Why are fund managers suddenly terrified?

published 20 October 2016

161020-uk-stocks-b — Fund managers are heavily underweight the UK, which is unsurprising

Sentiment is a tricky thing in markets.

It's something that contrarian investors like to keep an eye on. Contrarians like to invest against the crowd. If the crowd love an investment, you should view it sceptically. If they hate an investment, you should be looking for the upside.

Trouble is, sentiment hard to measure systematically. There are plenty of surveys that try to unearth investors' feelings about the market. But none of them is consistently reliable.

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In truth, price is probably the best measure of sentiment. If the price is going down, people don't like the investment. If it's going up, they do.

However, there is one survey I like to keep a close eye on. It's a monthly survey of global fund managers by one of the big US investment banks.

And right now, these fund managers are terrified

No one likes UK stocks

The monthly Bank of America Merrill Lynch global fund manager survey is one of the few sentiment indicators I monitor regularly.

The BoAML survey shows where big investors around the world are putting their money, and it can give you some interesting pointers as to which assets are overbought and which ones are unjustly neglected.

This month's is a particularly intriguing one. It shows that fund managers are very nervous indeed. The last time they had this much cash in their portfolios other than right after June's Brexit vote was just after September 11th 2001.

Now, high cash levels are usually quite a bullish sign. In the recent past at least, I've noticed that you tend to get high cash readings in this survey after markets have had a bit of a scare.

It's also worth keeping an eye on the most-loathed asset in the survey. Usually what happens is that within a relatively short period, the cash built up during the fearful times gets poured back into that widely loathed sector. Emerging markets and commodities saw this exact effect earlier this year, for example.

But this month's is harder to read. Managers are heavily underweight the UK, which is unsurprising, and also arguably good news for UK stocks, because when an investment is widely hated it doesn't take much good news to turn things around. Sentiment towards the eurozone has deteriorated too. But other than Britain, there's no obviously "detested" market.

As for the reasons that investors are giving for being nervous they're interesting too. There are three main "tail risks" that are keeping managers awake at night.

One concern is a break-up of the European Union. That's an old story, of course. But it's been given some added piquancy by Brexit and Deutsche Bank's share price collapse.

You can see why investors are worried. Big elections in Germany and France coming up next year. Italy having a referendum in December. Britain's Brexit negotiations hanging over the whole thing.

However, it's not clear why this should be the specific, urgent thing driving fund managers to the (cash-stuffed) mattresses right at this very moment.

The US election: Trump is bad, but that doesn't make Clinton good

Another worry is the pending US election. This makes more sense. After Brexit, I can't imagine that any sensible human being is taking any electoral outcome for granted. Markets have pretty much priced in a Clinton victory now, but Trump could still spring a nasty surprise. So it makes sense that you might want to keep some powder dry for that eventuality.

Of course, even if he doesn't, investors might be starting to wake up to the idea that a Clinton administration may not be all they'd ideally want for the US economy, particularly if Trump's increasingly obvious unsuitability for office means she ends up with a landslide.

As David Rosenberg of Gluskin Sheff points out: "Equity investors may have to switch their nervousness from the possibility of a Trump victory and all the uncertainty associated with that, to the growing prospect of a Democratic sweep and the left-leaning, anti-business/market implications of that development."

In particular, he says, financial stocks and the energy sector might struggle under a Clinton administration.

My colleague Dan Denning discusses the US election and the potential threat to the eurozone from Trump in the latest issue of MoneyWeek magazine, out tomorrow (sign up here if you're not already a subscriber).

The biggest threat to global investors

But it's the other big worry that I find most interesting concerns about rising interest rates. As Jonathan Allum of SMBC Nikko points out, fears over rising rates chime with another reading in the survey the trades that managers believe are the most overcrowded.

These overpopular trades are: long high quality stocks (ie all those blue chip, solid dividend, steady Eddie, reliable earnings-type stocks, embodied by the consumer goods sector, for example); long investment grade corporate bonds (another "safe-ish" asset paying a reasonable income); and minimum volatility strategies (a variation on the theme of the first two).

In other words, people are over-invested in "safe", income-generating trades. And the biggest threat to those trades is rising interest rates, perhaps as the result of changing central bank strategies, or caused by rising inflation.

In short, it looks as though global managers are getting jittery that a real change in central bank and government policy is coming. And for once, I think they're probably right.

Societe Generale's Albert Edwards pointed out in one of his regular letters yesterday that a big change has already happened in Japan. It's just that markets haven't quite twigged the significance yet.

"The announcement that 10-year yields [on Japanese government bonds] would be pinned at 0% was a massive change in policy that has not been fully understood by the markets," he says.

This "basically gives the Japanese government a fiscal blank cheque to spend and borrow as much as it likes and if QE needs to be 70trn, or 170trn per year to keep yields at zero, so be it. These are wartime measures and indeed the last time we saw something like this was in the US at the end of WW2 when ten-year yields were capped at 2.5%."

As other governments start to shift towards a focus on fiscal policy rather than monetary policy, volatility will pick up as markets try to figure out where the cards will eventually fall.

So for once, I'd be tempted to follow the fund managers. Make sure you have some cash in your portfolio. You might need it.

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.