MARKET PERSPECTIVE’
By J mulraj
Jan 6-12, 2024
In an autonomous driven investment world
The image is that of a woman staring at a bottle on a shelf, whose label said ‘Concentrate’! Concentration of institutional holding in a handful of stocks is one of the risks emanating from an autonomous driven investment world.
Mutual funds are managed either actively, where a fund manager decides which stocks it should invest in, or passively, in index funds or index ETFs (exchange traded funds). In these vehicles, stock selection is automatic, mimicking the underlying index. In USA, today, 45% of funds are passive, up from 22% a decade ago. Returns to investors in passive investments match the movement of the underlying index. As Jeffrey Archer would say, not a penny more, not a penny less. So investor psychology is moving towards passive investing, or accepting the same return as the market, and not trying to beat it.
In USA institutional (mutual funds, banks, corporates) hold 80% of corporate equity, and individuals the rest. The ratio used to be reverse a few decades ago. As households got comfortable with investing through mutual funds, institutions became larger holders of equity, therefore able to exercise greater control over corporate management decisions. Today, the assets under management (AUM) of US mutual funds are $27 trillion, more than the $23.5 trillion assets of the banking industry. So the mutual fund industry has more financial clout than the banking industry. Blackrock, the world’s largest asset manager, has an AUM of $9.4 trillion compared to America’s largest bank, JP Morgan Chase, whose assets are $3.9 trillion.
What’s the point of all this?
The point is explained by Felix Zulauf, a Swiss hedge fund manager. He says that 62% of global funds accruing to the fund industry flow into US equity, in proportion to market capitalisation. Of this 62%, 30% is invested in just 7 stocks, called the Magnificent 7 (Watch at 15:53).
This is concentration.
These 7 stocks are the top 7 tech companies, including Alphabet (Google), Amazon, Apple, Meta (Facebook), Microsoft, Nvidia and Tesla. The Magnificent 7 represent 30% of the market cap of the S&P 500. So they, essentially, pull the market up when they appreciate, which they do because 30% of inflow of global funds going to US are invested in them in an autonomous driven investment world.
In India, too, the top 5 stocks ( HDFC Bank, RIL, ICICI Bank, ITC and Infosys) have a combined weightage of more than 50% of the BSE Sensex.
Why do active fund managers concentrate holdings in a handful of stocks. Well, firstly, they are excellent companies, performing well. For another, they have a high market cap, allowing for easier entry and exit at lower cost. But also, importantly, the fund manager’s pay includes a variable component which is linked to his performance relative to the benchmark index. Thus the fund manager needs to invest in these select stocks, lest he underperforms the index should they rise, and so suffer a lower pay.
Stock markets have enjoyed a bull run for years, fueled by excess liquidity. Today, the two largest economies, US and China, are facing their own set of problems, due to which the liquidity propelling the market has shriveled. When liquidity reduces further, the concentration risk will manifest itself.
The set of problems in the US start with a high Government debt load of $34 trillion, the annual interest bill on which is $1 trillion. US interest rates, already up 5% in a bid to fight inflation, may not be considered high enough, (especially after the stance of an increasing number of countries to reduce, for fear of being sanctioned, their exposure to the USD) to attract foreign investors to buy US debt. So, rolling over the debt as it matures, will become tougher, and more expensive.
The US also faces issues with increased vacancy rates in Commercial Real Estate (CRE), offices , or shops and small businesses. Demand for office space is low after the work from home trend has accelerated. Shops and small businesses are shutting, unviable after the 5% interest rate hike. Around $117 b. CRE debt comes up for renewal in 2024. Looking to low rental income, part of this may not be renewed. It will be mainly the community banks (similar to Silicon Valley Bank) that will bear the brunt. Expect more failures of such rural banks.
Not only the smaller, community, banks, but the larger ones are also facing an issue with higher delinquencies (loan not serviced for 3 months). Watch this video (4:00). Delinquencies are estimated to be $25 b.; they were $31 b. during the 2008 GFC. With interest rates up 5% the demand for loans will also be impacted, which will reduce liquidity.
There will also be political risk in USA, which goes for the most divisive Presidential elections in November.
According to Kyle Bass, founder of hedge fund Hayman Capital, China has a bigger debt problem, China’s local Government (Provincial Government) debt is $11 trillion. This was used by local Governments to part fund real estate projects, usually housing. The major income source for local Governments was the auction of land parcels for such projects.
A huge part of the $11 trillion local Government is in default, because several realty companies like Evergrande, have defaulted. So a large chunk of this debt will have to be written off. To compare, during the GFC (Global Financial Crisis), some $800 b. banking assets were written off (see 1:37). So the Chinese local Government debt problem can dwarf the GFC. A sobering thought!
The real estate boom was, essentially, a giant Ponzi scheme, and has created an inventory of 65-80 m. vacant homes. The apartments were supposed to be nest eggs, and the chickens are now coming home to roost.
Add to that the geopolitical risks from several conflicts, and the future looks cloudy and uncertain.
What brightens the future is technology. Readers should hear this to understand that, if what Tony Seba, founder of think tank RethinkX says should happen, there will be an abundance of clean, cheap energy (even before nuclear fusion), the cost of transportation will be one tenth of what it is now, EVs will completely replace ICE (internal combustion engines) by 2030, and the use of precision fermentation in agriculture, as a source of protein, which will disrupt the animal farming industry. To get the same amount of protein from precision fermentation instead of from animal farming, requires a fifth of the energy (see 19:34), a tenth of the water and a hundredth of the land! This will free up huge land and water resources. Better still it will, according to Seba, result in a 90% reduction in CO2!
This begs the question, and demands an answer, why world leaders are faffing around spending money and time on senseless wars, and developing more sophisticated, and scary, weapons of mass destruction, when they ought to, instead, study and work on, technologies that provide mankind with a cornucopia of energy, transportation and food, and achieve climate change goals.
Why?
Last week the Sensex closed at 72568, up 542 points over the week.
Investors must decide whether the risks are emanating from a financial crisis, from banks considered too big to fail, or from foolishness of political leaders considered too dumb to think.
Comments may be sent to jmulraj@asiaconverge.com
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