Allocation Views: AI froth, sticky inflation and the search for broader opportunity

Summary

We have improved our view on equities into July, despite signs of exuberance in some markets, as strong corporate fundamentals and healthy growth justify valuations.

Investor appetite for the artificial intelligence (AI) trade has concentrated equity index composition and caused some frothiness in technology stocks, but this appears to be contained, in our view. The broader equity market, notably in the United States, is supported by strong earnings and a resilient macro backdrop, while beneficiaries of AI capital expenditure (capex) continue to justify ambitious earnings growth expectations.

Material progress toward reopening the Strait of Hormuz has also significantly improved the outlook for equity markets in regions with a high sensitivity to energy prices.

Persistent inflation and hawkish policy rhetoric could challenge our view, though fiscal stimulus across many regions provides some offset.

Macro Themes

Steady growth

• Robust earnings expectations fuel an optimistic post-conflict outlook, supported by improving earnings breadth.
• The US economy has proven resilient, while labor-market data has stabilized.
• Leading economic indicators look healthy, but we are monitoring the impact of higher input costs.

Persistent inflation

• US inflation dynamics continue to be challenged by elevated core inflation, driven by services ex-housing.
• We expect limited second-order effects from the energy impulse, as conflict in Iran moves closer to a resolution.
• Core goods inflation is also above trend. Tariff pressures may have peaked but global supply chain tightness is currently providing an offset.

Policy bifurcation

• There is an increasing bifurcation between supportive fiscal policy and restrictive monetary policy as markets assess the energy price shock.
• The Middle East conflict has catalyzed a recalibration of policy expectations, with a tightening bias in most regions including the United States.
• Fiscal policy is supporting growth but contributing to expanding deficits. US tax refunds have been offsetting tariff headwinds, while energy support packages could also prove influential.

Portfolio Positioning Themes

Equity optimism

• Corporate fundamentals remain strong amid double-digit earnings growth expectations for the next 12 months.
• Conflict in the Middle East appears to be moving toward a resolution, and we would expect markets to look through any temporary setbacks.
• Positioning is showing signs of euphoria in some areas, but sentiment is neutral overall, remaining broadly supportive of risk assets.

Diversifying equity exposure

• We retain a preference for US large-cap equities, with a focus on the beneficiaries of AI capex. We also have diversified into value stocks amid concentration concerns.
• Reopening the Strait of Hormuz has improved our view of energy-sensitive markets in Japan and the euro area.
• We also favor emerging markets amid falling energy prices, healthy corporate fundamentals and exposure to AI capex beneficiaries.

Rebalancing duration

• We expect demand destruction to have a greater impact on monetary policy decisions than market pricing suggests, decreasing the chance that international central banks meet market hiking expectations.
• Resilient US growth and challenging inflation dynamics complicate Fed policy. We have moved further underweight US duration amid sustained upward pressure on yields.
• Excess returns for equities appear more attractive than credit, amid strong earnings and tight spreads.