Is this the beginning of the ‘big unwind’?

Is this the beginning of the ‘big unwind’?

Market participants had largely normalised the exceptional distortions that have characterised financial markets since the Global Financial Crisis (GFC). Until the first week of August, that is. What set off the latest bout of market jitters, and outright fear that sent the CBOE Volatility Index (VIX) spiking to 65% intraday on 5 August 2024, is still a subject of debate. The Bank of Japan raised its policy rate to 0.25% on 1 August, and the US Bureau of Labour Statistics released weak unemployment data on 2 August, but ordinarily, neither of these developments in isolation would be expected to cause the level of market disruption we have seen in response. For context, the other two major spikes in the chart below were caused by the GFC and Covid-19 pandemic respectively.

However, on the basis of somewhat mundane news, the VIX delivered its biggest intra-day swing – ever. What is going on, and is it simply a matter of the Japanese yen carry trade unwinding, or alternatively due to various derivative trades that can exacerbate price moves (depending on whose view you subscribe to)?

VIX Index

Source: Bloomberg

We believe the wild moves we have seen in markets are symptomatic of large imbalances in global financial markets unwinding, exacerbated over the short term by extreme positioning. We have argued for some time that easy money policies, together with a misallocation of capital, a mispricing of risk and excessive speculation, created persistent distortions in global markets in the post-GFC world, even before the advent of large-scale fiscal stimulus following the Covid-19 pandemic.

These long-lived imbalances have been normalised to a large extent by markets, and have even fed on themselves as momentum and passive investment strategies have continued to drive up prices beyond what we would consider to be normal for market cycles. This has been exemplified by the extreme exuberance we have seen in artificial intelligence (AI) stocks and exceptional levels of market concentration, as well as the ever-increasing dominance of US shares in global market indices.

With or without the advent of a US recession, we believe the unwinding of these imbalances is all but inevitable as we move from a world of ‘easy money’ to a capital-scarce one marked by higher long-term interest rates. However, most investors are ill prepared − not only for the bumpy period of recalibration we are likely to see in markets, but also for the very different environment that we anticipate will emerge thereafter. We have written extensively on why we expect inflation to be higher and more volatile than in the post-GFC period, the challenging fiscal situation in the US in particular, and the potential impact of these factors on investment outcomes going forward.

In a world where money is cheap and abundant (exemplified by easy monetary policy and low interest and inflation rates), shares with high potential levels of future earnings growth have been preferred to shares that are likely to deliver substantial near-term cash flows. As capital becomes scarce and more expensive, however, the bar for speculative assets rises, and investors tend to favour those assets with high free cash flow and dividend yields. In this world, markets are no longer prepared to pay a premium for (uncertain) future outcomes, and prefer to reward more reliable near-term performance.

With the assets that have done well over the past decade having increased their dominance in indices, many investors are unwittingly beholden to the strategies of the past, especially those who have favoured passive investment strategies. These investors are potentially in line for a double whammy, having paid dearly for assets that are set to struggle in a very different environment to the one they thrived in previously, and also having limited exposure to the kinds of assets which we believe will do well in the future.

What can investors do to protect their portfolios at times like these?
We find clues to what could do well in a future marked by inflation and capital scarcity by taking learnings from the past, and by seeking to understand where supply dynamics (which are far more predictable than demand indicators given often long lead times) can work in favour of investors. We believe selected opportunities exist in some investment-starved sectors of the real economy, which also tend to benefit from an inflationary environment. Importantly, in terms of our proven 3M investment process, we prefer to invest where these opportunities are found in deeply out-of-favour or underappreciated areas of the market, where we can buy them at a substantial discount to fair value. These opportunities are by their very nature underrepresented in indices – and thus we believe the future is bright for independent-minded stock pickers who are able to construct portfolios that look different to the benchmarks.

Diversification will always remain key, but investors should note that some safe-haven assets of the past may not provide as much protection as they would “normally” expect – as was seen during the simultaneous retreat in global developed market bonds and equities in 2022. Going forward, we believe a truly diversified portfolio will have to look beyond simply tweaking allocations to equities and bonds, especially if the holdings of these assets are passive or similar to indices. Protection in an inflationary environment may come from unexpected sources, like owning select resource shares and gold.

We do not expect the recalibration in markets to proceed smoothly, or uniformly. Markets may regain some of their lustre and those sectors that have done well over the last decade may well power ahead again, but the distress signals are becoming ever harder to ignore. Investors will have to be deliberate in constructing portfolios suited to the challenges we believe lie ahead. And partnering with investment managers who can seek out differentiated opportunities in the market, rather than simply replicating benchmarks, will be key.

John Gilchrist is the Chief Investment Officer at PSG Asset Management.