The market risks fund managers are worrying about

Fears of an AI bubble have been replaced by an even bigger concern among global fund managers: a ‘disorderly rise in bond yields’.

This is according to the most recent Bank of America Global Fund (BofA) Manager survey, a monthly snapshot capturing an in-depth view of the things major asset allocators are nervous and excited about.

It includes many of the biggest asset allocators in the world. A total of 190 investment managers overseeing $512 billion in assets took part in the survey. Among them, 170 managers ($470 billion in assets) completed the global portion, while 87 managers ($211 billion in assets) completed the regional portion.

‘Disorderly’ = chaotic = bad news for equities

Of the respondents, 33% said that a hectic rise in bond yields was their ‘biggest tail risk’, surpassing an ‘AI bubble’ in markets, which dropped from 32% the previous month to 28% in September.

‘Tail risks’ are the rare, extreme outcomes that lie outside of a manager's base case. They’re the things not worrying managers in the day-to-day, but they are keeping an eye on because if they happen it’ll have an all-consuming impact on the market.

Examples of this would be the Covid-19 pandemic. Back in late 2019/early 2020 when reports of coronavirus began to trickle in, few fund managers – or indeed anyone - was anticipating a complete global shutdown, which became a reality just a few months later.

Other tail risks BofA respondents have given in the past include geopolitical conflict, a second wave of inflation, hawkish central banks and the US trade war triggering a recession.

Why bond yields have taken the stage

Government bond yields have risen across major developed markets as investors reassess inflation and interest rate expectations. This is largely due to continued tensions in the Middle East and the impact on the energy and oil prices.

Longer dated bonds in particular – 10 to 30-Year maturities – are the most widely held assets of this ilk, and the yields on them rose ahead of major central bank decisions earlier this month, mainly in the US which is the goliath issuer of these types of bonds.

US-10 Year Treasuries surpassed a 5% yield on the 16 September, about a week after this survey was conducted.

While there are negative implications to bond yields going up – government debt becomes more entrenched – it isn’t an inherently bad thing. The main worry from fund managers is how jarring these swings in the bond market are. The BofA managers weren’t purely worried about a rise in bond yields full stop, but a ‘disorderly’ one, the kind which can send equity markets into a quick tailspin.

James Flintoft, Head of Investment Solutions at AJ Bell, pointed out that it wasn’t just long-dated bond yields that had gone up. Those at the shorter end – two - to three years – had also jumped, where yields remain heavily influenced by expectations for future central bank interest rates.

This has been a very popular part of the market with investors. Analysts anticipate several rate changes from the central banks in the coming months, and short-dated bonds are less sensitive to this type of policy change.

Indeed, short-dated bonds were voted the second ‘most crowded trade’ by fund managers (18%).

Where fund managers think investors are following the herd

‘Most overcrowded trade’ is the area of a market where there are a lot of people holding the same position. Having a lot of money concentrated in one place carries several risks. For one, it can create demand that pushes prices away from fundamental values - this can lead to sharp reversals when the crowd begins to exit.

Being ‘long’ is a term investors use when they believe the share price will go up, the opposite of ‘shorting’ when you expect a price to go lower.

Coming in ahead of short-dated bonds, global fund managers have pipped ‘long semiconductors’ as the most crowded trade for several months now, with ‘long Magnificent Seven’ coming third.

The overcrowded trade claim has been a theory around sectors like semiconductors for some time, as well as US technology stocks and most recently, South Korean AI-darlings Samsung and SK Hynix.

Nvidia and Taiwan Semiconductor Manufacturing Company (TSMC) are the biggest stocks in the semiconductor space, commanding about 63% of the entire global semiconductor sphere.

BofA analysts are still bullish on both companies. They note that following their catchup with Nvidia just after it announced a $105 billion deal with OpenAI, the ‘all in AI’ strategy was reaping rewards now, with the stock up 20% year-to-date, there were risks if the AI demand slows down.

What fund managers are buying

It's not total doom and gloom among fund managers. There are plenty of areas that they do like.

In September, they were most overweight – owning a bigger percentage than the benchmark – global equities emerging market stocks and healthcare.

The latter saw one of the largest increases in fund manager allocation during September. The IA Healthcare and Biotechnology sector had one of the biggest performance turnarounds in the summer, owing to stock specific stories like Moderna, which saw its share price double after incredibly positive results from trials of a skin cancer vaccine and the persistent success of weight loss drugs.