Markets and midterms: why we remain constructive

We’ve seen a pretty sharp sell-off in markets this week. We wanted to think about the drivers behind it and how it impacts our thinking.

The volatility this week didn’t come out of the blue. Investor concerns about the so-called “Artificial Intelligence (AI) Trade” have risen in recent weeks. That’s prompted some weakness in the tech-heavy Nasdaq index in the US, down 15% from its recent high in October. 

Other markets have seen sharper declines over the past few months. The Korean index fell 36% from its peak in June until the end of October. Following this week’s decline, the index now stands 44% below its recent highs. We believe that expectations for AI growth had already moved lower even before this week’s moves.

The sell-off coincided with the results of the US midterm elections, which saw US voters deliver a pretty damning verdict on the incumbents. Democrats regained control of the House and the Senate. Data centre construction had been an important topic of debate during the campaign, with Democrats arguing for a slower expansion, or a moratorium in some regions, on the build out.

At the same time, the sharp moves in stock prices this week suggest that there was a lot of leverage in equity markets. Data suggests that retail investors have become bigger users of equity options to try to magnify their returns, and that can exacerbate swings in equity prices during periods of market volatility. 

Our view on the market sell-off

Market sentiment remains fragile, but we believe the underlying fundamentals still look pretty solid. Corporate earnings remain robust, with S&P 500 earnings in the third quarter growing around 30% year-on-year. Some of that reflects higher oil prices, but the underlying picture is pretty healthy. 

Analyst expectations for 2027 are also so far pretty healthy, with both double-digit earnings growth forecasted for both US and Europe. The combination of strong earnings growth and market weakness means that equity valuations have moved lower. Forward Price/Earnings for global equities is below its ten-year average.

We think that the results of the US midterm elections could prompt slower expansion of data centres in the US, and probably increased regulation. We don’t believe this will undermine the long-term prospects for AI. Politicians are keen to deliver growth, jobs and a lower cost of living to their constituents. That’s not an easy challenge, but we’d expect them to look for ways to encourage investment, albeit with fewer incentives than might have been the case previously. 

Data centre investors will probably need to invest more in providing power and utilities than they might have hoped, and work harder to ensure that their demands on power and water don’t come at a higher cost for households in those regions. A slower roll-out might prove more sustainable, allaying concerns that hyperscalers would burn too much cash too quickly in their quest for growth.

The basic questions haven’t changed in the past week: can providers of large language models like Anthropic and OpenAI earn a decent return from their investments? Do end users derive a benefit from these products and services, and are they prepared to pay for them? For now, we still think the answer to those questions is yes.

It’s also interesting to see that the sell-off in equities has coincided with a repricing of rates expectations. Investors now expect slightly fewer rate hikes than they did three weeks ago. Intuitively, we think that makes sense. AI investment spending has been a significant driver of global growth, so slower spending should translate into slower growth. It’s something that Central Bankers will likely watch closely in the coming months.

Finally, the geopolitical situation remains very uncertain. Negotiations between Iran and the US, via intermediaries, are ongoing, but the potential for re-escalation is very much alive. 

What does it mean for portfolios?

Periods of market volatility can be painful, but we aim to maintain our long-term focus. That’s always been the case, but it’s become even more relevant as technology has allowed traders to act even faster and with less friction. 

From a research perspective, we remain constructive on the outlook for earnings growth. There remain a number of risks, from geopolitics, higher interest rates or a drop in AI spending, but our base case is that we’ll see decent growth, in economies and earnings in 2027. 

When we think about our positioning, we consider our internal benchmarks and portfolio volatility targets. In that context, we think that we have scope to increase our equity exposure, if that’s consistent with the research view. 

Diversification is key – across geographies, factors and asset classes. It’s interesting, for instance, to see how fixed income has held up fairly well over the past couple of weeks. As equity markets have become more concentrated, maintaining that diversification within equities has become even more important. 

Short-term volatility can sometimes create opportunities for long-term investors. Market volatility could persist for a bit longer, but at this point we continue to see a decent macro outlook, solid earnings growth and improving valuations. Those are assumptions that we’ll continue to debate, but based on our current outlook, we’re considering when and how to increase our equity exposure, rather than reduce it.