The Double-Edged Sword of Leverage
The first month of a new quarter is always dominated by earnings results from the previous quarter. Artificial intelligence remains the top theme driving stock market performance, so in July that meant the most intense scrutiny was on how much Big Tech is investing in AI.
The reactions to the massive capital expenditures were mixed — Amazon and Microsoft stocks popped, while shares of Alphabet, Apple, and Meta fell — and there were other reasons for sharp volatility during the month. Memory stocks continued to lead the charge, and some speculative investors bet on even more upside by borrowing against their stock holdings or buying leveraged ETFs to further increase exposure.
Take memory companies SK Hynix and Samsung (accounting for nearly half of the entire KOSPI index at their peak), which are domiciled in South Korea. Retail investors invested billions of dollars in leveraged single-stock ETFs of the companies, and they were only introduced in late May.
Leverage cuts both ways, however. Once the AI trade began to wobble in late June, that set off a period of margin calls and forced selling, with volatility in the KOSPI spiking to levels comparable with the S&P 500 during the Great Depression.
This deleveraging cascade reached a crescendo in late July when Situational Awareness Limited Partners, a hedge fund that was highly exposed to AI stocks, was forced to get out of its positions because it had used leverage extensively (at its peak, it was nearly 4x leveraged).
In the short-term, it remains to be seen if any downside remains for AI stocks. The longer-term fundamental story is mostly unchanged, however, as analysts' capex expectations have been revised even higher through 2029. With the benefit of hindsight, we may even look back at this moment and say it marked the bottom.
No Guidance? No Problem, Say the Bond Vigilantes
Amid the upheaval in the stock market, the Federal Reserve was debating what to do on the monetary policy front. In Kevin Warsh's second meeting as Fed chairman, the Federal Open Market Committee left its benchmark interest rate unchanged at a target range of 3.50%–3.75%. But there were several takeaways nevertheless.
For one, though markets had priced in no change — giving it roughly 70% odds – three officials dissented in favor of a 25-basis-point rate hike. Their general thinking was that inflation remains elevated and monetary policy isn't restrictive enough to get it back down to the Fed's 2% target, especially in light of the ongoing AI demand and oil price shocks.
The post-meeting press conference, however, was where things got extra interesting. Just like the June meeting, Warsh noted that officials were united in their fight against inflation and that forward guidance was a mistake in non-crisis situations. But question after question from reporters focused on trying to gauge if or when he might support an interest rate hike — in effect trying to suss out the chairman's so-called reaction function to economic data. He wouldn't say.
Investors weren't pleased with the lack of clarity. By refusing to lay out his thinking, Warsh sparked some doubts regarding his inflation-fighting credibility. Would he actually support a rate hike if conditions required one? Given he was nominated to the chairmanship by President Trump, who has advocated for rate cuts, some suspect the answer could be no. Bond vigilantes got the message, sending long-term bond yields soaring as they priced in higher inflation expectations.
Market Recap
Macro
• The United States and Iran resumed fighting after the prior month's memorandum of understanding fell apart.
• In a 9-3 vote, the Federal Reserve left its benchmark interest rate unchanged at a target range of 3.50%-3.75%.
• Though the unemployment rate declined to 4.2% in June, job growth unexpectedly slowed to 52k.
• Core consumer prices declined in June for the first time since May 2020.
• Oil prices surged 21.7% to $85/bbl, as vessels transiting the Strait of Hormuz plummeted to near-zero.
• Boosted by intervention from Japan's Ministry of Finance in the last two days of July, the Japanese Yen appreciated from a value of 163 against the dollar to 157.
Equities
• Value stocks outperformed growth stocks by 8.5 percentage points, the style's best relative performance since February 2001.
• Energy stocks rose 12.6% in July, the sector's best month since January and second-best since October 2022.
• South Korea's equity market finished July with realized 30-day volatility of 97.8%, easily the most on record and rivalling what the S&P 500 saw during the Great Depression.
Fixed Income
• The 2y-10y Treasury yield curve spread widened from 29 basis points to 44 basis points, as investor inflation expectations rose.
• While 1-year inflation expectations fell from 2.15% to 1.92% in July, 10-year expectations rose from 2.37% to 2.43%.
• Beginning the month at 2.70%, High Yield bond spreads finished the month at 2.79%, while Investment Grade spreads rose from 0.74% to 0.78%.
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