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The author is a senior advisor at Engine AI and Instada and a former Chief Global Equity Strategist at Citigroup
It’s easy to blame President Donald Trump for his recent convulsions in global financial markets. But remember that such set-up events are regular events. The S&P fell by about 20% in 2022, but the world wasn’t over. It fell almost 10% last summer. This is a set that most market participants have already forgotten.
My point is that even with catalysts, the surge in market volatility is not a surprise. This time, you can either blame Trump, or rates rise in 2022, or rewind the Japan carry trade last summer. Financial markets could drop faster. Get over that.
But that doesn’t mean there’s no “pain deal.” The decline in asset prices is first accelerated by excessive leverage and then accelerated. As popular strategies in good times become more crowded, their underlying returns decrease. The only way to continue streaming is to add leverage.
However, these winning bets could quickly change into the next pain trade. Initial losses and rising volatility create so-called margins and seek more collateral. If an investor cannot post any extra capital, the lender will settle his position. Stop Loss – Vending Trigger Points – Exaggerate Doom Loop. This continues until excessive leverage is cleared. The market then rebounds. However, anyone who picks up a penny that gets too close to the approaching steam roller will be crushed. Since winning the Trump election last November, the market has followed this familiar pattern.
So, where is the pain this time? Higher volatility has whipped CTA funds chasing the momentum of CTA funds. This is a sector that draws its name from its roots with strategies pursued by product trading advisors. The Socgen Trend Index, which reflects performance, has dropped by almost 10% to date.
Rumors of big losses by hedge funds employ the infamous “basic trade” strategy that seeks to profit from slight differences in prices in the US Treasury and related futures contracts.
Elsewhere, long-term equity hedge funds have fallen into an even longer position as markets recovered after the US election. However, according to Morgan Stanley, they reduced their net leverage from 50% to 37% of market turmoil following Trump’s “liberation day.” The latest pain deal is a rapid valuation of Taiwan’s dollars, which appears to have caused confusion among the island’s life insurance companies.
Building a basic narrative about this movement in financial markets is always fascinating. Asset prices collapsed as investors set prices on the effects of Trump’s tariffs and threats on the independence of the Federal Reserve. They recovered when the president rowed back.
Certainly there are many stories of the fall market blinking him. However, we consider these short-term asset prices to be more technical, reflecting the inevitable pain among leveraged strategies at the time of rising volatility. “Traders have moved on to Trump’s latest announcement.”
It is too early to say that the market is priced the long-term economic implications of Trump’s policies, especially since they really don’t know what these policies are. Well done enough to buy a recent dip for all you smart (or lucky) people. The S&P 500 is currently up about 14% from its recent low. But remember that your profits came from buying distressed sellers rather than the basic view that Trump’s policies are good for the market. It’s too early to make that call.
When leveraged speculators shake up, the short-term pain trade usually disappears. But the long term can restructure the entire investment environment. For example, the 2000-03 Bear Market caused a major loss to the UK pension fund, which is encouraged by well-intentional law, which fundamentally reduced the weight of domestic stocks.
Where is the long-term pain trade brewed now? One candidate is private equity. Investors in this asset class used leverage to buy companies with the understanding that they could sell in 5-10 years, but traditional exit routes are largely closed. Their lenders won’t force PE companies to sell, but their final investors are in a panic. This will not turn into a short-term car accident that is so familiar to the open market, but slow-motion train wrecks are still a clear possibility. After all, pain trading isn’t just for traders.
