Crowded trades and the challenge of volatility
One of the more interesting and powerful implications of the pandemic, relating to investment markets at least, is the velocity at which every new piece of news or data is priced-into markets. We only need to look back at the events of March and April 2020 to be reminded that we experienced both the fastest fall and recovery in sharemarkets the space of just a few weeks.
The proliferation of data and information, along with the so-called “democratisation” of investments that the digital economy has supported, has truly changed the way we look at investments. This has had both positive and negative implications for the market, with the latter identifiable in what are being termed as “crowded” trades. Crowded trades are those that quickly become popular to the masses and inevitably result in over-valuations or bubbles in various parts of the market. While intuitively these ideas make sense, they tend to result from the extrapolation or assumption that short-term trends are likely to persist in the future.
One such trade in the last few years was investing into the fastest-growing technology companies, but those that were not making any profits. As the funds exposed to these companies outperformed, they naturally attracted investors lured by “fear of missing out” (FOMO), yet the trend quickly turned in 2022 as the Federal Reserve decided it was time to combat surging inflation around the world.
The “crowded” trades quickly switched to lower-quality, cyclical businesses, primarily commodities and energy-related, which despite strong performances in the short term, amid an energy crisis of historical scale, appear likely to dissipate in the months and years ahead. This narrative or popularity-driven approach to investing makes it extremely difficult for any investor, professional or DIY, to keep their head and stay on course.
The most popular parts of the technology sector have lost about US$2 trillion in market value in 2022 alone, with as many as half of all companies listed on the popular Nasdaq exchange trading at less than 50 per cent of their previous high. In fact, in some cases, companies are trading more than 70 per cent below, with the popular Buy Now Pay Later sector in Australia a popular example. There was a similar case in China, albeit a reverse, in that the perceived threat of China ‘doing a Russia’ and invading Taiwan, sent the domestic market down as much as 30 per cent in just a few weeks.
The velocity at which the market is moving tends to make even the most patient investor feel like they must make changes to their portfolio to either protect or grow. Yet in most cases, taking action in response to surges in volatility are the polar opposite of what should occur. Case in point, was the fact that the S&P/ASX200 managed to recover losses of as much as 15 per cent during February to finish slightly higher for the March quarter. Therefore, those who felt forced to act to ‘protect capital’ once again did the opposite, capitalising losses.
One of the more concerning areas of perceived ‘certainty’ lies within interest rate and bond markets, where market experts and economists continue to predict doom whilst second guessing the actions of central banks that have been central to smoothing the business cycle for close to three decades now. This refers to the so-called ‘pricing in’ of rate hikes, despite both expert predictions and the yield curve itself having consistently proven to be very poor predictors of the future.
Interest rates to drive markets
If you don’t read the financial press, you may not be aware that global government bonds have just experienced their worst selloff in history. The Bloomberg Global Aggregate bond index has fallen 7.3 per cent over the last 12 months and is 11.2 below the levels of January 2021. This means for those holding portfolios of long-term government bonds, they have suffered significant capital losses on what are perceived to be low risk assets.
The driver has of course been the decision by both the Federal Reserve and Bank of England to commence the process of raising interest rates in their economy. Whilst experts suggest this is to directly combat inflation, most evidence has shown that it is in fact pandemic-related supply chain and labour issues that have been the key driver. Hence central banks are approaching the process from the viewpoint of ensuring they do not contribute to already higher inflation by keeping policy too expansionary for too long.
A major question, however, is what happens when the price of energy retreats, dragging inflation lower with it, likely at the same time that both governments and central banks are withdrawing support from the economy. Is there a risk that a policy mistake sends the global economy into recession? Definitely.
While we would suggest that the reversal of globalisation is overstated, as is the threat of USD$200 per barrel oil, all of these risks must be considered and accounted for within portfolios. It is clear that the ‘emergency’ interest rate settings of the last few years are gone, but what is not clear is the rate at which they will be reversed and the implications this will have for different economies. The latter point is among the most important, as not every country, sector or company reacts in the same way to a higher cost of capital. This is evidence by the significant divergence across the sectors of the Australian sharemarket:
