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Every week, Kyle Caldwell and guests take a look at how the biggest stories and emerging trends could affect your investments, with practical tips and ideas to help you navigate your way through. Join the conversation, tell us what you want us to talk about or send us a question to OTM@ii.co.uk. Visit www.ii.co.uk for more investment insight and ideas.
Hello, and welcome to on the money, a weekly look how to get the best out of your savings and investments. In this episode, we're gonna be looking at whether global equity markets are sufficiently diversified. Joining me give his expert views on this topic is Dean Cook, multi asset full manager at Aviva Investors. Heading into 2025, ahead of the sell off that started in around mid February for The US stock market in response to uncertainty over the tariff policies. There's already been plenty of column inches written, and we covered it in the podcast extensively about how increasingly concentrated The US stock market have become.
Kyle Caldwell:So at the start of the year, the magnificent seven stocks accounted for around a third of the S and P five hundred index. For the global stock market, those seven companies accounted for around 20% of the MSCI World Index. Dean, I firstly wanted to ask you, should those who invest globally, whether that be in an actively managed fund or owning the market through an index fund or
Dean Cook:an ETF, be concerned about how much the global stock market has in those seven companies? Thanks, Kyle. I think it's important to be considerate about where the earnings is coming from. So 2024 was a year where those very large technology companies delivered the lion's share of the earnings growth of The US market. So this isn't a sort of .com bubble rerun whereby a lot was promised, but very little delivered.
Dean Cook:These are companies with with actual earnings, actual customers, and actual cash flow kicking out the bottom of it. The latest earning season, so this is q one twenty twenty five that we're now reviewing a couple of months after the fact, you've seen some quite interesting trends. So having seen quite a lot of share price depreciation over the the recent times sort of year to date, Those very large technology companies have actually been posting some quite impressive earnings figures, certainly compared to to expectations. I think on average, six of the seven of those large seven companies have reported average net income above expectations of about 10%. So beating people's expectations by about 10% is nothing to be sort of sniffed at.
Dean Cook:And that's compared to a wider market that was only 6% of it expectations. That's still good. But this we were coming to this earning season with the expectation that the performance of those larger technology companies was maybe gonna be kind of coming closer into line with the rest of the market, but you're still beginning to see still seeing certainly the the outperformance of them relative to to the rest of the market. So it's quite a long way of saying that as long as companies are delivering on their expectations, you you shouldn't be as worried about their concentration in in wider markets, but you do need to be thoughtful about it when building portfolios and and not leaning too hard into those
Kyle Caldwell:types of things. And as stock markets are structures on a market capitalization weighted approach, If a sector has a really strong solid performance like technology has for much of the past decades, pardon when interest rates started going up, that's increased the percentage weighting to the technology sector for global investors. Are global investors now overexposed to technology?
Dean Cook:Yes. So for context, about 25% of the global market cap is is made up of the of the technology sector, which sounds like a big number. But I I guess what one needs to bear in mind is that technology is a really broad term. It encompasses a whole host of industries, many of which, if you think about it, didn't even exist a decade ago. So to to pick sort of two random names, the likes of an NVIDIA, which makes chips and things for for semiconductors, is not competing for revenues with a Zoom that does sort of web conferencing.
Dean Cook:So to kind of turn the questions on on its head almost, all companies require technologies to a greater or lesser extent. If you think about, say, Visa or or or a bank, these are platforms of technology that happen to be regulated and and and deal with money. So you can more or less see technology wherever you'd care to look across the global market cap. So how diversified are global stock markets? And due to global markets being diversified, can investors simply sit back and buy and hold?
Dean Cook:Sure. So global equity diversification is important. What does it mean? It means that you're not kind of putting all of your eggs into one basket. You're taking an anger aggressive groups of companies and benefiting from the offsetting performance of one versus the other.
Dean Cook:It's more or less the only free lunch in investing according to Harry Markowitz, famous investor. And it and it will, generally speaking, give investors a better chance of realizing their investment goals over the very long term. The way I thought about this is that the the extent of one's preference for buy and hold over something more dynamic probably relates to the investor themselves. So what is it that they're trying to achieve? What time horizon do they have?
