The markets tell us what investors are doing. But what, exactly, are they thinking? Edison’s Inside the mind of investors aims to find out. In this edition, we talk to Alec Letchfield, partner and chief investment officer at Hansa Capital Partners.
Global equity investors are currently mulling over some big questions. Key among them is whether the so-called ‘Magnificent 7’ (M7) US tech stocks, which are considered to have the greatest exposure to the AI revolution, can maintain their strong performance in the coming years.
Alec is concerned about the growing concentration in global stock markets and, particularly, in US mega-cap technology companies. He points out that the M7 account for almost 30% of the S&P 500 and c 18% of global markets.
Exhibit 1: Weighting in top 10 holdings
Source: Hansa Investment Company
The M7’s performance has been extraordinary but the growth of these companies has also been exceptional. Unlike the circumstances of the last tech bubble in the late Nineties, the current surge has been backed by strong fundamentals. Most importantly, a flywheel effect seems to have been created. The larger the mega-cap tech names become, the more powerful they are. Nonetheless, Alec is cautious about the outlook for these stellar performers. He says: ‘It would be surprising if the current backdrop didn’t ultimately end up in a bubble. Human nature and the fear of missing out normally guarantees this. The challenge, as ever, is knowing where we are in the process.’
Given such concerns, and with global equity indices at (or near) all-time highs, some investors may be tempted to stay on the bench, waiting for markets to become less expensive. Alec argues that this approach would be a mistake. For him, it is important to stay in the game, even if it means taking the occasional knock when enthusiasm overruns.
‘The near-term outlook for stock markets will continue to be driven by the inflation/interest rate dynamic and economic growth, as well as the outlook for the M7. With interest rates now heading down, and economic and corporate growth largely supportive, this should help underpin share prices,’ he says. ‘While we do not think markets are overextended, and outside the US many markets look cheap, we are becoming a little wary about the ongoing strength of the M7. We are, in large part, believers in the AI revolution but we also recognise that everything has a price, and fear that the strength of performance, combined with the amount of capital being pumped into the tech sector, may lead to more volatility going forward. This will have a significant impact on world markets given their high M7 concentration.’
The preponderance of technology companies within the US stock market is a significant factor behind the extreme valuation gap between the US and the rest of the world, in Alec’s view. As the famous quip goes, stock markets have discounted nine out of the last five recessions. He thinks such caution, combined with investors’ natural desire to not lose money, has probably destroyed more value than anything else in investing. ‘By keeping people out of stock markets, or lulling investors into buying expensive hedging, the doom-mongers have caused many investors to miss out on returns by sitting on the sidelines. Therefore, while we are conscious of some pockets of exuberance, we advocate being fully invested, with a strong bias towards equity markets, albeit with diversification becoming increasingly important.’
The obvious follow-on question is: which equity markets should investors look to invest in?
Alec remains constructive on the US despite his concerns about the risk of a bubble in the M7 stocks. ‘As we always say, you bet against the US at your own peril!’
Hansa Investment Company maintains a significant overweight to Japanese equities. Alec states, ‘Japan has a long history of grabbing failure from the jaws of success as efforts to change peter out, often due to political instability or institutional inertia. This time around though, we are feeling more optimistic. Politically, despite the recent change in prime minister, Japan is looking unusually stable. With an ageing population and the Chinese powerhouse breathing down its neck, the Japanese authorities are increasingly recognising that radical action is needed and that productivity growth is essential to prevent a slide into oblivion. This recognition, combined with a starting point of low Japanese equity valuations and deeply inefficient balance sheets, creates huge opportunities for investors, especially given the herd-like mentality of corporate Japan. If one company makes efforts to raise shareholder returns via greater dividend payments or share buybacks, others tend to follow.’
He adds: ‘We are also more positive on emerging markets (EMs) than we have been for several years. EMs have broadly been more prudent in their fiscal and monetary policies, both during and after COVID-19, than many developed markets (DMs), so they are in relatively better economic shape, especially compared to previous decades. The valuation gap between EMs and DMs is also extreme and, while we agree that many EMs should trade at a discount for various reasons, some markets are now looking attractive from a valuation standpoint. The sheer scale of countries like China and India makes their economies increasingly important to the global market, while other countries, such as Brazil and Indonesia, are also growing rapidly. The combination of these factors now makes EMs more difficult for investors to ignore.’
With less than a month to go before the US presidential election, investors are very focused on the poll’s potential impact on world markets.
Alec believes a Donald Trump victory would most likely mean an emboldened, vindicative President who would ramp up the rhetoric and tariffs against China, and the world in general, while Kamala Harris portrays herself as a centrist and continuity candidate, although many of her actual policy positions, in his view, remain vague. He says both candidates are likely to have little regard for US government debt levels, which are already at a record high. He comments that Trump’s policies would probably act as rocket fuel to the US economy in the short term, before leading to a potentially almighty recession in the longer term. However, he thinks that it is worth noting that neither the Republicans nor the Democrats is likely to gain control of the presidency and both chambers of Congress. This means that the US government will probably remain deadlocked in key areas.
Despite this, Alec notes that the US stock market currently makes up around 64% of global indices, making the current global market one of the most concentrated and US-centric ever. This suggests, whatever the outcome, the US election result is likely to have a significant impact on world markets. As a disconcerting aside, Alec observes that the current concentration of global markets is comparable to the level seen in 1929, which ended with The Great Depression.
Alec believes that, historically, geopolitics largely represented opportunity rather than risk but current circumstances are clearly more risky than usual. He is, therefore, giving a lot of consideration to the question of how best to manage such risk. He says, ‘protecting portfolios should the worst happen, with conflict leading to a broader war, is challenging. By its nature, war is a binary risk, with a low probability, but high impact, if it occurs. Hedging is one option but in practice is typically prohibitively expensive, especially if it is a persistent, rather than temporary, strategy. Instead, we would advocate diversification across asset classes, sectors and countries, to dampen the impact of any event should the worse come to pass. Also, a higher hurdle should be set when investing in the more vulnerable regions and countries, such as China. Another option is seeking solace in more defensive assets. Partly this is through more defensive hedge funds, which has been our favoured approach, but it is also notable that assets such as gold and cryptocurrencies have been robust over the past year or so.’
In sum, the questions investors are grappling with are weighty, the answers by no means unclear and the tail risks deeply unwelcome. However, capital must be protected and nurtured over the long term, regardless of the market and geopolitical environment and, for Alec, this job does not get done by cowering on the sidelines.
We would like to thank Alec Letchfield for sharing his views in this edition of Inside the mind of investors.
