How diversified is the global stock market?

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In this episode, we look at whether global equity markets are sufficiently diversified. Are they too tech heavy and too reliant on the fortunes of the US? Joining Kyle to give his views on the topic is Dean Cook, a multi-asset fund manager at Aviva Investors.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to On the Money, a weekly look at how to get the best out of your savings and investments.

In this episode, we're going to be looking at whether global equity markets are sufficiently diversified. Joining me to give his expert views on the topic is Dean Cook, multi-asset fund manager at Aviva Investors.

Heading into 2025, ahead of the sell-off that started in around mid-February for the US stock market in response to uncertainty over the tariff policies, there's already been plenty of column inches written, and we covered it in the podcast extensively, about how increasingly concentrated the US stock market has become.

So, at the start of the year, the Magnificent Seven stocks accounted for around a third of the S&P 500 index. For the global stock market, those seven companies accounted for around 20% of the MSCI World Index.

Dean, I first wanted to ask you, should those who invest globally, whether that be in an actively managed fund or owning the market through an index fund or an exchange-traded fund (ETF), be concerned about how much the global stock market has in those seven companies?

Dean Cook, multi-asset fund manager at Aviva Investors: Thanks, Kyle. I think it's important to be considerate about where the earnings are coming from. So, 2024 was a year where those very large technology companies delivered the lion's share of the earnings growth of the US market. So, this isn't a dotcom bubble rerun whereby a lot was promised, but very little delivered.

These are companies with actual earnings, actual customers, and actual cash flow kicking out the bottom of it. The latest earnings season, so this is Q1 2025 that we're now reviewing a couple of months after the fact, you've seen some quite interesting trends. So, having seen quite a lot of share price depreciation over recent times year to date, those very large technology companies have actually been posting some quite impressive earnings figures, certainly compared to expectations.

I think on average, six of the seven of those large seven companies have reported average net income above expectations of about 10%. So, beating people's expectations by about 10% is nothing to be sniffed at. And that's compared to a wider market that was only 6% expectations. That's still good. But we were coming to this earnings season with the expectation that the performance of those larger technology companies was maybe going to be coming closer into line with the rest of the market, but you're still seeing certainly the outperformance of them relative to the rest of the market.

So, it's quite a long way of saying that as long as companies are delivering on their expectations, you shouldn't be as worried about their concentration in wider markets, but you do need to be thoughtful about it when building portfolios and not leaning too hard into those types of things.

Kyle Caldwell: As stock markets are structured on a market capitalisation weighted approach, if a sector has a really strong solid performance, like technology has for much of the past decade, barring when interest rates started going up, that's increased the percentage weighting to the technology sector for global investors. Are global investors now overexposed to technology?

Dean Cook: Yes. So, for context, about 25% of the global market cap is made up of the technology sector, which sounds like a big number. But I guess what one needs to bear in mind is that technology is a really broad term. It encompasses a whole host of industries, many of which, if you think about it, didn't even exist a decade ago.

So, to pick two random names, the likes of an NVIDIA Corp (NASDAQ:NVDA), which makes chips and things for semiconductors, is not competing for revenues with a Zoom Communications Inc (NASDAQ:ZM) that does web conferencing.

So, to turn the question on its head almost, all companies require technologies to a greater or lesser extent. If you think about, say, Visa Inc Class A (NYSE:V) or a bank, these are platforms of technology that happen to be regulated and deal with money. So, you can more or less see technology wherever you'd care to look across the global market cap.

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Kyle Caldwell: So, how diversified are global stock markets? And due to global markets being diversified, can investors simply sit back and buy and hold?

Dean Cook: Sure. So, global equity diversification is important. What does it mean? It means that you're not putting all your eggs into one basket. You're taking an aggregate of groups of companies and benefiting from the offsetting performance of one versus the other.

It's more or less the only free lunch in investing according to Harry Markowitz, famous investor. And it will, generally speaking, give investors a better chance of realising their investment goals over the very long term.

