Risk-on sentiment has dominated markets in a post-Brexit world characterized by expectations for lower-for-longer interest rates. The result? Certain investments have become very popular, and investors will want to tread carefully and be selective.
The chart below shows where the crowds are, based on an analysis of fund flows, fund positioning and price momentum. Postions with scores between 1 and 2 (and -1 and -2) are considered as popular, and those with scores above 2 (and below -2) as very popular. The higher the score, the more popular the overweight is. The lower the score, the more popular the underweight is. The most popular investments today: overweight U.K. government bonds (gilts), emerging market (EM) sovereign debt, developed market credit and gold, as well as underweight eurozone equities.
Managing risk is key
Investment popularity does not tell us much about the direction of returns over the long run (i.e. the next 12 months). In fact, many of today’s consensus trades could be long-term winners as low economic growth and low interest rates persist.
Yet some popular positions are approaching extreme levels (scores above 2 or below -2), which can be seen as an important signal of short-term risk. These positions may be vulnerable to a market shock or rising volatility, especially when combined with high valuations. It’s crucial to manage this risk by being selective.
Reducing popular positions where prices have moved beyond fundamentals (examples are gilts and bond-proxies such as utility stocks) may be beneficial. Resisting taking contrarian positions in sectors facing big structural challenges (e.g. European banks) may also be productive. But popular overweights with supportive fundamentals and valuations (such as EM debt and U.S. credit) are still worth considering, and gold can offer portfolio diversification benefits. More than $8 billion has flowed into dividend equities since the Brexit vote, according to EPFR, and we prefer dividend growth over dividend yield. An overweight EM equity position doesn’t appear popular despite recent inflows into the asset class.
Bottom line: Be mindful of the short-term risks embedded in consensus trades, and look for potential opportunities the crowds haven’t yet reached.
Build on Insight, by BlackRock written by Richard Turnill