Multi-Asset Solutions Weekly Strategy Report
Global markets and multi-asset portfolios
- From a portfolio perspective, exposure to tech winners in U.S. equities is not a free lunch. The same growth stories that prompted outsize U.S. equity returns in recent years and a faster recovery from the COVID-19 shock make the U.S. a higher volatility, higher beta market, at least for now.
- The shift is a symptom of rising market concentration, which reflects the potentially powerful influences of investor crowding, swings in sentiment and high valuations, along with business fundamentals.
- We still score U.S. equities as an overweight, and like its tech exposure in combination with cyclical equity markets including emerging markets and Europe.
- Given the S&P 500’s reduced defensiveness, and the fact that bond yields are pinned down by monetary policy, it has become more difficult to find effective portfolio hedges.
A new role for u.s. equities in multi-asset portfolios?
In recent years we have been hard-pressed to underweight U.S. equities in our multi-asset portfolios. When global markets are on the ascent, the S&P 500 rarely lags other regions and oftentimes leads. At the same time, it has historically been a relatively high quality and low beta index, suggesting a degree of defensiveness in a downturn. The U.S. has thus been an attractive market both from the perspective of its underlying economic attributes as well as portfolio diversification.
Has rising stock market concentration upended this unambiguous support for U.S. equities? Concentration is certainly an acute issue in the S&P 500, which has seen a huge rise in the proportion of its value accounted by just a handful of megacap tech stocks — precisely the area of the market that sparked equity volatility over the past few weeks. In our view, acknowledging this higher concentration and volatility requires an increasingly balanced approach to investing in the U.S., one weighing the market’s leverage to long-term growth stories against its more limited defensive characteristics.
A vulnerability of concentrated markets: Tech-driven volatility
This year’s U.S. market outperformance and its faster recovery from the March lows has largely reflected the strong performance of a small band of popular winning stocks. Before the volatility that began in early September, the top five largest stocks in the benchmark U.S. index accounted for around a quarter of its total value — an all-time high. Their shares at that point had risen by over 50% year-to-date, while the overall market had gained just 11%.
Without taking a view on whether or not these share price gains were fully justified by long-run business fundamentals, we believe this rapid rise left the overall U.S. market heavily exposed to any change in investors’ bullish view on these stocks. And while today’s U.S. tech champions have successful and highly profitable business models — many growing their profits throughout the COVID-19 crisis — the extreme investor crowding has stoked valuations that seem at least superficially very high, leaving stock prices vulnerable to swings in potentially overheated investor sentiment.
Exacerbating the issue has been the role of equity derivative markets in the U.S. tech- stock run-up. While U.S. tech stocks had moderately outpaced other regions’ tech sectors for much of this year, this outperformance accelerated markedly in the latter half of August, before sharply reversing in September. The tech stock gains seemingly coincided with increased buying of bullish exposure through equity options (market participants continue to debate the extent to which this was driven by a new wave of retail investors or increased institutional activity in the space). The surge in options trading also at least partly explains the odd phenomenon of a strongly rising equity market alongside metrics of increased implied volatility, driven by options market pricing. This was not just a U.S. occurrence, but it was more pronounced in the U.S. market and at this point, headline volatility metrics remain elevated compared with other regions (e.g. VIX at 26, vs. the Eurostoxx V2X at 22), and even more so in the tech-dominated Nasdaq (VXN at 35%).
To be sure, this is not the first time concentration has become an issue in the U.S. market. Many investors recall the late 1990s tech bubble and, back in the 1960s and 1970s, the “Nifty Fifty” group of expensive large cap stocks that dominated the U.S. equity market. However, the current degree of concentration exceeds both of those episodes. More ominously, perhaps, neither of the earlier periods lasted, and in both instances extended valuations were forced to unwind — pretty spectacularly when the tech bubble burst in 2000.
A benefit of concentrated markets: Exposure to winners
The bright side of market concentration is that it gives equity winners an unimpeded run. A subset of the tech winners, and a very concrete example of how concentration differentiates markets, is the S&P’s exposure to virtual lifestyle stocks. Our recent research on working from home (WFH) attempts to quantify both the size of the economic trend and the gearing of financial markets to it.1 The primary effect of WFH for equities is a tailwind for companies that provide the hardware and software tools to enhance home productivity (e.g., computer hardware and software, semiconductors and electronic components, cable and telecommunications, consumer digital services); ancillary services (e.g., cyber security, industrial REITS, professional business support) and other beneficiaries of the spending reallocations that result (e.g., home improvement, household furnishings and appliances, electronic entertainment, delivery services).
The relative losers are predominantly those in sectors where spending is displaced by the changes in economic activity (e.g., office and retail REITS, automobiles, energy and industrial materials, airlines, tourism, hotels). Adding up the market weights of the industry winners and losers illustrates the significant concentration of economic exposures in the S&P 500, and also the large disparities in those exposures across markets (Exhibit 1).
EXHIBIT 1: EQUITY MARKET EXPOSURES TO THE ‘WORKING FROM HOME’ (WFH) THEME