Over the last six months, I have been considering portfolio construction in this (potentially) new environment. The discourse in the media appears to have changed, with volatility lifting substantially. However, is the current environment, in fact, different from recent history? What does this mean for investors, if anything, and what adjustments may be necessary to navigate it? How do portfolios typically look today, and what risks may have been unintentionally increasing? In this two-part series, I will examine the risks I believe have accumulated in portfolios and discuss potential ways to mitigate them.

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In this first article, I will seek to outline the potential risks that have crept into markets as they have evolved over the last 10 to 15 years.  

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Before articulating these potential issues, it is worthwhile exploring recent history to understand the macroeconomic environment that has driven markets over the last decade.

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What drove investment returns over the last decade

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Despite the post-COVID inflation spike, multi-asset portfolios have delivered strong returns over the last decade. The key contributor to this performance has been the exceptional returns generated by equities during this period, anchored by the “Great Moderation”. This period was characterised by ever-moderating inflation and volatility pressures. The subdued inflation pressures and relatively weak growth allowed monetary authorities across the developed world to reduce interest rates progressively. Against this backdrop, we also witnessed the emergence of (very) unconventional monetary policy. As markets and economies weakened, central banks became more comfortable implementing Quantitative Easing in its various forms, believing such actions were unlikely to reignite inflation. Over time, central banks became seemingly reliant on QE to pump prime any actual (or perceived) market or economic disruption, eventually leading to the unprecedentedly low interest rates experienced during the COVID period. By then, QE had well and truly entered the common vernacular, moving away from its previously hidden academic origins.

The largest beneficiary of the Great Moderation was equities. The ever-declining discount rate, most commonly the 10-year Government Bond rate, was a huge positive tailwind for equities, particularly Growth stocks. As interest rates moved ever lower, the earnings multiple investors were willing to assign to stocks continued to increase. Fundamentally, as interest rates decline, so does the discount rate applied to price future or expected investment cash flows. As the discount rate fell, this provided scope for the market to bid up asset prices. This process was true of both stocks and bonds.

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A factor further aiding the market's ability to drive valuations higher was the view that central banks had investors' backs and, at the first sign of any weakness, would pour liquidity into markets to support prices. Much like Pavlov’s dog, the market learnt to react to these signals, buying the dip whenever there was a hiccup, further exacerbating the price level investors were willing to push markets to.

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Central Bank support also obstructed the creative destruction process. In an economic regime where support is provided at the first sign of difficulty, overleveraged and poor business models can remain solvent. This process provides a veneer of stability to the economy, where there may be inherent structural weaknesses.

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Finally, Technology stocks received a strong boost during COVID-19 due to the rapid adoption of technology to facilitate isolation requirements across our daily activities, including work. This led to the arrival of the “Magnificent Seven,” a group of seven technology stocks driving a sizeable portion of the market uplift. The arrival of the Artificial Intelligence (AI) mania further exacerbated investors’ demand for technology stocks.

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The process outlined above evolved over a long period of time. While there have indeed been market drawdowns since the GFC, each has been relatively short-lived. The underlying positive influences described above have supported the market in quickly realising new highs.

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Equity Performance is illustrated using three common equity indices to 31 March this year below:

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• MSCI All Country World - 11.08%

• ASX 300 - 7.15%

• MSCI EM - 5.84%

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It should be noted that the above also includes the large drawdown witnessed in 2022, during which the S&P 500 declined by 19.4% and the local All Ords fell by 7.2%. Using only a decade of returns, I have also explicitly removed the strong market uplift witnessed post-GFC from mid-2009 onwards as Central Banks threw the kitchen sink at markets and the global economy to stave off a potential economic depression.

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The Building Risks

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Despite these strong returns, risks have been slowly building across the market. These are subtle, though important, changes that investors should at least be aware of. Recent market volatility has illuminated some of these concerns.

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The two main risks I see are the current highly concentrated nature of the equity indices and the subsequent factor loadings that this has introduced into equity indices. These factors, combined with the perception of a new, perhaps more volatile economic regime, may pose an increasing risk to portfolios. This has been highlighted by the market action witnessed over the past two months.  

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Concentration Risk

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The last time I remember concentration levels similar to today’s was during the dot-com boom. As the dot-com boom unwound, there were major implications for investors, especially those heavily invested in the technology and telecommunications sectors, which had grown to a substantial proportion of the Index.

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However, I am more than willing to admit that there are considerable differences between today and the dot-com era. First of all, today’s tech companies are profitable, and in many instances, very profitable. This is demonstrated in the graph below, from the T. Rowe Price website.

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If margins (and hence profitability) have grown this strongly, the argument follows that some of these companies deserve the high earnings multiples (P/E ratios) assigned to them. This may be true, though I will not argue whether current valuations are justified. I want to highlight that as these companies have grown in size, so too has their impact on the indices within which they reside. Also the style or factor loadings within the index have changed over time in line with the growth in the tech sector.

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Global Equity Indices have thus become far more growth—or momentum-oriented. Many will also highlight that the indices' “Quality” has improved, which is true as these companies are highly profitable with strong and increasing profit margins. Quality is another factor investors typically ascribe to an investment style.

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I didn’t want to delve too far into styles/factors other than to say that Investment factors are the fundamental, persistent drivers of risk and return across asset classes. Factors can be considered systematic characteristics or market exposures that drive the risk and return profile of a broad set of securities. They represent a source of systematic (non-diversifiable) return historically rewarded by markets. This can include Value and Quality. For those who wish to extend their knowledge on this subject, many articles have been written that discuss the Fama and French Five-factor model, which builds directly on the Capital Asset Pricing Model (CAPM).

