Leaning in

Market volatility has picked up of late, which was bound to happen at some point after an almost straight-line move upward in equity markets since mid-April. The recent bout of volatility has coincided with consternation on the outlook for Fed easing and increased scrutiny on the return on investment from AI-related capital expenditures.

We believe the Fed will remain on an easing track, with downside risks to the labor market outweighing the upside risks to inflation. As a result, we have added US duration to hedge our otherwise pro-risk positioning.

Addressing concerns around AI is less straightforward, and we expect the market to grapple with this theme for some time. Nevertheless, the AI trade is becoming more nuanced, with increasing dispersion within megacap tech among perceived relative winners and losers – we view this as a healthy development. High market concentration and valuations underscore the case for balancing index and active exposure, to ensure diversification should the ROI of AI investment fail to meet lofty expectations.

We think underlying fundamentals will remain solid and with markets having derisked, we have added some exposure to risk assets, including to high yield bonds.

Equity weakness essentially began around the October 29 Federal Open Market Committee meeting, where Fed Chair Powell introduced uncertainty about the likelihood of a third consecutive rate cut in December. Since then, several Fed committtee members have added to a more hawkish discourse, reducing market expectations for a December rate cut to a coin toss.

Despite this, we expect Fed Chair Powell to weigh the downside risks to employment as greater than the upside risks to inflation, and build a consensus for a December rate cut. The unemployment rate is gradually rising and inflation has generally come in lower than expectations. Meanwhile, one-year CPI swaps are trending lower, building confidence that tariff-driven inflation will be outweighed over time by disinflationary pressures elsewhere.

Exibit 1: Inflation swaps are trending lower, signaling less market concern on inflation

US inflation swaps

Should we be wrong and the hawks prevail in keeping the Fed on hold with no rate cut, we expect weakness in risk assets to be short lived. The Trump administration will soon announce its successor to Fed Chair Powell, whose bias will likely be to bring rates closer to 3%.

And while economic growth is likely to bounce back early next year from government shutdown induced weakness in Q4, it is highly uncertain whether the labor market will re-accelerate in kind. That a key driver of growth, AI capex, is not particularly additive to job growth (and AI may ultimately be a headwind to employment growth), suggests to us that the case for further easing is likely to remain strong. We note that despite the shift in the expected timing of Fed cuts, the market-implied terminal rate is largely unchanged.

Given our expectation for further Fed easing, and our view that the downside risks to the labor market are greater than the upside risks to inflation, we have added a long US duration position to portfolios. This should help to diversify some of our long risk positions should the labor market deteriorate more than expected.

Exibit 2: Market pricing of the Fed’s terminal rate has been stable

US 2y1m OIS swap

Tech has underperformed in recent market weakness, despite the megacaps posting another exceptional earnings season. The debate on whether the substantial capital expenditures in AI will ultimately deliver attractive returns has gone from simmering to super-charged.

Despite some near-term discomfort for portfolios, we actually view these dynamics as quite healthy for the sustainability of the AI investment theme. That the market is starting to punish certain companies for outsized capex plans without a commensurate revenue outlook can provide a certain ‘market discipline,’ much like bond market vigilantes encourage governments to rein in spending. Bubbles happen when investors completely abandon fundamentals in favor of risk seeking — this doesn’t appear to be what is happening.

Indeed, the market is becoming more discerning in how it is pricing AI. The stock price correlation between publicly traded hyperscalers has fallen from near 80% in June to 20% now, the lowest since 2017. This change in stock price correlations indicates that the market is becoming more selective about potential relative winners and losers in this space, a healthy development.

Exibit 3: The average correlation across the top five hyperscalers has fallen

Average 3m pairwise correlation for the top 5 hyperscalers

In general, we think the increased market concentration in the AI theme, along with declining correlations speaks to the growing need for investors to ensure they are actively diversified in their exposures. The Magnificent Seven now accounts for 35% of the S&P 500 by market capitalization, and about half of the index is either directly in the technology sector or closely linked to it through business models and infrastructure. Essentially, going purely ‘passive’ is very much an ‘active’ bet. Many active managers have struggled in recent years amid narrow performance in equity indexes, but as the market becomes more discerning on the AI theme and focus shifts from AI enablers to adopters, we expect diversification within equity indexes to become increasingly important.

Exibit 4: Market concentration has increased significantly

Market cap of 10 largest companies as share of S&P 500 total

Despite a garden variety pullback in equity markets, some of the measures of sentiment and positioning we track have downshifted sharply. This creates fertile ground for a rebound as the markets refocus on solid earnings, continued monetary accomodation and the USD 55 billion boost to US disposable income coming this spring (from the US fiscal legislation passed earlier this year).

We remain constructive on the outlook and maintain an overweight position in equities. Indeed, earnings continue to exceed expectations, with the most recent quarter delivering the largest proportion of upside surprises among S&P 500 companies since 2021. Earnings globally are showing impressive breadth, and we continue to favor regions where this is most paramount, in emerging markets and Japan.

And despite recent concerns in areas of credit, we reiterate that while there are pockets of excess, private sector leverage in aggregate is at multi-decade lows (see Macro Monthly: The key to this cycle’s resilience). In this context, we have taken advantage of the recent widening in credit spreads to add high-yield US credit. Increasing leverage among AI hyperscalers is happening in the IG market, while the underlying supply-demand dynamics in high yield remain favorable.

The main economic risk still relates to the labor market. We are cognizant that softness could accelerate into something worse, and so have hedged our risk asset exposures with an increase in duration. Despite more hawkish Fed speak from some members of the FOMC, we think the Fed will not hesitate to ease more should the labor market fail to show durable signs of stabilization.

Asset class views