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Adapt Your Portfolio for Market Distortions and Fiscal Risks

06 August 2024

Read Time 6 MIN

Investors should diversify due to U.S. equity market distortions, stay short on fixed income, and look to commodities as global growth picks up.

As we zoom out and examine the financial markets from a macro perspective, we highlight here three key factors investors should be paying attention to and our takeaways from these observations:

  1. The U.S. equity market remains highly distorted. Investors may want to diversify their equity portfolios to avoid over-exposure to megacaps in the S&P 500.
  2. As fiscal spending surges and a reckoning looms, we expect gradual easing by the Federal Reserve, with a small risk of a rate spike. Investors should consider staying on the short-end of fixed income.
  3. Global growth is picking up. Investors may want to look at commodities for global growth exposure.

The S&P 500 may have rallied 15.5% through the first half of 2024, but this rise was notably distorted. Comparing the performance of large-cap growth and value stocks over the past few decades, we see that growth outperformance matches the so-called internet bubble of 1999.

Growth/Value Distortion Reaches Internet Bubble Levels

Growth/Value Distortion Reaches Internet Bubble Levels

Source: Morningstar. Data as of 17 July 2024. Past performance is not a guarantee of future results. Index performance is not illustrative of fund performance. It is not possible to invest in an index. Value represented by Russell 1000 Value Index. Growth represented by Russell 1000 Growth Index.

This is not new. The S&P 500 market cap index has been buoyed by the strong performance of mega-cap tech companies, including leading chip manufacturer Nvidia, given their large weighting within the index. Comparing different segments of the equity market in different eras, we see that the Nasdaq 100 Index has led the market since 2014, followed by the S&P market cap index. The equal-weight S&P index has lagged, indicating that the average large-cap stock's performance has been considerably lower. Small caps, international stocks and emerging markets stocks have also underperformed.

Market Cap Weighted S&P 500 Index Doesn’t Always Rule

Price Performance in Different Regimes

  2014 - Current (%) 2000 - 2007 (%) 1996 - 2000 (%)
S&P 500 Index 177 1 148
S&P 500 Equal Weight Index 117 78 77
Nasdaq 100 Index 406 -52 714
Russell 2000 Index 74 44 81
MSCI International Developed Index 19 36 55
MSCI Emerging Markets Index 1 160 12

Source: New Edge, Cameron Dawson. RIA. Newedgewealth.com dated 14 June 2024.

After the 1999 peak in growth stocks, the Nasdaq actually fell in the next period, 2000-2007. The prior trend was almost entirely reversed. Emerging markets and international equities significantly outperformed, with equal-weight indices showing dramatic outperformance. The tech run-up leading up to 2000 presents performance figures that are strikingly similar to the current market trends, underscoring the cyclical nature of stock performance across different eras. This historical context illustrates that periods starting with overvalued growth stocks can lead to vastly different market returns, despite the tech companies' growth.

Nvidia’s forward price-to-earnings ratio is at about 33 times earnings, and this high valuation reflects expectations of growth. Although Nvidia and other tech giants like Apple and Google are exhibiting more solid sales growth and profitability than during the 1999 internet bubble, these are rich valuations that come with risks. If there's a tech hiccup like a slowdown in demand, shrinking margins, or supply chain issues, particularly related to Taiwan, these stocks could become vulnerable, affecting returns significantly.

Nvidia Valuations Are High But Mixed in Historical Context

Nvidia Valuations Are High But Mixed in Historical Context

Source: Bloomberg. Data as of 22 July 2024. Forward P/E on 12-month basis (next 4 quarters), this is lower than 2024 calendar year.

I highlighted last quarter how large fiscal deficits continue to be, thanks to the boom in government spending. This has contributed to higher for longer inflation and helps explain why the Fed hasn’t been easing.

The Trump and Biden administrations have been large spenders, creating a budget deficit of 7% despite being in an economic boom with low unemployment. Medicare and Social Security deficits are looming and sets 2025 up to be a critical year for fiscal policy.

High Budget Deficit Despite Economic Boom and Low Unemployment

High Budget Deficit Despite Economic Boom and Low Unemployment

Source: MacroPolicy Perspectives/OMB, BLS/Haver. Any projections shown are for illustrative purposes only and are not intended as predictions of future results or events.