The way I thought about this is that the extent of one's preference for buy and hold over something more dynamic probably relates to the investor themselves. So, what is it that they're trying to achieve? What time horizon do they have? And how comfortable are they taking risk in equity markets more generally?

We think that there's room for value add in the building of your strategic asset allocation, that long-term mix of assets that helps to deliver on your savings objectives, as well as tactical asset allocation, which gives you the space for shorter-term calls in different markets.

So, one particular example that that comes to mind at the moment, there's lots of talk about it in the market, is the role of the US dollar in portfolio composition and construction. One could build the argument that over a longer-term basis, the US dollar is quite overvalued, and you're beginning to see, slowly. global pools of capital start to move away from the US dollar.

Now, as a buy and hold investor, you need to be quite thoughtful about those types of longer-term trends because that will affect your investment journey.

Kyle Caldwell: Due to the fact that the US stock market comprises around 70% of the global market, investors are very exposed to the US dollar and to US companies. Are global investors too heavily reliant on the fortunes of one country?

Dean Cook: So, yeah, very topical question, one we're getting quite a bit at the moment. I'd probably think about this in a similar way to technology that we were talking about earlier. Not only are these US-domiciled companies generating revenues in the US, but they're also generating them all over the world. And over half the revenues of the Magnificent Seven that we were talking about earlier, these very large sort of AI thematic companies, they generate over half their revenue outside the US.

So, you're right, that taking things at face value, the US is a large proportion of the global market cap, but it happens to be home to some of these marvellous, very large global businesses. And so we try to be a bit more thoughtful about where the revenues are being generated rather than simply where a company is listed.

Kyle Caldwell: And for investors looking to increase diversification on a country level, what would you suggest? How would they go about doing that?

Dean Cook: Sure. Yeah. As I kicked off with at the beginning, we take the starting point that most stock markets are reasonably efficiently, valued and smart, and one needs to set quite a high bar for making material deviations from the global stock market. But if you were to be thinking about other markets that would complement America, then it's probably natural to look at the next largest, so, your likes of Europe and Japan.

Europe's got some interesting dynamics at play at the moment. They're on a programme of expanding fiscal expenditure in the defence space, and keen to ensure that companies are investing for growth there. So, it's quite an interesting dynamic that's going on.

Similarly, in Japan, where there's been a multi-year programme of corporate transformation almost. So, shareholders beginning to hold their companies to account, to demand better-run companies, the returning of cash to shareholders, and some sensible reorganisation of balance sheets. So, an interesting couple of trends that we're seeing there.

The benefit of those two markets relative to the US is a lower starting valuation, so those are cheaper stock market compared to America. And over the last 10 odd years, America's justified that premium valuation because it's delivered greater earnings growth relative to the rest of the world. But if there's an argument that the tide might be starting to turn, then markets like Europe and Japan are going to be top of the shopping list for many investors.

Emerging markets is a little more finely balanced, I'd say, in terms of a region that might benefit from this. So, the likes of China may well be slightly better equipped to deal with a protracted trade war with the US. But, actually, the usual benefits that emerging markets have from a weaker dollar, which is the situation that we're seeing ourselves in at the moment, might not necessarily manifest this time around.

Often as the dollar declines, so it gets cheaper relative to other currencies and you see emerging market stock prices do reasonably well and economies as well. The reason for that is a lot of those emerging markets will be borrowing in dollars. So, as the value of the dollar falls, it becomes cheaper to finance those deficits.

But at the moment, what you're seeing at the same time as the dollar falling is treasury yields, so the borrowing costs in the American market have gone up, and that offsets some of the benefit for those companies and governments.

Similarly, a declining dollar environment is generally consistent with rising risk appetites and people being risk-seeking in their activities, and that has historically benefited emerging market equities. But it's less clear to me that we're in that sort of environment at the moment given that the proximate cause of the shock that we've experienced over the last couple of months has been America and the dollar itself.

