THE jarring contrast of China’s market bust and soaring US stocks may cloud the vulnerability of the latter to events in Beijing, and some fear Wall Street’s narrow focus heightens that risk.
A relentless plunge of Chinese equities over the past year – on a mix of property sector woes, deflation, piecemeal policy supports and dire demographics – is compounded by capital flight on fears of deepening geopolitical rifts, not least over Taiwan.
The flipside stateside is record high US stock indexes – infused by buoyant domestic growth and employment, interest rate cut hopes and a “reshoring” of chipmaking and supply chains that may also owe much to that geopolitical reboot.
But for active fund managers who endlessly bemoan the concentration of stellar US index gains in a handful of megacap tech stocks – a “Magnificent 7” that now accounts for almost 30% the S&P500’s market value – the contrasting national fortunes are not necessarily parallel universes.
One of those asset managers, Boston-based GMO, went into bat again this week about just how shaky that megacap market leadership may prove – in part due to the outsize exposure of these historically expensive stocks to any escalation of China risks.
Acknowledging the pain for US stock picking funds trying to beat passive index gains now dominated by the “Magnificent Seven”, GMO pointed to data showing almost three quarters of large cap ‘blend managers’ underperformed the S&P500 last year – and 90% of them lagged over the past decade.
And a decade of relentless outperformance of these giants – admittedly from a relatively cheap starting point – flies in the face of historical trends that typically see the top 10 market-cap stocks in any one year lag the market a year ahead.
Extraordinary tech advances and the most recent artificial intelligence (AI) boom alongside investor obsession with holding cash-rich “quality” stocks may partly justify the expensive price tags, it said, adding price and earnings multiples of 35 times for the “Magnificent Seven” combined were now 50% higher than the wider market.
And yet concentration of equity holdings in this small pool of mega firms leaves everyone prone to any “idiosyncratic” governance problems – lawsuits, strikes, boardroom shifts – or sectoral mishaps like antitrust regulation.
And indeed leftfield geopolitical shocks.
Already, Tesla’s separation from the rest of the vanguard – Microsoft, Apple, Amazon, Alphabet, Meta and Nvidia – is a case in point and makes the group look a little more like a “Six Pack” than “Magnificent 7”. But there’s still a lot of eggs in one very small basket.
“We have never seen over any 10-year period a decline in diversification of the magnitude we have just witnessed,” GMO’s Ben Inker and John Pease told clients in a quarterly letter, urging “patience” in active management that must surely have already run thin.
In looking at many things that could now go bump in the night, GMO pointed to an unfolding crisis in the world’s second biggest economy – and how all seven stocks are exposed.
“They are all reliant on the general availability of semiconductors, most of them have considerable investments in AI, four of them have ties to (Taiwan electronics supplier) Foxconn, and their average revenue exposure to China and Taiwan is close to 20%,” it said.
“A geopolitical event that hurts US companies’ access to China, Taiwan and the semiconductor industry would therefore be profoundly uncomfortable for this group of companies.”
In short, the asset manger said that investors who are now averse to the 4% combined weight of China and Taiwan in MSCI’s all-country index should be mindful of the 17% weight of the ‘US superstars’ in that same index.
By the same token, of course, any success China may have in stabilising its property sector and wider stock market – or in easing diplomatic tensions – could again underscore the group.
But this week’s soundings from Beijing’s top brass ahead of the Lunar New Year holiday may not be all that soothing.
China’s President Xi Jinping last Thursday told Russian President Vladimir Putin the two countries should pursue close strategic coordination and defend the sovereignty, security and development interests of their countries.
And then there’s this year’s US elections, with Republican front runner Donald Trump ahead in opinion polls and promising a resumption of trade tariff wars with China if he’s returned to the White House in November.
GMO are of course only one of many who have fretted about the narrowness of US equity market gains over the past year – and indeed for much of past decade aside from 2022’s interest rate related swoon.
Societe Generale’s long-term sceptic Albert Edwards pointed out again this week that the US IT sector now accounts for one third of the entire US equity market – surpassing its peak share at the apex of the dotcom bubble in 2000.
And that’s even though only three of the “Magnificent Seven” are technically part of that IT sector.
“The key call for investors is whether this is a bubble that will ultimately burst, and if so when?” he said.
But, as ING’s strategists point out, the consensus of equity analysts is for more to come – with higher price targets for the “Magnificent 7” anywhere between another 6% for Apple or 20% for Amazon from here.
Only Nvidia has a lower one after another eye-watering 50% surge so far this year.
If higher interest rates in 2022 was the only event of the past decade to seed a major reversal of the group, the prospect of Federal Reserve rate cuts this year puts that risk aside. Recession too, it seems, is also a distant prospect.
In the absence of market indigestion or some sudden rotation of investor appetites, events in Beijing maybe be one of the few dark clouds on the horizon. — Reuters
Mike Dolan is a columnist for Reuters. The views expressed here are the writer’s own.