This helps explain, in part, the Fed’s hesitation to cut interest rates as it navigates the aftermath of pandemic-related spending and monetary policies. Even if the Fed cuts interest rates, a significant drop is unlikely unless there's a severe economic contraction. My view is that the government will need to employ some combination of tax increases and spending cuts to manage the debt, while the Fed may cut rates to stimulate that. While this scenario isn't disastrous for the stock and bond markets, there remains a risk of 10-year interest rates spiking if these fiscal challenges are not adequately addressed.

The global economy moved into expansion mode at the start of the year, as measured by global PMI. The U.S. is growing at a slower pace, but growth engines like India have been growing rapidly. China’s growth statistics have been relatively weak, though I think they are making progress towards resolving their property issues. I think the rest of Asia has been key in carrying global growth. This is supportive of commodities demand, and we saw in Q2 the start of a commodity prices rally.

Global Growth Back to Expansion

Global Growth Back to Expansion

Source: Bloomberg. Data as of July 2024. Purchasing Managers’ Index: economic indicators derived from monthly surveys of private sector companies. A reading above 50 indicates expansion, and a reading below 50 indicates contraction.

  1. Market distortion: At the end of the second quarter, the stock market was significantly distorted, with growth stocks dramatically outperforming value stocks. Stocks like Nvidia, while not excessively overvalued, still show significant distortion when viewed over a multi-year period.

    How to invest: Ensure that your equity portfolio is diversified and not overly concentrated in the S&P 500 market cap index. Consider including equal weight large caps, mid caps, small caps, and international stocks to spread risk and capture broader market opportunities. It's important to rebalance your equity portfolios to avoid overexposure to overvalued growth stocks.

  2. Fiscal spending: Government spending levels are currently very high, and addressing this issue will likely become a priority after the presidential election.

    How to invest: Given the high interest rates on short-term fixed income, it could make sense to stay on the short end to mitigate the risk of a potential spike in long-term interest rates. This approach can offer a safer return profile in the current fiscal environment.

  3. Global growth: There has been a noticeable uptick in global growth, which can have positive implications for various sectors, including commodities.

    How to invest: With global growth picking up, commodities could benefit from this situation, making them a potentially viable addition to a diversified investment strategy.

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IMPORTANT INFORMATION

This is a marketing communication. Please refer to the prospectus of the UCITS and to the KID before making any final investment decisions. This information originates from VanEck (Europe) GmbH, which has been appointed as distributor of VanEck products in Europe by the Management Company VanEck Asset Management B.V., incorporated under Dutch law and registered with the Dutch Authority for the Financial Markets (AFM). VanEck (Europe) GmbH with registered address at Kreuznacher Str. 30, 60486 Frankfurt, Germany, is a financial services provider regulated by the Federal Financial Supervisory Authority in Germany (BaFin).

The information is intended only to provide general and preliminary information to investors and shall not be construed as investment, legal or tax advice VanEck (Europe) GmbH and its associated and affiliated companies (together “VanEck”) assume no liability with regards to any investment, divestment or retention decision taken by the investor on the basis of this information. The views and opinions expressed are those of the author(s) but not necessarily those of VanEck. Opinions are current as of the publication date and are subject to change with market conditions. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results. Information provided by third party sources is believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. Brokerage or transaction fees may apply.

All performance information is based on historical data and does not predict future returns. Investing is subject to risk, including the possible loss of principal.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck.

© VanEck (Europe) GmbH

Important Disclosure

This is a marketing communication. Please refer to the prospectus of the UCITS and to the KID before making any final investment decisions.

This information originates from VanEck (Europe) GmbH, which has been appointed as distributor of VanEck products in Europe by the Management Company VanEck Asset Management B.V., incorporated under Dutch law and registered with the Dutch Authority for the Financial Markets (AFM). VanEck (Europe) GmbH with registered address at Kreuznacher Str. 30, 60486 Frankfurt, Germany, is a financial services provider regulated by the Federal Financial Supervisory Authority in Germany (BaFin).

The information is intended only to provide general and preliminary information to investors and shall not be construed as investment, legal or tax advice VanEck (Europe) GmbH, VanEck Switzerland AG, VanEck Securities UK Limited and their associated and affiliated companies (together “VanEck”) assume no liability with regards to any investment, divestment or retention decision taken by the investor on the basis of this information. The views and opinions expressed are those of the author(s) but not necessarily those of VanEck. Opinions are current as of the publication date and are subject to change with market conditions. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results. Information provided by third party sources is believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. Brokerage or transaction fees may apply.

All performance information is based on historical data and does not predict future returns. Investing is subject to risk, including the possible loss of principal.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck.

© VanEck (Europe) GmbH / VanEck Asset Management B.V.