John Pattullo: Herd mentality reaches dangerous levels in fixed income

John Pattullo

The market turbulence we are currently witnessing is being caused, at least in part, by the well known herd mentality of the investment community. Herd behaviour comes from euphoria/greed, the fear of being ignorant or panic/loss aversion seeking safety in numbers.

While the technical reasons differ every time in the market, the real reason remains that we are all human. Human nature leads to bizarre trends, such as equities becoming Giffen goods: the more the price goes up the more people want it, presumably finding the higher prices more reassuring of a good investment.

In recent years, ultra-loose monetary policy around the globe has driven investors into taking higher risk. Thus many have piled into the same trades in stocks, bonds, property, currencies and commodities betting on central banks continuing to provide easing measures. This has led to correlated strategies and crowded positions.

Unfortunately, as a result, when one part of the financial market trembles, big ripples form in the other parts. Now quantitative easing seems to be losing its effectiveness. It has been argued the weakness in oil has caused a reverse QE effect: “petro‑dollar” investments are reversing as sovereign wealth funds also exit such trades. It is hard to quantify this but we feel it is material.

The tourists came en-masse

Different asset classes have traditionally appealed to select audiences or investor bases. However, that changed in recent years with investors’ desperate search for returns leading them onto new areas, often without a proper understanding of them. These “tourist investors” spent money with characteristic largesse, creating hefty positions and leaving them vulnerable to sharp reversals if markets hit a liquidity vacuum.

There have been a string of fashionable plays, some of which still exist today, while others have either wound down or are beginning to do so. The list includes long positions in the US dollar, “defensive expensive” equities, high yield debt or contingent convertible bonds, or short positions in the euro, oil, energy, mining and sovereign bonds.

Trade-driven financial crises

The crowded consensus positioning has become a dangerous dynamic, particularly in fixed income, where there is uneven market liquidity and, due to regulations, banks do not have the capacity or the desire to recycle the risks.

When all investors hold the same view, the smallest evidence it could be wrong can create an outsized reaction. Consider both the equity and bond flash crashes of recent years. In the current environment, external influences such as a speech by US Federal Reserve chair Janet Yellen or European Central Bank president Mario Draghi can easily trigger a reaction.

In early February, a new fear gripped the markets: that of negative interest rates. Sweden’s central bank was the first to introduce negative rates in February 2015 but it has been followed more recently by the ECB and the Bank of Japan.

Concerns that central banks are using negative rates as the latest tool to fight against recession and the threat of deflation are spilling over into the banking sector. This is further compounded by the continued flattening of the yield curve.

Deutsche Bank is the latest example, as investors worry about banks’ lending margins and ability of some to shoulder the burden. Fears over the ability of Deutsche Bank to pay coupons on its riskiest bonds (cocos or additional tier one bonds) have not only caused its credit risk to soar and share price to fall but has dragged down most other banks in the process.

Patience and perspective

We prefer to remain patient in the current market, awaiting opportunities to materialise as crowded trades get washed out. It is worth noting some of the crowded trades actually make sense from an economic or fundamental aspect, it is just that the valuations are currently too rich.

Recently we have added duration, a popular short trade for many, and run excessive record cash levels in our funds. We expect a major capitulatory moment, possibly driven by the inevitable devaluation by China or a significant “surprise” default from the energy sector in either the emerging or developed markets (or both). We remain respectful of the timing of the cycle and when this washout happens hope to lock in some attractive yields.

John Pattullo is co-head of retail fixed income at Henderson Global Investors