There remain points of promise for investors across the asset class spectrum.
Key takeaways:
- Bond yields will remain elevated: High deficits and loose fiscal policies are putting pressure on the long end of the yield curve, but this can present an attractive re-entry point into fixed income at the shorter end.
- Diversify across asset classes: Positive correlations between bonds and equities are also here to stay. Investors can respond by looking to alternative sources of protection like commodities, while watching their currency exposures.
- AI maintains its momentum: The market is looking for signs to justify immense AI-driven capex spend; we are positive meanwhile that the opportunity set remains immense.
Economies and asset markets are handling the pressures of conflict and rising bond yields well. The big supporting driver is the AI capex cycle, says Salman Ahmed, Head of Macro and Strategic Asset Allocation. The spend coming from AI hyperscalers (plus that from across the rest of the vast AI value chain) is immense and is also translating into corporate earnings. If anything were to disrupt that cycle there could be a significant rupture, but Ahmed doesn’t see that coming any time soon.
High yields don’t mean low spirits
The headline concern is rising bond yields. Ahmed explains that fiscal policies in leading developed markets are out of sync with economic cycles, in particular in the US, where the debt-to-GDP ratio is above 100 per cent. These deficits are here to stay, and they put significant pressure on the long end of the yield curve.
In part this could represent a normalisation of bond yields to historic means, which have been suppressed by years of below-target inflation, says Marion Le Morhedec, Global Fixed Income CIO. In many ways she isn’t surprised by today’s pressure, which reflects longstanding concerns over ballooning deficits. What has changed is that government bonds are increasingly competing against AI hyperscaler issuance. Moreover, the investor base for sovereign debt has shifted from central banks to new participants like hedge funds.
This is not necessarily a bad thing, in Le Morhedec’s eyes. She thinks
“the repricing of the fixed income market is pretty healthy and gives really good entry levels”.
More than that, she says that we are “back to what fixed income is about: fixed income is about carry, it’s about the right selection of sectors, the right sector rotation, and issuer selection”.
And while the backdrop pressures long-dated duration, she sees a sweet spot in short-dated bonds, and in particular high yield. She notes too that the average credit quality has improved markedly over time.
Punam Sharma, Head of Equity Research, Europe, is similarly sanguine. While rising yields can harm equity valuations, she doesn’t see this invalidating their broader momentum. There remains a powerful earnings growth story, sectors with strong pricing power, and good cash conversion across the market.
Sharma also points out that credit growth serves as a multiplier of nominal GDP growth which can benefit certain sectors. High inflation in particular is a boon for banks, whose net interest income is a function of interest rates. She identifies other positive idiosyncratic trends: strong automation driven by labour scarcity, a powerful industrials story, and booming government spending in aerospace and defence sectors.
AI A-OK
Our investors remain broadly positive on the AI story, despite sideways moves in equity markets since August.
“From a fundamental equity investor perspective,” says Sharma,
“I would say this valuation consolidation when company fundamentals continue to improve is a very good backdrop for active alpha opportunities.”
She argues that the market wants proof that AI spending is going to lead to tangible outcomes, and that is causing the wobble. Investors needn’t worry: Sharma sees no sign of the red flags you’d expect of a late-cycle consolidation; instead, inventories remain stable with few cancellations of orders.
Meanwhile, Sharma is confident that the market will receive the signs it’s looking for. Leading AI companies are launching products targeted at the consumer that are directly leading to a spike in valuation, and she anticipates far more of these to come
Finally, Sharma points to the “feedback loop” being created across the AI value chain. Within semi-hardware, for instance, she explains that excessive demand for compute is driving more investment and a positive growth-multiplier effect.
Beyond AI
These are positive dynamics for markets, but there is a risk that this momentum leaves investors exposed if they don’t protect against the potential downside, especially as correlations between equities and bonds turn more positive. Matt Quaife, global head of multi asset, recognises that this makes life more difficult for investors looking to build a well-diversified portfolio. The typical 60/40 split between the asset classes will no longer suffice, but Quaife recognises that this is nothing new.
“When inflation is more volatile than growth, you’re going to get more positive correlation […] it’s actually the period since 1995 and its long negative correlation that seems the outlier.”
Quaife is therefore looking elsewhere for the sort of protection bonds once offered: greater use of options in equities; diversifying into alternatives like gold or absolute return strategies; replacing duration with other forms of carry.
He stresses the influence that different currency exposures can have on a portfolio. Dollar exposure in portfolios has crept up at the same time that the greenback has weakened, for instance. He recommends investors review their currency exposure to ensure they’re comfortable with their levels.
That dollar weakness reverberates across all kinds of assets. A stressed dollar is usually good for emerging market (EM) equities and bonds. For Sharma, one attractive aspect of this universe is being able to pick your earnings exposure. For example, if you want exposure to AI but not the US, you can look to north Asian markets which lead in semiconductor and memory names. For manufacturing, turn to China, which offers global leaders in the electric vehicle and battery spaces. Sharma is particularly bullish on Brazil, where the weak dollar and high real interest rates have stabilised the currency, and whose market is well-positioned ahead of its domestic elections in October.
Le Morhedec is positive on EM debt for similar reasons, despite limited inflows in recent years.