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Kyle Caldwell: And, of course, as you've just spoken about, different macroeconomic environments favor different industries and can favor different regions as well. We've, of course, had technology stocks top the performance charts for much of the past decade, but there have also been periods in which energy shares have been in vogue.

We're now in a period where interest rates are starting to fall, although it looks very unlikely that we're going to return to the days of interest rates being ultra low. Which types of sectors do you think will fare better than others as interest rates are declining?

Dean Cook: You're quite right to point to that broad spread of sector performance from year to year, and I guess that should tell you not to over-concentrate your portfolio in any one sector because there'll be years where it won't be such an easy ride.

The bond bull market, so the fact that fixed income has delivered strongly positive returns for upwards of 30 years, has benefited. It certainly did until 2022 when inflation hit and interest rates started rising. It benefited a certain sort of staple-like company that had those bond-like characteristics, so very stable recurring revenues and the like. It's fair to say it's probably kind of played out now. And you're also similarly correct that during that period of very, very low interest rates just after the global financial crisis, it was also a period of low economic growth, and that led to a growth scarcity, if you will.

So, investors were quite happy to pay more for companies that could deliver earnings growth because we were in an environment that had very little of it. And where we stand today, as you said, in an environment where interest rates are coming down, they're probably not as low as they were in the past.

But you're also in an environment where bond markets, if you're going out into the fixed-income world, have quite high yields relative to what, certainly for a period of time, we became accustomed to.

So, if you think about that as a dynamic, you've got lower interest rates and higher bond yields that allows banks to take deposit monies in and pay lower rates on those deposits, and then lend it out on a longer-term basis to corporates or mortgage holders. And that's quite a profitable business when you've got a nice big spread between those two numbers.

But as you say, year to year, different sectors are going to win, and it's important to come at it from a diversified perspective.

Kyle Caldwell: And over the long term, the composition of the global stock market changes. I think if we go back to the late 1980s, Japan was the biggest country in the global stock market, a much bigger percentage then than it is today. Research from Research Affiliates, which is a company that specialises in predicting the future returns of asset classes, found that of the largest 10 stocks globally at the start of each decade, only two of those 10, and sometimes only one, were able to defend their position a decade on in terms of still being one of the largest 10 stocks globally.

A very big question, but I'm going to ask it anyway; how do you think the next decade will pan out for global markets? And how do you envisage the composition of the global equity market changing from today?

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Dean Cook: That's the big question, isn't it? And I suppose my glib response would be, in 10 years’ time, you're going to see a different composition of the top 10 stocks. History tells you that's probably going to be the case. Many of them, we probably haven't even heard of yet. They may not even exist.

One thing that that teaches me anyway is that the sort of arbitrary groupings of stocks as we talk about them, either in the financial press or when it becomes a useful model for understanding how the world is behaving; so that sort of Magnificent Seven reference from earlier, that tells you that those types of arbitrary definitions are probably unhelpful when it comes to building resilient portfolios for the long term because what is profitable investment through time is going to change.

A factor I think is really interesting when thinking about some multi-period return, so coming on for decades of performance, is the rise of private capital. So, it's well known that the number of stocks listed on the market has declined over time and companies are staying private for longer. So, that tells you that there's a period of a company's life where it's probably growing pretty quickly, might have reasonably high needs for ongoing investment, but the profits to those who do invest through that period can be quite large.

Obviously higher risk, but that's commensurate with the returns that you're seeking. And you may well miss out on some of that for those people who are only invested in public markets, in listed equities. So, I think that being thoughtful about asset classes like private equity, which might allow access to faster-growing parts of the market, is an important consideration when looking at these things in the round.

Kyle Caldwell: My thanks to Dean, and thank you for listening to this episode of On the Money. If you enjoyed it, please follow the show in your podcast app and do tell a friend about it.

If you get a chance, leave us a review or a rating in your podcast app too. You can join the conversation, ask questions, and tell us what you'd like to talk about via email on OTM@ii.co.uk.

In the meantime, you can find more information and practical pointers on how to get the most out of your investments on the interactive investor website at ii.co.uk. I'll see you next week.