EFG Asset Management CIO Moz Afzal (pictured) says investors have to live with concentration risk from time to time.
As has been well documented, the so-called ‘Magnificent Seven’ dominated US equity markets last year while the newly-crowned ‘Fab Four’ stocks Nvidia, Amazon, Meta and Microsoft have continued that momentum into 2024.
However, such narrow market leadership has caused concern over concentration risks developing in the market.
Currently, the 10 largest stocks in the MSCI All Country World Index make up 19.5% of the benchmark, well above the dotcom era peak of 16.2% in March 2000. US stocks make up over 70% of the index, according to MSCI data.
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Speaking to Portfolio Adviser, EFG’s Afzal says that investors have had to deal with concentration risks in the past and they ebb and flow with market dynamics.
“Of course, artificial intelligence is driving the narrative at the moment,” he says. “Compared to the last 20 or 30 years, the concentration is definitely elevated, but it’s not as extreme as it has been in previous periods.
“We have to live with the fact that we’re going to have these outsized movements from time to time. Is the risk greater now than it has been before? Yes, but its marginal compared to history.”
He adds: “In an economic growth environment, where most people are in the soft-landing scenario, the companies with the greatest growth profiles are going to be the ones that are going to be emphasised more than others in this particular macro environment that we’re in.
“So it’s not surprising given that cloud and AI is riding the major leadership at this point in time, and earnings and revenue growth numbers we’ve seen from both companies over the last 12 months have been quite spectacular.”
AI
On the growth of tech stocks in the US on the back of increased interest in AI, Afzal says we are in the early stages of the technology’s development, which currently favours the larger companies with the resources to spend on R&D.
However, he says there are signs market leadership is already beginning to broaden out.
“A stat which I think is quite staggering, if you look at Microsoft or Apple, you have one company which is equivalent to the entire Russell 2000. It just shows you that you don’t need a lot coming out of those very large companies to filter down.”
“If I look at previous periods of huge technological change, investors overestimate the near term and underestimate the long term. I think there is that risk of overestimating short-term impact [with AI] for sure, you just have to look at the percentage changes companies have had over the last six months, you’re entering into that realm [of being too expensive].
“However, if you look at the mid-tier companies, they are probably the ones that are next in the pecking order. Many of those companies have been left behind relative to those large companies in the short term.”
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Afzal believes natural investor behaviour is a factor behind the increase in concentration.
“Whenever you’ve had any trend that’s emerging, investors go to the so-called ‘safe ones’ first. Investors have been burned over the last three years, since the peak in late 2021 with mid cap companies. The first time they’ve started to reallocate capital back into stock markets, they’re going into the large companies first because its relatively safe.
“The classic situation at the moment is that no one is going to fire a fund manager if they buy Microsoft, because everyone owns the largest company in the index. So I think the natural investor behaviour has been to start to dip their toe back into equities again, after a tough two or three years, starting with the bigger companies. And then as the comfort level appears, and those smaller mid sized companies start to show better earnings results and an improvement, they will naturally filter down into those mid tier stocks and below.
“We’re starting to see that now and I think we’ll see that further over the course of the year. The larger companies may well be the ones that are still doing reasonably well, but are working themselves into the valuations that we’re seeing at the moment, but the small or mid-sized firms that haven’t really recovered from previous peaks should start to get more attention.”
Election year
An event that will undoubtedly go hand-in-hand with volatility this year is the US Election.
On approaching election cycles as a CIO, Afzal says it is important to note the fourth year of a US presidential cycle is on average the highest in terms of geopolitical volatility.
“I fully expect there’s going to be volatility, particularly in the run up which at the moment is highly uncertain. Trump is clearly winning, and the US stock market likes Trump to win because he wants to introduce market-friendly measure such as a cut to corporation tax and deregulating the economy. That’s good for financials, healthcare or biotech and the tech sector itself.
“On the other hand, he’s not great for importers, because he may well put tariffs up and be much more protectionist. You can see some of that narrative playing out at this point in the election, because at the moment, he’s winning.”
By sector, he adds that materials and energy may be especially volatile in the runup to November due to the ongoing Russian invasion of Ukraine.
“Healthcare is also a really important one because Biden’s Inflation Reduction Act has provisions on healthcare drug pricing, for example. And so if Trump does indeed come in, healthcare could be a beneficiary as he may redact some of those healthcare pricing initiatives that come into force in 2025 and beyond under Biden.
“Under the Biden administration, the ability of the large tech companies to be able to enact acquisitions and mergers has been massively stunted. And so the conventional wisdom is that if Trump comes along, he will allow M&A to happen again.”