Dean Cook:And how comfortable are they taking risk in equity markets more generally? And we think that there's room for value add in the building of your sort of strategic asset allocation, that long term mix of assets that helps to deliver on your savings objectives, as well as tactical asset allocation, which gives you the space for shorter term calls in different markets. So one particular example that that comes to mind at the moment, there's lots of talk about it in the market, is the role of the US dollar in in portfolio composition and construction. One could build the argument that over a longer term basis, the US dollar is quite overvalued. And you're beginning to see slowly global pools of capital start to move away from the US dollar.
Dean Cook:Now as a buy and hold investor, you need to be quite thoughtful about those types of longer term trends because that will affect your investment journey.
Kyle Caldwell:And due to the fact that The US stock market comprises around 70% of the global market, then investors are very exposed to the US dollar and to US companies. Are global investors too heavily reliant on the fortunes of one country?
Dean Cook:So, yeah, very topical question, one we're we're getting quite a bit at the moment. I'd probably think about this in a similar way to technology that we were talking about earlier. Not only are these US kind of domiciled companies generating revel revenues in The US, but they're also generating them all over the world. And over half the revenues of the magnificent seven that we were talking about earlier, these very large sort of AI thematic companies, they yeah. They generate over half of their revenue outside of The US.
Dean Cook:So you're right that kind of taking things at face value in The US is a large proportion of the global market cap, but it happens to be home to some of these marvelous, very large global businesses. And so we try to be a bit more thoughtful about where the revenues are being generated rather than simply where a company is listed.
Kyle Caldwell:And for investors looking to increase diversification on a country level, what would you suggest? How would they go about doing that?
Dean Cook:Sure. Yeah. And as I kinda kicked off with at the beginning, we we take the starting point that most stock markets are reasonably efficiently sort of valued and and and smart, and one needs to set quite a high bar for making material deviations from from the global stock market. But if you were to be thinking about other markets that would complement America, then it's probably natural to look at the next largest. So your likes of Europe and Japan.
Dean Cook:So Europe's got some interesting dynamics at play at the moment. They're on a on a program of expanding sort of fiscal expenditure in the defense space keen to ensure that companies are investing for growth there. So it's quite an interesting dynamic that's going on. And similarly, in Japan, where there's been a multiyear program of corporate transformation almost. So shareholders beginning to hold their companies to account to demand better run companies, returning of cash to to shareholders, and some sensible reorganization of of balance sheets.
Dean Cook:So kind of an interesting couple of trends that we're seeing there. The benefit of those two markets relative to The US is a lower starting valuation, so there's a cheaper stock markets compared to America. And over the the the last sort of ten odd years, America's justified that premium valuation because it's delivered greater earnings growth relative to the rest of the world. But if there's an argument that that tide might be starting to turn, then markets like Europe and and Japan are gonna be sort of top of the shopping list for for many investors. Emerging markets is a little more finely balanced, I'd say, a in in terms of a region that might benefit from this.
Dean Cook:So the likes of China may well be slightly better equipped to deal with a protracted trade war with The US. But, actually, the the usual benefits that that emerging markets have from a weaker dollar, which is the sort of situation that we're seeing ourselves in the moment, might not necessarily sort of manifest this time around, often as the dollar declines, so it gets cheaper relative to other currencies. You see emerging market stock prices do reasonably well and economies as well. The reason for that is a lot of those emerging markets will be borrowing in dollars. So as the value of the dollar falls, it becomes cheaper to finance those those deficits.
Dean Cook:So but at the moment, what you're seeing at the same time as the dollar falling is treasury yields. So the the borrowing costs in the American market have gone up, and that sort of offsets some of the benefit for for for those companies and and and governments. Similarly, a declining dollar environment is generally consistent with rising risk appetites and people being sort of risk seeking in their activities, and that has historically benefited emerging market equities. But it's less clear to me that we're in that sort of environment at the moment given that the proximate kind of cause of the the shock that we've experienced over the last couple of months has been America and the dollar itself.
