 500 is highly positively correlated with the S&P 500 EPS. Assuming a further weakening of the U.S. economy in the future, a decline in corporate profits will further trigger adjustments in the U.S. stock market.

At the same time, assuming the U.S. economy weakens, the logic of the yen appreciating may be further strengthened, thereby affecting the liquidity of the Japanese stock market and the Japanese economy.

In terms of Japan's recent economic performance, uncertainties about recovery have gradually emerged. The actual GDP growth rate in the first quarter of 2024 has turned negative to -0.7%, and Japan's manufacturing PMI in July fell below the boom-bust line to 49.1%. Against the backdrop of the Bank of Japan's tightening monetary policy and the appreciation of the yen, Japan's exports may continue to be under pressure in the future.

At the same time, assuming the continuous adjustment of the U.S. stock market, carry trades will continue to be under pressure, thereby affecting liquidity. Specifically, Japan's balance of payments statistics show that in the past three years, Japan's investment in the U.S. market has grown significantly, indirectly reflecting that more funds borrowed in yen are invested in the U.S. market. Assuming the continuous adjustment of the U.S. stock market, along with the appreciation of the yen leading to higher carry costs, the profit margin of carry trades will shrink, and its scale may continue to contract, thereby affecting liquidity

3.3、 The third quarter is an important observation window

There is a strong correlation between the trends of the US and Japanese stock markets. By analyzing the monthly performance of the Nikkei 225 and S&P 500 over the past thirty years, it can be observed that there is a higher probability of adjustment in the US and Japanese stock markets in the third quarter.

Taking into account factors such as the current US economy, the trend of the Japanese yen, carry trades, etc., the future trend of the US economy is a key variable. Currently, the probability of continued weakening is still not low. Further combined with seasonal patterns, August to October is an important observation window.

4. Focus Four: How does it affect the A-share market, overall limited impact, some structural impact

Assuming further adjustments in the US and Japanese stock markets, how should the impact on the A-share market be evaluated?

On the one hand, considering various valuation indicators such as the P/E ratio, P/B ratio, etc., the A-share market is already in a historically low area. Therefore, assuming further adjustments in the US and Japanese stock markets, it is expected that the overall adjustment space for the A-share market is limited, and the impact is more reflected in structures that have a certain correlation with the trend of the US stock market, such as the NVIDIA industrial chain or sectors with heavy northbound capital holdings.

On the other hand, the A-share market is in a window period of structural bull market transformation, and more importantly, it is about finding clues to lead the new round of structural bull market.

Specifically, looking back at the structural bull markets in the computer industry from 2013 to 2015, the semiconductor industry from 2019 to 2020, and the lithium battery industry from 2020 to 2021, the operation of a structural bull market usually consists of three stages: the first wave is a general rise, the second wave is the main rise, and the third wave is the supplementary rise. During the first wave of general rise, there is usually a lack of fundamental clues, and it is typically a rise driven by expectations. After the general rise, there is usually a period of oscillation and differentiation. Following the oscillation, sectors and companies with fundamental support enter the second wave of the main rise, where attention should be paid to leading companies with positioning and profit advantages. After the main rise, there is usually another period of oscillation and differentiation. Companies at relatively low levels benefiting from the diffusion of fundamentals typically experience the supplementary rise. Of particular note is the pace of industry profitability release, as at the start of the first wave of the market, profitability is often in the early stages of reversal, typically corresponding to negative profit growth. After a period of consolidation, as profitability enters an upward channel quarter by quarter, the structural bull market enters the main rising phase Combining the above clues, we believe that one should focus on newly listed stocks in the past 2-3 years, while also paying attention to the domestic computing power, consumer electronics, and AI application industries in potential directions.

For the domestic computing power sector, it has already gone through the expected drive phase of a general rise and a consolidation period, and is currently entering a phase of fundamental drive for an upward trend, with future profit release as the core driving variable. As for consumer electronics, the second quarter of 2024 is expected to be a phase of upward trend, currently transitioning into a consolidation and adjustment phase. After this phase, attention should be focused on the fundamental clues of consumer electronics. In terms of AI applications, with robots and autonomous driving as typical representatives, they are currently in a thematic phase driven by events, with a mid-term focus on the emergence of popular products.

Article author: Wang Yang S1230520080004, Chen Hao, Source: Wang Yang Strategy Research, Original Title: "Will there be a second round of adjustments for US and Japanese stocks?"