Portfolio diversification as a way of combating concentration risk

Monthly report from MAPFRE Gestión Patrimonial

In difficult times, you can always count on someone to lend a helping hand and following the significant contractions in both equities and fixed income seen in April, help is here in the form of the latest macro data. The “soft landing” scenario gained further strength in the United States as part of an inflation reading that for the first time in several months did not surprise on the upside and other activity data (in particular in relation to the labor market) that suggests a slowdown of the North American economy, thus dispelling doubts of possible overheating.

The opposite was true in Europe. The data is indicative of an improvement in macroeconomic conditions (although their starting point was particularly low) and have failed to change the minds of the members of the Council of the European Central Bank (ECB) in terms of cutting rates at its June 6 meeting. As we approach the mid-point of the year, we are coming into a key period where inflation and the reaction of the central banks will mark the future path of financial markets which, based on their recent behavior, seem to be waiting for something to change.

It is difficult to break out of this vicious cycle that central banks have dragged us into by making monetary policy decisions based on macroeconomic data that, at best, have been giving mixed signals during the post-pandemic period. In any case, from a strictly macroeconomic perspective, there would be no reason for the Fed or the ECB to embark on a streak of interest rate cuts. On the one hand, the time at which inflation will return to within the 2% target still seems some way off and, on the other, growth forecasts for 2024 set out a nominal rate that is even higher than the levels at which 10-year bonds are priced on both sides of the Atlantic. It is inflation that needs to start moving downwards rather than reference interest rates.

The ECB makes its move

On June 6, the ECB decided to cut the deposit facility interest rate from 4% to 3.75% almost two years after it moved to increase interest rates for the first time in over a decade and only nine months after its last hike. The decision was made by consensus, with even the voting members most opposed to a lax monetary policy showing their support for the decision, likely based on the fact that the organization did not set out a schedule of successive rate cuts.

This decision sees it join other central banks such as those in Canada, Switzerland and Sweden that have already cut rates this year. We have already indicated that the decision does not appear to reflect the underlying macroeconomic scenario, rather it is more likely linked to financial stability risk management. With expected growth for the Eurozone of 0.7% and inflation of 2.4% in 2024, the European curves have a long way to go bearing in mind that the German reference would be below the neutral rate and the remaining bonds would need to adjust to the usual risk premium at which they are usually priced. It is clear for everybody to see that, as a result of the pandemic and the subsequent fight to curb inflation, public accounts have been hit hard and many countries have high deficits and debt/GDP ratios. So much so that Standard & Poors lowered France's credit rating from AA to AA- on May 31 due to the country's difficulty in reducing the deficit. This serves as some justification for this move as a preventive measure to reduce systemic risk, although it comes at the risk of potential price overheating on account of the depreciation of the euro.

The Fed holds off for now

The decision taken at the most recent meeting of the Federal Open Market Committee (FOMC) to hold firm as regards rates dispelled concern among investors that rates could be hiked following the surprising performance in inflation in recent months. The Fed’s chairman, Jerome Powell, refused to increase rates, although he did insist on the need to keep rates higher for longer. This positive reading by the market about the possible future performance of official interest rates, combined with the weakness of certain macro data (ISM, retail sales, consumer confidence, and so on) has resulted in a significant revaluation along the American treasury curve (the two-year bond fell by 16 basis point while the ten-year bond fell by 18) as well as adding expectations of a rate cut in December.

This leads us to a period in which we are likely to witness a division in monetary policy, the consequences of which remain unknown: on the one hand, the ECB's decision could represent a repetition of past errors by anticipating the Fed with its rate cuts or, on the other hand, the US central bank could cool the economy too much as a result of its continued restrictive approach to monetary policy. What we can be most certain about is that it is unlikely that interest rates will return to pre-pandemic levels, which is positive for investors.

Concentration risk increases

Based on the performance of equity indexes, we might be tempted to think that the market is in very good health. However, the yield returned in May remained low or was led by very few companies. The main reason was once again the publication of results by Nvidia, which clearly beat its profit expectations (up by 21% compared to the previous quarter), margins (up by 2.4%) and revenues (up by 18%). If that weren’t enough, the company announced an increase in the dividend that, although symbolic given the company's need to make capital investments, offers an idea of ​​the solidity of its financial structure. The market reaction was particularly positive, with the company's value appreciating by more than 40%, bringing its accumulated profits for the year to over 200%.

The stellar performance of the world’s most advanced semiconductor company was matched by Apple, which presented better than expected results in China and announced the largest share buyback in history (110 billion). And so, with Nvidia accounting for 4.45% of the MSCI World and Apple for 4.36%, these two companies alone accounted for almost half of the index’s total returns, despite it being made up of more than 1,600 companies. The frustration of many active managers who do not have these companies in their portfolio or have them underweighted therefore comes as no surprise; they continue to see their relative yield take a hit, resulting in an outflow from active management to passive management (in a kind of snowball effect that in turn sees the most popular stocks rising even further).

As this chain reaction becomes more evident and given the passivity (or even complacency?) of investors, it is becoming increasingly necessary to build diversified portfolios that reduce this concentration risk and avoid the harmful effects that this risk would have on the value of investments should flows turn against these large companies.

Conclusions: The outlook is not negative

From a macroeconomic perspective, there have been no major changes over the past month. Growth in the United States has cooled and it has begun to improve in Europe, although not enough to alter the monetary policy that central banks have subject to us recently. Liquidity, after several weeks in the red, turned around in May and as a result, financial conditions remain lax. In turn, inflation does not seem likely to rebound strongly again unless the geopolitical situation worsens. However, it will remain above the central banks' target for longer than initially expected, which means that we are unlikely to see rate cuts as big as those that the market and central bankers themselves would like.

Higher rates for longer have always put the brakes on economic performance, although that does not seem to be the case at the moment. With this in mind, the risk faced by the market is that a limited number of few companies continue to capitalize all returns, resulting in many investors pursuing these returns without being aware of the risk that this entails.