‘Don’t put all your eggs in one basket’, or at least not too many eggs, is a widely known maxim. These days, however, a benchmarked global equity portfolio has a very high share of US ‘eggs’. The market capitalisation of the MSCI World and MSCI All Country World indices represented by the US is at all time highs. The large weight partly reflects highly valued mega-tech and artificial intelligence companies. Long-term investors might want to consider whether allocating in line with these global equity indices is wise given the lack of geographical diversification and the considerable optimism reflected in future earnings growth estimates for US technology shares.
One weakness often seen in investor portfolios is high geographical concentration arising from either a home bias or benchmark composition. Home bias is when investors favour companies they are familiar with, which are often from their own country. Home bias can result in portfolios being comprised mainly of stocks from an investor’s domestic market.
The other source of geographical concentration stems from the composition of benchmark equity indices. The popular large-capitalisation MSCI indices are meant to represent the global opportunity set available to equity investors. Due to the relatively strong performance of the US stock market over time, the share of that opportunity set represented by the US has inevitably risen.
The MSCI USA index now represents almost two-thirds of the market cap of the MSCI All Country index (which includes both developed and emerging market stocks), and more than that when we look at the MSCI World index (developed markets) (see Exhibit 1).
The rising share reflects the higher returns from US equities: the MSCI USA index has returned 12% per year on average over the last 10 years, while the MSCI World ex-USA index only 5% (both total return in US dollars).
The strong returns recently for shares of the ‘Magnificent 7’ (Alphabet, Apple, Meta, Amazon, Microsoft, NVidia, and Tesla) and other US technology stocks has been a key driver of this phenomenon.
Historically, there is no one winner
Should investors count on this US dominance continuing? A neutral, market capitalisation-weighted allocation to the MSCI All Country World index would have most funds invested in the US. History suggests, however, that the US market might underperform in the years ahead. As every investment disclaimer reads: “Past performance is no guarantee for future returns.”Historically, there is no one winner
No one country systematically outperforms all others. Indeed, geopolitical upheaval, debt crises, regulatory reforms, or bursting bubbles are rarely global events: they affect some countries while others are immune or may even benefit from setbacks elsewhere.
Year to year, there are often large differences between the best and worst-performing country indices. Outperformance tends to lead to overvaluation or risks that precede a correction.
While US equities outpaced other markets from 2010 to 2020, performance was worse in the prior decade due to the bursting of the dot-com bubble and the subprime crisis (see Exhibit 2).
US valuation – Isn’t it a bit rich?
After more than a decade of outperformance, US equities now look expensive compared to other major markets on many valuation metrics.
For example, the forward price/earnings (P/E) ratio is currently more than twice as high as the UK and nearly 90% higher than Germany. Historically, the ratio for both has only been about 30% more.
The P/E ratio for the ‘Magnificent 7’ is even loftier (see Exhibit 3). One must consider whether future earnings growth warrants such a large gap.
Euphoria linked to artificial intelligence
After the launch of ChatGPT in late 2022, 200 million users were won over in a few weeks. It is hard to think of another technology that has taken hold so quickly.
The possibilities seem endless, and investors have been quick to price future earnings into the valuations of related companies. NVidia, for example, has seen its stock rise by 300% and its market capitalisation now exceeds USD 1 trillion.
The dramatic rise of the ‘Magnificent 7’ underscores the transformative power and cost-effectiveness of technology in the digital age, but there are risks.
Artificial intelligence looks to be a revolution that will profoundly change our lives, just as the internet was. While today’s leaders are US technology companies, their success will certainly attract new competitors. In 2000, Palm enjoyed similar enthusiasm and was highly capitalised, only to be supplanted in 2003 by BlackBerry and in 2008 by Apple with the iPhone.
Another risk to the dominance of the ‘Magnificent 7’ is that open-source AI must compete with large proprietary models. We believe markets are underestimating this threat. The gap between state-of-the-art AI models such as GPT-4 and their open-source counterparts is closing rapidly.
Robust portfolio construction
The dominance of US equities today in global indices means one must be mindful of geographical diversification, particularly when US equities appear expensive relative to many other markets.
Constructing a ‘robust’ portfolio with a long-term investment horizon, capable of taking advantage of a less ‘unipolar’ economic environment in the future, requires monitoring the balance between US equities and the rest of the world.
Daring to deviate from the major benchmarks may at times be prudent.
Disclaimer