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The rest of this article will focus on the Growth/Momentum and Value styles.

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What happened to Value?

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Over the last decade, Growth stocks have performed exceptionally well, while Value stocks have languished. The underperformance of Value stocks or Value as a style has borne witness to countless papers and arguments debating the continuing existence of the Value premium, and whether it has somehow been arbitraged away.

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The graph below highlights the recent drastic outperformance of Growth vs Value.

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As is usually the case, in hindsight, assigning a rationale for the continuously widening chasm between these two equity styles is simple. As interest rates moved closer to zero, the future expected cash flows associated with these companies/stocks, which by their nature have more value in the outer years of the investment, were subject to increasingly less discounting, resulting in ever higher present values. The increasing margins exhibited by these stocks also supported the ability to ascribe ever greater value to future expected profits.

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This was a huge tailwind for growth stocks.

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The Tech and Tech-related stocks now dominate the US S&P 500 Index. I have highlighted how much the US has, in turn, begun to dominate global stock indices.

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As discount rates declined, higher-growth stocks began to comprise a greater and greater share of the overall market. To demonstrate this phenomenon, as of 31 Dec 2023, the top 10 stocks of the S&P 500 comprised 27% of the market. A level of concentration beyond that seen in the heady days of the dot-com boom.

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Demonstrated in the chart below

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Contrasting this, the top 10 stocks in the S&P 500 as of 2010 comprised approximately 15%. Australia was partially isolated from this trend due to the relative lack of technology plays on the local market. However, we still had the WAAAX stocks, including Wisetech, Altium, Appen, Afterpay and Xero. All of which witnessed a stellar lift in share prices over the last decade or so (noting the issues currently with Wisetech!).

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The Risks

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Today's equity markets look eerily similar to the index structure during the dot-com boom, which became increasingly concentrated and biased towards growth/momentum.  

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The coalescing of prolonged outperformance of the growth factor and the current market volatility is heavily impacting growth-biased strategies, as demonstrated in the table below (see YTD and 1Yr returns for Growth and Value style indices). It is usually during periods of uncertainty that growth or long-duration assets are at their most vulnerable. Noting that the 10-year material outperformance of Growth has driven the concentration levels we see today. Any underperformance in recent market volatility could be a surprise without understanding the leverage portfolios have to these factors. These biases can only be discovered through a deliberate and focused interrogation of the underlying portfolio exposures. Through experience, having witnessed this previously, these reversals can be both swift and violent.

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Are we entering an economic environment where Growth may be facing more of a headwind?

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Market Fragility

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Up until recently, underlying economic volatility was very low. Inflation and other economic variables displayed quite muted volatility compared to longer-term norms.

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The Trump presidency, whether you like him or not, has seen the US take a drastically different stance on geopolitics and how he deals with friend and foe, also becoming far more transactional. This stance is likely to see economic volatility lift, and potentially substantially. Trump is looking to drive manufacturing and other industries back onshore, using unconventional policy measures, with tariffs his current go-to. This is analogous to the early 1800s when America first introduced tariffs to support and grow domestic industry. The unfortunate truth is that these policies take time to work through the system, and there are obvious near-term reactions from trading partners, not to mention the damage this does to the long-run competitiveness of the protected domestic industries. The complicated supply chains of today’s modern globalised economy all mean that tariffs will likely introduce far more volatility in economic outcomes over the short to medium term.

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The administration is also moving in other directions, all of which are focused on structurally altering the US economy and the current global world order. As this unfolds, Trump’s more spontaneous and less restrained policy implementation urges may exacerbate market concerns unless his policy agenda gains traction and delivers on its promised outcomes.

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Until this happens, investors may add a more significant “margin of safety” than today’s investors have become accustomed to. Long-term bond yields may also fluctuate around a higher mean. All of this could provide a headwind to equity returns.

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What does all this mean for portfolio construction?

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The strong outperformance of growth stocks and the US equity market means that portfolios are inherently less diversified than 10 and even 5 years ago. This has implications for asset class and overall portfolio design. As markets currently stand, portfolios have a substantial weight towards technology and as such, should this sector underperform, it could have a large impact on overall returns.

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We’ll discuss ways to mitigate these risks in the next article!

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Shaun O’Malley, former GM Investments Spirit Super and MTAA‍

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Disclaimer

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This article is intended for wholesale investors as defined under the Corporations Act 2001 (Cth) and is not intended for retail investors. The information provided herein is for general informational purposes only and does not constitute financial, investment, or professional advice.

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The views expressed in this article are those of the author and do not necessarily reflect the official policy or position of Kings Gate Capital Partners. While every effort has been made to ensure the accuracy of the information, Kings Gate Capital Partners makes no representations or warranties, express or implied, as to the completeness, accuracy, reliability, suitability, or availability of the information contained in this article. Any reliance you place on such information is therefore strictly at your own risk.

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Investing involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decision, you should seek independent financial, legal, and tax advice tailored to your specific circumstances.

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This article may contain forward-looking statements that are subject to risks and uncertainties. Actual results may differ materially from those expressed or implied in such statements. Kings Gate Capital Partners disclaims any obligation to update or revise any forward-looking statements to reflect new information or future events.

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For more detailed information contact us directly.

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