Leverage: Friend or Foe?

Leverage: Friend or Foe?

The last ten days delivered the sharpest test of risk appetite this year, as the crowded AI trade that had powered markets to record highs unwound with remarkable speed. What began as an orderly rotation accelerated into a violent de-risking, culminating in the worst single session for US equities since 2020. Crucially, this was not a story of broken fundamentals as corporate earnings remained strong nevertheless excessive leverage in the system has served as a reminder that the same borrowing that amplifies gains on the way up can force indiscriminate selling on the way down.

The episode put leverage squarely in focus. As AI valuations came under scrutiny and financing costs rose, crowded positions began to be cut, and the selling fed on itself. Hedge fund net leverage fell to around 47%, near the low end of its historical range, with institutions reportedly reversing much of the AI exposure built up since 2025 in a matter of days. Several highly leveraged strategies were forced to liquidate positions to meet margin requirements, the classic mechanism by which a concentrated, crowded trade becomes a disorderly one. Importantly, the fundamentals have not cracked as around 80% of companies beat earnings this season, with S&P 500 profit growth tracking near 27% for Q3. Hence someone can assume that this recent market move was a positioning and de-leverage event, not an outcome of weak earnings.

In terms of market moves, the sell-off was steep. The S&P 500 fell 4.4% in its worst day since 2020, and on a separate session the Nasdaq 100 index dropped around 5%, with the largest technology names collectively losing roughly $1 trillion in value. The epicenter was the AI complex with chipmakers and data-center names bore the brunt, with Nvidia falling over 7% and some semiconductor peers down 14-15% in a single session. The move was amplified by stretched valuations and the sheer concentration of the market in a handful of names, but tellingly it had the hallmarks of forced deleveraging rather than a fundamental repricing.

Away from equities, the reaction was constructive. Gold, after a sharp pullback below $4,000 earlier in the week, rebounded above $4,100 as investors sought safety, while expectations for a December Fed hike faded as the equity turmoil raised the prospect of a more cautious central bank. The US 10-year Treasury yield eased back toward 4.85-4.8% context as some demand returned to bonds. Oil was volatile, with Brent swinging nearly 9% lower on one day before recovering toward $97, buffeted by ongoing Middle East uncertainty. The dollar was firm, leaving EURUSD on the back foot, wrapped around 1.1187.

On the political front, the US midterm elections on 3^rd of November were a notable event. The results pointed to significant Democratic gains, and while the initial market reaction was a relief rally, attention quickly turned to the policy implications. Concerns that a shift in the political landscape could increase scrutiny of, and potential opposition to, the rapid datacenter and AI infrastructure build-out, that has underpinned the technology rally. We should note that the under-performing sectors in the equity market portrait the above concern in a very distinct way and in our view, overreacting as of now.

In Europe, markets were dragged lower in sympathy, with technology and defense names leading the declines and the Euro Stoxx 50 easing from its recent highs. French government bonds remained a background concern amid the country’s ongoing fiscal and political strains, though the stress stayed largely contained. The ongoing US government shutdown, now among the longest on record, continued to delay official data, leaving investors to navigate the turbulence with reduced visibility.

On the corporate side, the earnings backdrop remained reassuring beneath the market noise, with many companies beating expectations and the broader economy showing resilience. The debate is no longer whether AI demand is real, but whether the pace and financing of the investment are sustainable and whether valuations had simply run ahead of themselves. With the recent drawdown, there is scope post all deleveraging events, for a potential rebound given the resilient fundamentals.

Looking ahead…

The key question is whether this was a healthy, leverage-driven cleansing of an overcrowded trade or the start of something more durable. With positioning now far lighter and net leverage reset, the conditions for stabilization are arguably in place, provided earnings continue to hold. The December Fed meeting (8-9 December) and the resolution of the shutdown remain the key macro swing factors. Encouragingly, the seasonal backdrop turns supportive from here, with November and December historically among the strongest months for equities and the year-end “Santa Claus” rally approaching. Our base case into year-end remains constructive, but the past ten days are a timely reminder that leverage cuts both ways. Have a good weekend.

Written by: Michael Konstantinou, Head of Portfolio Management