There is always a good reason not to invest.
That might seem strange coming from the Director of Research of The Motley Fool – a company that consistently preaches the benefits of long-term investing.
But it's true – there is always a reason not to invest. Which, ironically, is the same as saying there is always a reason to invest as well.
Every market condition, every piece of news, and every economic indicator can be seen as both a risk and an opportunity. The key is to focus on the long-term potential rather than getting caught up in short-term fears.
The latest 'scare' came late last week, and stretched into this week as well. Weak jobs data and murmurs of a potential US recession.
Indeed, that in itself could have pushed the market either way, at a time where bad economic news is often treated as good news. As backwards as that might seem, the rationale is that bad economic news could entice central banks – including the US Federal Reserve and the Reserve Bank of Australia – to cut interest rates, which would be good for business and consumer spending and, typically, good for share prices. When the 'R word' (recession) is also thrown in, though, it can often cause the market to panic.
But bad economic news aside, it was arguably the 'carry trade' that stole the show. This is something that many ordinary investors probably don't understand too well, with that uncertainty adding to the panic being felt.
What is a carry trade?
Imagine that your friend offers to lend you money for free. At the same time, another friend says he needs to borrow money from you, and is willing to offer you 5% interest for your trouble. You could borrow money from your first friend for free, and then make a 5% return by lending it to your other friend. You could make 50 cents by borrowing, and then lending, $10, or you could make $50 by borrowing and then lending $1,000. The more the merrier.
That's a really, really simplified explanation of a carry trade. And of course, it's much more complicated in the real world. But the point is, a carry trade is when an investor is able to borrow on the cheap from one party, and invest at a higher rate of return with another. The 'carry' is the difference in interest rates between what you pay, and what you get.
Snapping back to reality, in this case it was a country, Japan, that offered ultra-low interest rates. In fact, the country's interest rate had been negative 0.1% until earlier this year, before which it had sat at roughly 0% since the late 1990s (talk about cheap!).
Then, on 30 July 2024, the Bank of Japan increased interest rates for the second time since 2007, to around 0.25%.
Source: Trading Economics
Compare that to the United States, where the federal funds rate is at a two-decade high of 5.25% to 5.50%, as seen in the chart below.
Source: Trading Economics
In the real world, currency exchange rates take much of this interest rate differential into account, so it's not as simple as borrowing at essentially 0% and investing at 5.5%. The potential returns are typically far less than those numbers suggest, which is how markets should work: the 'arbitrage' opportunity is essentially erased.
But there is the potential for some return – albeit typically a small one. And when the percentage return is small, you need to invest large sums of money to make it worthwhile. While that typically rules out ordinary investors, hedge funds and other large entities can borrow huge amounts of money (whereby a small return on a large sum of money can still generate pretty considerable gains). This is an important point: leverage is what makes the carry trade work.
Now, in this situation, investors were likely surprised by the fact that Japan raised interest rates. It had, after all, only increased rates one other time since before the Global Financial Crisis. When it raised rates, even to just 0.25%, the spread between Japan and the United States (and other markets) was narrowed, erasing much (if not all) of that profit potential. Because leverage had been used, in essence there would have been margin calls issued, whereby 'borrowers' of Japanese yen would have been forced into selling assets to make repayments.
Forced selling pushes down prices, which can lead to more margin calls, which can lead to more forced selling, and so on, as the vicious cycle continues.
It seems that the Bank of Japan has eased some of the fears raised, after it 'walked back' talks of further interest rate increases, at least while the market is unstable. That, in turn, has led to some relief on markets around the world.
Which takes me back to my earlier comments about there always being a time not to invest. This was just another example of that. You could easily justify waiting out the uncertainty, and investing after that. But you can be sure there'll be yet another reason not to invest even when that uncertainty eases: maybe something else around the world is causing unrest, or perhaps it's because you've just watched share prices rebound strongly, and you tell yourself "I'll wait until shares are lower again" (and if they're lower, chances are they're lower because of something else that has caused uncertainty!).
Hopefully, you get my point by now.
At The Motley Fool, we're very focused on the long run. That's not to say that we don't care about what happens in the economy, nor that we don't take that into account when we analyse our businesses.
But it is to say that we do our best to look beyond those worries, and understand that the market has consistently gone up over time, despite those temporary shocks. Wars, changes of government, interest rate hikes, recessions, you name it… life goes on and years later, we often see these incidents (however bad they felt at the time) appear as mere blips on the historical stock charts.
In other words, there is always a reason to be invested!
Fool on!
