Record highs can be misleading

It wasn’t long ago that many investors were still debating whether AI would genuinely become a transformative force for businesses and economies. Today, most have accepted that it will.

The bigger question now is whether AI companies can keep delivering the sort of growth that investors have come to expect. Many of the strongest-performing companies in the market are also the biggest beneficiaries of AI spending. Their earnings have been strong enough to support valuations that would have once seemed ambitious.

But that success is creating a potential problem. The more the market depends on a narrow group of companies, the less room those companies have for disappointment.

Last Thursday's technology sell-off is a good example.

Reports suggesting that OpenAI's annualised revenue was around USD50 billion rather than USD70 billion triggered a sell-off in AI-related shares. The Nasdaq fell around 1.3%. The reported difference reflected revenue measurement rather than a collapse in demand, but investors reacted quickly, nonetheless.

The question of whether growth expectations have moved beyond reality is likely to become more important as other AI companies seek public-market funding, including the anticipated flotation of Anthropic next month. Investors will increasingly focus on revenues, funding requirements and eventual returns on the vast sums being invested across the industry.

Neither the record highs nor the tech sector sell-off changes our constructive view on equities.

Economic growth remains resilient and the AI investment cycle continues to support company earnings. We therefore maintain a moderate overweight position in equities, with preferences for US and emerging-market stocks. 

However, a more concentrated market strengthens the case for diversification.

Investors often think about diversification when markets are struggling. In reality, it can be just as important when markets are performing well. The risk is not that growth disappears overnight. The risk is that confidence becomes concentrated in a small number of companies, sectors or themes.

That is one reason we continue to complement our equity exposure with an overweight allocation to gold and downside equity protection in eligible portfolios. 
We also see increasing value in parts of the bond market. Government bonds remain volatile, with US 10-year Treasury yields reaching around 5.36% last week before retreating, falling roughly 10 basis points during Thursday equity sell-off. However, the bond market’s adjustment is not one-way. Demand for US Treasuries remains, suggesting investors are becoming attracted by the higher income available. 

Reflecting both those opportunities and our concerns about European political and fiscal risks, we recently reduced European government bonds from overweight to neutral and increased US Treasuries to a moderate overweight position. 

The coming weeks may help determine whether the current rally can broaden or whether it continues to depend on a relatively small number of market leaders.

Third-quarter earnings season begins this week with major banks reporting results. Investors will also be watching US inflation data and economic releases from China for further evidence on growth and pricing pressures.

For now, investors remain comfortable with a market increasingly driven by a small group of companies. Earnings season could help tell us whether they should be.