Weekly Market Analysis: Beware Consensus Trade in Uncertain Times

A strong US dollar, a hawkish Fed, a slowing world economic outlook and acute European misery are consensus expectations. Speculators and hedge funds have built sizable short positions in non-US currencies, US equities and US bond futures. And similarly, assets around the rest of the world reflect bearish expectations that we cannot measure as directly.

As we have seen over the past two months, consensus market action leads to substantial counter-trend rallies. Equity market rallies during bear markets and rapid falls in developed and emerging market currencies can lead investors astray. They may even convince some investors that the economic outlook has changed even when such an assessment is premature. Things may look cheap or expensive, but neither may be true. CIO’s most recent forecast update estimates the forthcoming economic impact of rapid central bank tightening steps. While CIO is confident the US and other world economies will slow, we need to be mindful of the volatility inherent at this uncertain time. Therefore, it’s important to proceed with caution and discipline in how CIO manages portfolios to protect and build wealth.

CIO sees overbought and oversold global markets in wartime as reasons to maintain the highest quality, income-oriented investments for the present time. And the likelihood CIO will make major changes to portfolio composition this coming year is rising accordingly.

Foreign exchange markets demonstrate the depth and speed of the impacts of war most clearly, Commodity prices also reflect supply developments, security issues and macroeconomic demand. Most recently, Citi has seen a sharp revaluation of the currencies of energy importers (e.g., Euro area, Japan). With central banks competitively raising interest rates to combat the inflation associated with the war, these currency movements are major and impactful. Economies experiencing these combined shocks will see varied responses from policy makers based on their economic pain thresholds. Central banks have not synchronized their policies.

CIO expects the US labor market to peak early in the coming year and for 1-2 million US jobs to be lost. After a very limited gain in labor markets since end 2019, CIO doesn’t expect the drop to be historically large. However, the current path of Fed policy tightening is too extreme for the current economic and inflation outlook. The extreme strengthening of the US dollar is just the latest sign that US policy rates cannot be sustained at the levels Fed policymakers now project.

Portfolio Considerations

Investor positioning is highly bearish, more so for Europe than the US for understandable reasons. However, “deep shorts” and extreme pricing for currencies can make for very volatile markets, with temporary gains and losses masquerading as a new, sustainable trends. In this environment of rapid central bank tightening so fast and historically large that impacts cannot be measured contemporaneously, it makes sense to husband capital and earn income from stable and reliable sources. CIO remains effectively overweight US dollar assets. While CIO is slightly underweight global equities and overweight global bonds, strategists have far higher weightings in US assets than non-US assets. This has benefited portfolios as the US dollar returns of equity markets such as Japan (where CIO is underweight) have been dramatically worse measured in dollars than yen. For many non-US investors, unhedged US dollar bond holdings have added value simply through currency appreciation      

Note: Past performance is no guarantee of future results. Real results may vary.