Despite most major equity indices being in the black so far this year, under the surface, explosive geopolitical conflict and volatile AI trades have left their mark.
In absolute terms, most major equity markets have delivered double-digit sterling returns, with even the worst performer (Euro Stoxx) still up 7.1%. But in terms of maximum drawdowns, investors’ potential for loss this year if they bought and sold at the worst time is approaching five-year highs.
Four of the seven markets in the shortlist above have reached their highest maximum drawdown since the end of the pandemic (2022), while the three remaining are at their third highest level in the past five years. The MSCI Emerging Markets index, for example, is only a one percentage point improvement compared with 2022.
So while volatility and short-termism in equity markets are hardly new, for David Coombs, head of multi-asset at Rathbones, current levels look particularly extreme.
“The market has become even more short term, and I didn’t even think that was possible.
“I sit here as a risk manager, and I just think it’s nuts,” he told Portfolio Adviser. “I literally feel like I’m sitting in a casino.”
Active, long-only equity strategies have essentially become a minority in global market movements and trades, he explained, increasing the already heightened market volatility.
“When I was learning investment, you could pick a blue-chip portfolio of 25 stocks, and it’d be seen as not very high risk,” Coombs said. “The world’s moved on from that.”
For example, huge stocks such as Micron or SK Hynix, with hundreds of billions in assets, can move double digits per day, which he said is extraordinary compared with how he started. Instead, he argued that market risks are shifting much more rapidly, as sentiment rotates from AI winners to AI losers seemingly on the back of small changes in news flow.
Just last week in the US, markets went from relatively sanguine after the ‘blue wave’ in US midterms to tech stocks selling off rapidly owing to fears of increased regulation.
See also: Markets mount fragile recovery from AI sell-off as Nvidia CEO scandal looms
“I just think you need to be prepared for more and more savage rotations as the sentiment goes from AI is all win to AI is all lose and so on,” Coombs said. In this market, he added it is important to remember that an investment manager should aim to manage risk.
“I’ve always called myself a risk manager first, and that’s because if you don’t get the risk right, you can forget about the returns.
“What you’ve got to do is manage risk, and the key point in all of that is that risks change,” Coombs said. “People talk about correlations and volatility, and it’s almost always backwards-looking and assumes risks are constant, but they aren’t.”
This is the challenge facing modern portfolio construction, and it means managers need to be more innovative and adaptable in terms of positioning. Coombs explained that in the first six months of the year, the team made around 4,000 trades across the 20 multi-asset portfolios to manage this.
“It feels to me that I’ve probably changed more names this year than ever before,” he said. “You can’t stand still as a fund manager.”
For example, investors cannot rely on traditional assumptions about what a defensive stock or sector is, because risk dynamics have changed so fast that traditionally “defensive” assets are arguably not fit for purpose, he said.
“I asked during our weekly meeting, what is defensive anymore? People told me utilities or consumer staples,” Coombs continued. “I don’t think they are anymore, particularly.”
For an example in one of their own holdings, Coombs pointed to Wisconsin Energy Group. Popular portfolio theory, he said, would see this as a core, defensive holding as a utility company. However, in modern markets, it’s essentially a way of playing AI because it builds data centres for Microsoft, he said.
By contrast, a stock such as Apple now seems to be more defensive, despite being “ridiculously expensive”.
“Apple ironically behaves like a defensive stock, because it outperforms when AI is out of favour,” he said. “That’s because it’s not seen as an AI player and it doesn’t have a lot of large language models, so if AI is not as important, Apple does well.”
See also: What are growth stocks doing in your value index?
Coombs added that even fixed income, which had been out of favour since 2022 when the negative correlation between bonds and equities broke down, now looks appealing again, because investors can get 4-5% for holding them.
This means the risk-reward has shifted compared with four years ago, a trend which Coombs argued most modern models “are not necessarily picking up”.
“So, what’s defensive anymore? Well, it depends on what you’re trying to be defensive for, doesn’t it?” Coombs said. “There’s no such thing as a safe haven, because it depends on what your problem is.”
