Three factors heavily influenced the financial landscape over the last 12 months — AI-focused technological optimism, hoped-for leveling up, and higher government bond yields. All three will continue to be in play this year but in a manner that suggests greater volatility, and the need for an investing rethink that incorporates a larger universe of opportunities in both public and private markets.
Optimism about the productivity-enhancing potential of exciting tech innovations is reflected in the extent to which a handful of companies have led the surge in the S&P 500 Index from one record level to the next. It is a well-founded sentiment, given the many ways in which artificial intelligence will improve what we do and how we do it. It is also warranted by the speed with which advances are being made. The money being thrown at the sector and the frequency of upgrades has some in the industry readily admitting that they are not sure where the technology will be in the next two years.
Looking forward, this optimism is likely to be amplified not just by the broader application of generative AI, which is best thought of as a general-purpose technology, but also by progress in other areas of AI. There is as well the exciting promise of ongoing work in quantum computing and life sciences. The next few years will be particularly consequential as we see interactions between artificial general intelligence, quantum and life sciences.
The concentrated nature of the stock market surge has resulted in several unusually wide valuation dispersions. These include tech versus the rest of the market, US versus foreign equities, and US equity returns versus bond returns. In triggering several unusual phenomena, including a negative equity risk premium, these divergences have led some in the market to expect a leveling-up, both within the US and internationally. We see this reflected in the significant flow of funds into broader equity indices, the bond markets and, increasingly, non-US stocks.
The hoped-for convergence, however, is far from automatic. For the rest of the world to catch up to the US, we need to see growth-oriented reforms that improve economic fundamentals in Europe, China and several emerging economies. In the case of the Europe Union, this requires strong political leadership, particularly from France and Germany, both of which are hindered by political uncertainties.
Convergence also depends on navigating policy measures that could worsen the headwinds to growth internationally. That is why markets are paying such close attention to US announcements, as well as the orientation of the Federal Reserve.
Already, US government bond yields have moved higher because of stronger-than-expected economic activity and rather sticky inflation. This has been compounded by the realization that the Fed will not be able to cut interest rates as far and as fast as many had anticipated a few months ago.
The unexpected rise in US yields has pulled up yields in other advanced economies too, particularly the UK, which is more vulnerable to spillovers from abroad due to its domestic challenges. It has also impacted emerging economies, including those that thought they had created considerable space to reduce interest rates. Together, these factors are frustrating the orderly alignment of the global economy, which would typically see lagging economies gradually bridge the gap with US economic exceptionalism. If it persists, such sluggishness could even undermine the US economy.
The more one examines these three prominent features of the financial landscape of the last 12 months, the more the analysis points to the likelihood of significant volatility ahead. After all, the conditions that would ensure orderly and mutually supportive handoffs to non-tech and international equities are far from automatic. These inherently complicated endogenous dynamics are compounded by political and geopolitical uncertainties.
In this environment, investors should be open to a continued evolution in investment approaches and not simply opt to position themselves for mean reversion. Put another way, the recent large value addition that has come from adopting a heavy thematic overlay to general market exposure, think AI in particular, could evolve into even greater specificity on name selection.
This is a world that favors active management over passive, index-based strategies. Investors should also look to benefit from a wider array of investment opportunities, including in overcoming both market and institutional failures through the application of developed market techniques to private credit markets in emerging economies. They should also look to venture more into opportunistic areas such as litigation finance that do not move in sync with the overall market.
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