Traders Tear Up Popular Trades That Reached 'Stupid Levels'

The foundational assumptions underpinning this year's global financial markets are being rapidly reconsidered. In bond and currency markets, investors are swiftly reallocating funds due to growing doubts about the U.S. economic outlook. This uncertainty has led to speculation that the Federal Reserve might cut interest rates more swiftly or deeply than initially planned. A key factor in this shift is the weakening American consumer, evidenced by a series of disappointing corporate earnings reports.

‍

Simultaneously, stockholders are increasingly skeptical about the immediate benefits of technology companies' massive investments in artificial intelligence. This skepticism has prompted a rush to sell shares in major winners like Nvidia Corp. and Broadcom Inc.

‍

Additionally, the prices of copper and other industrial metals are reversing recent gains. The decline is attributed to China's economic slowdown and concerns about the U.S. economy and technology sector.

‍

Even a report on Thursday showing stronger-than-expected U.S. growth in the second quarter did little to ease investors' concerns about the future.

‍

Louis-Vincent Gave, CEO of Gavekal Research, noted in a client memo, “It does seem that an unwinding has begun of popular trades that brought valuations to stupid levels.”

‍

Torsten Slok, chief economist at Apollo Global Management, advised clients that a faster economic slowdown would negatively impact earnings and increase the likelihood of a selloff in stock and credit markets.

‍

Notable Market Movements and Changing Assumptions:

‍

Government Bonds:In the bond market, the bleak global growth outlook is driving bets on rate cuts. Investors are flocking to short-dated securities amid concerns that monetary policy is too tight, anticipating that borrowing costs will eventually decline.

‍

On Thursday, the yield on the two-year U.S. Treasury note was just 12 basis points above the 10-year yield, marking the narrowest spread since mid-2022 and a significant shift from over 50 basis points a month ago.

‍

While the chances of a Fed rate cut at next week’s meeting remain slim, the market is now anticipating deeper cuts later this year. Traders are pricing in about 30 basis points of easing by September, indicating a roughly 20% chance of a significant cut, and more than 70 basis points of cuts through 2024, up seven basis points from Wednesday.

‍

This repricing is also benefiting the yen, which has rallied around 6% from a recent low, the largest gain among Group-of-10 currencies. Investors, who have typically borrowed in the low-yielding yen to invest in higher-yielding currencies like the Mexican peso or the Australian and New Zealand dollars, now foresee a narrowing gap between the Bank of Japan’s benchmark and those of its counterparts.

‍

Stock Markets:U.S. and European equity markets have been buoyed this year by the belief that inflation was under control, allowing the Fed to ease monetary policy later and avoid a recession. By mid-May, the Stoxx Europe 600 Index had reached a record, delivering a 12% return in 2024. The S&P 500 set a record as recently as July 16, with technology stocks leading the charge.

‍

However, many investors now believe that the Fed is lagging behind, with inflation subsiding but the economy weakening too much. Meanwhile, China is already easing monetary policy amid a slump in its economy.

‍

Some market observers predict that the Fed risks making a policy error if it doesn’t cut rates soon and may have to cut more later if it delays.

‍

Nearly a third of S&P 500 companies have reported second-quarter results, and the focus is increasingly on sales figures, where the economic slowdown is becoming evident. Only 43% of companies have exceeded revenue expectations, which would be the lowest in five years, according to Bloomberg Intelligence data.

‍

The AI enthusiasm has also waned. Investors were surprised by how much Alphabet Inc., Google's parent company, is spending on AI with little immediate revenue impact. The Nasdaq 100 Index has dropped more than 8% from its July 10 record, erasing $2.3 trillion in market value. Despite this, the index is still up 13% this year, and a Bank of America survey indicated that investment in the so-called Magnificent Seven stocks was the most crowded trade since October 2020.

‍

James Athey, portfolio manager at Marlborough Group, remarked, “Valuations of mega-cap tech were increasingly impossible to justify with anything but the most heroic forecast for future growth, earnings, and monetary policy. It’s inevitable that these kinds of extremes cannot persist.”

‍

Metals:Growing pessimism about demand and the tech industry is also impacting the metals market. Copper prices have fallen below $9,000 a ton for the first time since early April and are down about 20% from their mid-May peak. Aluminum hit a four-month low this week before rebounding.

‍

Investors who previously bought metals on expectations of tight supply and increased usage in data centers and other sectors are now worried about rising inventories and weak conditions in the Chinese spot market.

‍