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Thought of the day

Global equities are on track to post a third consecutive week of declines, the longest losing streak since this time last year. Worries over a prolonged war in the Middle East, and therefore a sustained disruption to global energy supplies, continue to weigh on markets. Israel has launched a fresh wave of attacks on Iran, despite US President Donald Trump’s request not to repeat its strikes on Iranian natural gas infrastructure, while Bahrain, Kuwait, and the United Arab Emirates all reported missile attacks in the early hours of Friday.

Meanwhile, investors’ questions about the sustainability of AI capital spending and the risk of software industry disruption have not gone away. Recent headlines in the private credit industry have also added to negative sentiment, with some loan valuations being written down and some funds placing limits on redemptions.

Here are our perspectives on some of the key market concerns to help investors navigate a complex investment landscape.

The path by which energy flows from the Middle East will be restored remains unclear. With the conflict approaching its fourth week, we believe investors should be cautious about assuming a swift resumption of energy flows, which we think could only be fully restored by a combination of military and political means. Short-term economic effects are likely to be shaped more by consumer behavior than by oil prices alone, but higher energy costs will eventually feed through to consumer confidence and economic growth if the disruption persists. With energy prices already high for a number of weeks and likely to remain there in the near future, modestly higher inflation and weaker growth will likely be a feature in the coming quarters. Major central banks this week have all acknowledged this with a shift to a more hawkish tone in their communications.

The rapid progress in AI capabilities points to shifting dynamics in the digital economy. We believe the long-term outlook for AI growth remains intact and expect the total addressable market will continue to grow. But we also have concerns that the market may not easily digest all the debt and equity issuance that AI companies foresee. Furthermore, continued growth in AI capabilities is posing risks to the “moats” of existing digital platforms, and it is hard to tell who the “winners” will be when the dust settles. Some software companies will inevitably see reduced demand and/or slimmer margins, while others may be able to evolve from selling tools to selling measurable outcomes, with AI agents creating powerful engines for new demand for companies capable of packaging and pricing according to value delivered.

Systemic risks stemming from private credit are likely contained. We downgraded direct lending as an asset class from Attractive to Neutral in September last year, reflecting a more balanced return outlook amid lower rates, tight spreads, and a bifurcation in credit quality. We think these factors remain in play—particularly for loans in the lower middle market and those originated in 2021-22—and we expect the overall default rate to tick higher to 4%. But for long-term investors who are prepared to tolerate illiquidity, the asset class still offers relatively attractive yields and diversification benefits, in our view. We note that redemption restrictions can protect against forced asset sales and are not a direct reflection on the credit quality of a lender’s loan book. We also view systemic risks stemming from private credit as contained, as direct lending remains a relatively small segment within the broader credit markets. Most lenders operate with underutilized borrowing capacity, maintain adequate interest coverage cushions, and exhibit limited asset-liability mismatches or run risk.

But while the investment landscape is complex, with an uncertain future and elevated risks, our recommendation for long-term investors is clear: Stay invested. Our base case is that equity markets will end the year higher, and that bond yields will end the year lower. We believe investors can navigate current challenges and capture future opportunities by staying invested, diversifying, and hedging.

For tech exposure, we believe investors should bring allocations to the US tech sector back into line with benchmarks and ensure they take a diversified and active approach across the AI value chain as well as geographies. China’s internet sector, for example, remains a source of opportunity, and barring an escalation into a Middle East risk-case scenario, certain segments in Asia and Europe offer robust growth at attractive valuations.

We also think private credit can add value to a well-diversified portfolio over the long term, and we recommend investors consider biasing exposure toward funds focusing on senior, sponsor-backed, upper-middle-market loans in non-cyclical sectors, which are proving more durable.

Read more in our latest Monthly Letter.