Where to diversify your equity portfolio if the US is too risky

While the outcome of the AI-driven ‘bubble’ is as easy to predict as the health of Shrödinger’s Cat, the equities panel at Natixis Investment Managers’ Japan CEO Symposium did agree that risks are elevated in equity markets right now. However, they also agreed that abundant opportunities exist for active managers and savvy investors alike.

Risks are elevated in US equities

Valuations were unsurprisingly a key topic on the day. As Bruno Poulin, CEO of Ossiam, points out the S&P 500’s CAPE ratio, a well-regarded market valuation metric developed by Professor Shiller, has “hit a level of 40 for the second time in history, the first time was in 1999” just before the dot-com crisis.

While he doesn’t think this necessarily means a market crash is imminent, he does think it signals two things: “First, you usually get lower returns after reaching these levels. Second, you become more sensitive to exogenous shocks from the market. So, in short, you need to adjust your risk budget.”

Along with the elevated valuations, T.F. Meagher, Head of Distribution for Harris l Oakmark is concerned about increased concentration within US equity markets. He says they now classify the S&P 500 as a “mega-cap growth fund” due to its concentration in technology as well as concentration within fewer stocks: “A handful of names make up over 25% of the S&P 500 index…so you wouldn't even be able to call the S&P 500 a diversified fund.”

Chris Wallis, CEO and CIO of Vaughan Nelson, agrees that the biggest risk right now is “excessive concentration within the US large-cap passive indices” though he doesn’t think this is necessarily a disadvantage for active investors who can use that volatility to gain more attractive entry and exit points for individual stocks.

Where to turn to for diversification

While T.F. Meagher is concerned about overall valuations in the US, he still sees good value within sectors like financials, healthcare, and energy: “We can build a portfolio of US value stocks today that trade at about half the P/E of the S&P 500 index with very similar growth characteristics.”  He is also ‘very optimistic’ about European equities and he is most bullish on Japan. Within the Japanese market Harris l Oakmark prefers small to mid-cap domestically-oriented companies and think the valuations within software and services look particularly attractive.

For Daniel Wiechert, Client Portfolio Manager at WCM, he sees an inflection point approaching where “the things that worked well in the past are less likely to work well going forward.” This makes him wary of areas like software as a service, outsourced IT services, and some of the more crowded AI trades. He does however see opportunity around the “$364 billion in capital commitments that Meta, Amazon, Google and Microsoft have made this year alone in building out their hyperscaler capacity.” This includes areas like HVAC, fibre optics, cooling systems, power, and electrification. Daniel also believes that the commitment of NATO member states to spend up to 5% of their GDP on defence by 2035 has made Europe a more attractive place to invest. He particularly likes opportunities in defence and infrastructure, as they “have been chronically underfunded for years.”

Our panel agreed that these elevated risks create a diverse set of opportunities for active managers, who can thrive amid volatility. Chris Wallis in particular was in a buoyant mood: “while it's a volatile headline environment...we're finding great investment opportunities across the globe and across the market cap spectrum.”