The late Harry Markowitz’s adage “diversification is the only free lunch in investing” has never been more applicable than in the current market environment, one that continues to bemuse fund selectors and industry commentators alike.
Forecasts of inflation returning to pre-pandemic levels have driven a surge in risk equities with ‘junk’ assets such as blockchain equities shooting the lights out so far this year.
VanEck’s blockchain ETF, the VanEck Crypto and Blockchain Innovators UCITS ETF (DAPP), has been the poster child of this exuberance with returns of 212% in 2023, as at the end of July.
Growth stocks – led by ‘the magnificent seven’ of Apple, Amazon, Alphabet, Microsoft, Nvidia and Tesla – have also surged, driving the Nasdaq 100 and S&P 500 up 45.1% and 20%, respectively, over the same period.
The latest US inflation readings of 3% in June and 3.2% in July have given investors cause for comfort with many eyeing riskier parts of the investment landscape.
Highlighting this, the Xtrackers MSCI USA Information Technology UCITS ETF (XUCT) saw €342m inflows in July alone, according to data from ETFbook, while investors pulled €453m from the iShares Physical Gold ETC (SGLN), the most across all ETFs listed in Europe.
Furthermore, despite calls from the Federal Reserve that it plans to hike interest rates before the end of the year in the face of a strong-than-expected US economy and stickier core inflation, markets are not currently forecasting this.
According to the CME’s FedWatch Tool, markets are pricing in a 12.2% chance of a rate cut at December’s Federal Open Market Committee (FOMC) meeting and a 62.7% chance of a hold at the current level.
With riskier assets perfectly priced following the rally this year, risks remain to the downside. As a result, any spike in inflation will quickly temper this irrational exuberance.
“Core inflation continues to be more stubborn,” David Henry, investment manager at Quilter Cheviot, said. “Those expecting cuts at some point this year or early next year may be disappointed.
“The Fed has stated rates will stay sufficiently high for the immediate future and it will be desperate not to have a repeat of the 1970s, where we saw inflation spike again as central banks were too early in easing off on monetary tightening.
“Investors should be wary that single data points continue to have a significant impact on markets, so while the battle to bring inflation down is not over yet, it is our view that clients would be best advised to remain invested in those quality names that can thrive in uncertain times.”
In this environment, adopting a granular approach will be crucial if investors want to weather the potential risks ahead.
This means equal-weight ETFs could be an option to remove concentration risk from portfolios while defensive sector ETFs such as consumer staples and materials reduce exposure to ‘growthier’ names.
“This is not a friendly backdrop for broad asset class returns,” Wei Li, global chief investment strategist at the BlackRock Investment Institute, warned. “Benefitting from this requires getting more granular and eyeing opportunities on shorter horizons.”