Kyle Caldwell:And, of course, as you've just spoken about, different macroeconomic environments favor different industries and can favor different regions as well. We've, of course, had technology stocks top the performance charts for much of the past decades, but there have also been periods in which energy shares have been in vogue. We're now, of course, in a period where interest rates are starting to fall, although it looks very unlikely that we're gonna return to the days of interest rates being ultra low. Which types of sectors do you think will favor better than others as interest rates are declining? So you're quite right to point to that sort of broad spread of sector performance from year to year, and and I guess that that should tell you not to over concentrate your portfolio in in any one sector because there'll be years where where it won't be such an easy ride.
Dean Cook:The bond bull market, so the fact that fixed income has delivered strongly positive returns for upwards of thirty years, has benefited. It certainly did until sort of 2022 when inflation hit and interest rates started rising. It benefited a certain sort of staple like company that had those bond like characteristics, so very stable recurring revenues and the like. That's fair to say it's probably kind of played played out now. And you're also similarly correct that during that period of very, very low interest rates just after the the global financial crisis, it was also a period of low economic growth, and that led to a sort of growth scarcity, if you will.
Dean Cook:So investors were quite happy to pay more for companies who could deliver earnings growth because we were in a an environment that that had very little of it. And I I guess where we stand today, as you said, in an environment where interest rates are coming down, they're probably not as as low as they were in the past. But you're also in an environment where bond markets, so if you're going out into the fixed income world, have quite high yields relative to what certainly for a period of time we became accustomed to. So if you think about that as a as a dynamic, you've got lower interest rates and higher bond yields that allows banks to take deposit monies in and pay a lower lower rates on those deposits, and then then lend it out on a longer term basis to corporates or or or mortgage holders. And that's quite a profitable business when you've got a nice big spread between those two numbers.
Dean Cook:But as you say, year to year, different sectors are gonna win, and it's important to come at it from a sort of diversified perspective.
Kyle Caldwell:And over the long term, the composition of the global stock market changes. Think if we go back to the late nineteen eighties, Japan was the biggest country in the global stock market, much bigger percentage then than it is today. Research from Research Affiliates, which is a company that specializes in predicting the future returns of asset classes, it found that of the largest 10 stocks globally at the start of each decade, only two of those 10 and sometimes only one were able to defend their position a decade on in terms of still being one of the largest 10 stocks globally. Very big question, but I'm gonna ask it anyway. How do you think the next decade will pan out for global markets?
Kyle Caldwell:And how do you envisage the composition of the global equity market changing from today?
Dean Cook:That's a the big question, isn't it? And and I suppose my my glib response would be, in ten years time, you're gonna see a different composition of the of the top 10 stocks. History tells you that's probably going to be the case. Many of them, we probably haven't even heard of yet. They they may not even exist.
Dean Cook:One thing that that teaches me anyway is that the sort of arbitrary groupings of stocks as as we talk about them either in the financial press or or when it becomes a useful model for understanding how the world is behaving. So that sort of magnificent seven reference from earlier, That tells you that those types of arbitrary definitions are probably unhelpful when it comes to building resilient portfolios from the long term because what is profitable investment through time is is going to change. A factor I think is really interesting when thinking about some multi period return like deck coming on for decades of of performance is the rise of private capital. So it's well known that the number of stocks listed on on the market has declined over time and companies are staying private for longer. So that tells you that there's a period of a company's life where it's probably growing pretty quickly, might have reasonably high needs for for ongoing investment, but the profits to those who do invest through that that period can be quite large.
Dean Cook:Obviously higher risk, but that's commensurate with the with the returns that you're seeking. And you may well miss out on some of that for for those people who who are only invested in public markets, in in listed equities. So I think that being thoughtful about asset classes like private equity, which might allow access to to sort of faster growing parts of the market is an important consideration when looking at these things in Iran.
Kyle Caldwell:My thanks to Dean, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app and do tell a friend about it. If you get a chance, leave us a review or a rating in your podcast app too. You can join the conversation, ask questions, and tell us what you'd like to talk about via email on 0tm@ii.co.uk. And in the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website at ii.co.uk, and I'll see you next week.