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SIMPLYBIZ INVESTMENT SERVICES
As the weather heated up over the summer so did equity markets . This led to turbulence at different points in July , August and September as volatility reached levels rarely seen over the past couple of decades . This came as the dominance of a handful of mega caps in the US reached extreme levels and some investors became nervous about the economic outlook , notably a perceived slow down in the US based on few data points . Does this mark a pivotal moment for investment markets ?
First , it is important to remember that there is the economic story and then there is the investment story . Let ’ s start with the economy . Higher inflation has not proved to be transitory although it has now come down after central banks ratcheted up interest rates . While it is probable that interest rates have peaked , they are unlikely to be reduced to the 0 % to 2 % level that we had seen for the 10 to 15 years up to 2022 . We believe interest rates are more likely to settle in the 3.5 % to 4.0 % range in the US , for example .
This economic story will have some key impacts on investment markets and therefore how to manage portfolios . To start with , this means the cost of capital will be a lot higher than it was before and one effect of this is that there is likely to be a rotation in equity markets between companies , sectors and geographical markets . There will need to be greater diversification in portfolios across asset classes , within asset classes and investment styles .
Over the last 10 to 15 years , portfolios have been able to deliver while being concentrated on US dollars , comprising primarily equities plus some Treasuries , with the proportion between the two based on clients ’ risk profile . If you went back 15 years and proposed this approach , it would appear mistaken by putting all your eggs in one basket . And yet it would have been very successful .
The market environment is changing , however . The superior earnings that have been delivered by US mega and large caps are now being seen beyond these stocks , not only in the US but also in international markets . Analysts are predicting that by the end of this year and the start of 2025 , the earnings will be similar across cap sizes , and there will be cheaper valuations available outside the large caps . Who would not want growth of a similar magnitude to some of the Magnificent 7 stocks at cheaper prices ? We believe we will gradually start to see this rotation happen .
The beginning of August was a fire drill in terms of what will happen when we see weaker returns from US large caps and how diversification can benefit client portfolios . This included the performance of equities outside the US and the fact that bonds worked as diversifiers to equities . This supports our view that the death of the 60 / 40 portfolio has been greatly exaggerated .
If , as we suggest , the concentration in equity markets of the mega caps in the US lessens over time , it is important to consider what the relative impact will be on active managers and passive vehicles within portfolios . If you take the US , which is the biggest passive market , the top 10 holdings in the S & P index represent 35 % of the whole index . For the last time we saw this concentration in the S & P500 , according to one of our US fund managers , you have to go back to the Great Depression . The market conditions back then were entirely different to what we have today and we do not believe all the growth comes from just seven stocks .
The S & P 500 is a market cap weighted index , which is how most investors buy it through passive vehicles . By number , the 500 stocks in the index mainly comprise consumer and financial companies , representing the US economy . It is also possible to take an equally weighted exposure to the S & P500 through a passive vehicle . But over the past five years , the market cap weighted has outperformed the equally weighted by some 40 %, which is quite extraordinary . What we have seen is that smaller sectors , like technology , have become a much larger exposure on an equally weighted basis .
This is where your risk is through passive vehicles . While passive has certainly helped us over the years in terms of a broader universe of options to use within portfolios , there is a big opportunity now for active management particularly in mid and small caps .