Making sense of shifting market dynamics

The dynamics in financial markets continue to shift. In some respects, the long-term themes remain intact – geopolitical uncertainty, rising oil prices and robust corporate earnings growth. But the market reaction, as was the case last week, has differed from what we saw earlier in the year. Government bond yields in the US and UK moved lower and tech shares were weaker. We continue to debate what, if anything, these moves mean for longer-term portfolio returns. Is this a start of a new trend, or a bump in the road for Artificial Intelligence (AI) stocks?

Let’s start with the macro backdrop. In general, the outlook remains decent, perhaps surprising given where oil prices are. Economic Surprise indices remain positive, indicating that macro data is coming in a bit better than analysts expected. That said, we’ve seen a bit of a deterioration in Europe over the past few weeks – mostly driven by France, where political and social uncertainty are taking their toll. 

In terms of geopolitics, the picture is more challenging. Oil prices have continued to move higher, perhaps reflecting concerns of a re-escalation in the conflict in the Middle East. That’s been a familiar theme, but the reaction from bond markets has been more surprising, as government bond yields moved lower in the US and UK this week. You might have expected higher oil prices to raise inflation expectations and prompt bond yields to rise. Instead US treasuries have been more of a safe haven over the past couple of weeks. Perhaps the move lower is just a normalisation after a strong move higher in yields over the past few months, but it might reflect investors shifting their allocation from equities to bonds, given attractive yields in fixed income. 

We are considering if the fall in longer-dated yields is a sign that growth might weaken in the coming quarters. The macro data doesn’t suggest that slower growth is imminent, but it’s something we’ll continue to monitor. A meaningful ceasefire in the Middle East could have a significant impact across financial markets. Lower oil prices could feed into lower bond yields, making capital cheaper for a range of businesses and sovereigns. That’s something investors have been hoping for for some time, and the outlook there remains uncertain.

On the equity side, we’ve seen a range of companies reporting earnings, mostly in the US. The overall picture remains very healthy, with third quarter earnings growth running above 20% year-on-year, albeit with many companies still to report. But strong results haven’t been enough to help tech businesses, a number of whom saw their share prices sell off in the wake of good results. The easy response to that is to suggest that market expectations were higher, but at the same time we’re seeing equity valuations (e.g. the forward price/earnings ratio) move lower. 

As we’ve noted before, that’s particularly true in Emerging Market equities, which trade at the largest discount to European equities in the past twenty years. Concerns about the health of the “AI trade” are still very much with us, and we’ve seen that particularly reflected in the credit space, where the cost of debt for certain AI businesses has risen sharply. We remain broadly constructive on the equity side, where we think underlying demand is still strong and the build-out of AI infrastructure continues. 

Looking forward, we see a couple of notable events in the next couple of weeks. US mid-term elections have the potential to cause some short-term volatility, given the febrile political environment. While we’ll monitor the situation closely, we typically don’t make portfolio changes in response to elections and we’d expect that to be the case this time as well. 

In the UK, we’ve got the Budget announcement – and we’ll say more about that next week. European governments face a number of fiscal challenges, and the UK is no exception. That said, the new Chancellor is aiming to build a reputation for fiscal conservatism, and that could play well with fixed income investors. 

Finally, we’ll likely get the kick-off of the long-awaited Anthropic IPO, with the formal release of its prospectus. That should give us more details about the business, and the risks. At a time of uncertainty around AI, the Anthropic IPO is likely to be an important bellwether for investor sentiment at least in the short-term, although it will likely be some time before it becomes a meaningful part of global equity indices.