Morning Note: Market news and our thoughts on portfolio diversification.
Market News
This morning in Asia, markets fell by the most in two weeks, with Japanese stocks leading the decline (Nikkei 225, -1.8%). Hong Kong shares rose, then pared the gains (Hang Seng, flat; Shanghai Composite -0.6%). The home-price slump in China has accelerated despite more stimulus. China factory output growth cooled to 5.6% year on year, below expectations of 6.2%. However, retail spending growth of 3.7% was better than the 3.0% forecast. The PBOC kept its one-year MLF rate unchanged. The S&P 500 Futures currently predict the market to open little changed this afternoon, while the FTSE 100 is currently trading 0.2% higher at 8,162.
This week another flurry of rate decisions may reveal a growing hesitancy by central banks to start cutting — in a month that was supposed to mark widespread easing — days after the Fed pared back its own plans for 2024. Neel Kashkari said US policymakers are well-placed to take their time, while Loretta Mester said she still sees inflation risks as tilted to the upside. The 10-year Treasury currently yields 4.25%, while the gilt yield has slipped to 4.05%. Gold trades at $2,319 an ounce.
The Tories are headed for a wipeout in the General Election, three new polls showed. It may be their worst defeat since the party was formed two centuries ago — “electoral extinction” in the words of one of the research directors. Rightmove house prices were flat month-on-month in June vs +0.8% m/m previously. Sterling currently buys $1.2670 and €1.1844.
In an appeal to moderates, Marine Le Pen told Le Figaro she’ll work with Emmanuel Macron if her party wins snap elections. Tens of thousands of protesters took to the streets to oppose her far-right policies. French bond futures fell in a sign that global assets may struggle, according to MLIV.
The oil price steadied after last week’s gain – Brent Crude trades at $81.70 a barrel. Bill Gates said he’s prepared to put billions into a nuclear power plant project in Wyoming. TerraPower expects to complete the new reactor in 2030.
Source: Bloomberg
Investment View - Diversification
Diversification, whether across asset classes or within them, is widely regarded as the only free lunch in investing. Over time, a diversified portfolio offers better risk adjusted returns than an undiversified one. We have no quarrel with this concept.
One area where diversification has a prominent role within the equity component of portfolios is where it comes to dealing with the issue of “home country bias”. A globally diverse portfolio offers better diversification than investing solely in your domestic market. This is especially true when the home market is dominated by just a couple of major sectors such as resources or banking. Again, no quarrel here.
However, let’s say you’re a UK based investor and you want to diversify away from the UK market. Let’s say you look across the Atlantic and see lots of excellent opportunities in the US market. How much should you allocate relative to your home market? Let’s say you’re really bullish on US equities. The same? Twice as much? You really like this market – 10 times as much? Let’s say this is the best opportunity you’ve ever seen. How about 19 times as much? Congratulations, you’ve just bought an MSCI World tracker.
I shares MSCI World ETF – Geographic Allocations
The nature of the investment management industry is that benchmarks drive allocations. Career risk dictates that material deviation from benchmarks for most managers is minimal. Hence, practically speaking, international diversification in this context simply means swapping one home country bias for another, as the US makes up 70% of the benchmark.
For at least the last decade, this has paid off handsomely. The US equity market has trounced other developed markets driven in large part by the tech behemoths. This has made benchmark driven international investing look pretty smart. But what about for US investors? Presumably the merits of international diversification apply equally to them, yet the impact has been much less favourable.
There is also a reflexive component to consider. As overseas money flows into US markets (as they must, to balance huge current account deficits that the US runs) they help to drive up the prices, increase the weighting in global benchmarks and the cycle repeats. However, trees don’t grow to the sky. The high concentration in the big tech names, the so-called “magnificent seven” has grabbed all the headlines but look just a little deeper and there are some lofty valuations. Costco for example trades on over 50 times this year’s earnings. It’s growing at roughly 10% but even so, it is after all, a supermarket. The prospective returns for today’s investor feel meagre, at best.
Recency bias dictates that the tendency is to address these risks after they have manifested themselves in prices. However, investors should be aware that their “internationally diverse portfolio” could just as accurately be described as a concentrated bet on one the most expensive markets in history.