A Message from Our Chief Investment Officer: Enough diversification
September continued the pattern of big swings from month to month in market returns and big differences between top and bottom performers. The real drivers of this market behaviour are two factors: rising oil prices and the AI boom.
Skirmishes are once again constraining global fuel supplies, pushing up prices for all oil and gas products and overall inflation, although the rise is small. Central banks are responding by raising interest rates and investors are responding by pricing in more rate rises, causing a rise in bond yields. Notably, inflation linked and emerging market bonds have performed better than US government bonds and so has the much-maligned UK bond market. We will soon see if the UK treasurer will take action to rein in the deficit, but so far the signs are promising. The key takeaway is that investors are adopting a pessimistic view on bonds, mistaking 2026 for 2022 despite today’s much higher interest rates, higher yields and AI’s powerful disinflationary effects from increased supply and competition.
Meanwhile the AI boom is surging. More money is being raised to fund the race for Artificial General Intelligence, as companies use the old-fashioned way of raising capital for large, infrastructure assets: debt. At the same time, companies that own Large Language Models are seeing more revenue as businesses and individuals experiment with the new technology. Investor enthusiasm for AI remains high. You can see this in equity fund flows, AI stock outperformance and investors conceding rights and accepting dilution of their returns. The latter was exemplified earlier this year by shareholders allowing Elon Musk permanent control of SpaceX alongside an extreme compensation package In stark contrast, a sell off is taking place for “bond proxy” companies such as utilities that have stable revenues and higher dividend yields.
What happens next is being driven by how AI is linking businesses, industries and countries, as AI fundraising, spending and usage scales up. In an echo of the late 1990s, there is a growing relationship between revenues and profits of disparate sectors, such as Communication Services, Consumer Discretionary, Information Technology and Financial Services. Clearly the US and global equity indices are less diversified than usual because these tighter links mean future revenues and profits are more prone to rising and falling together.
Broad global research, patience and being prepared to be contrarian are essential for finding complementary opportunities that offer a different source of risk and return versus AI plays.
Prior examples in Morningstar portfolios include targeted exposures to Latin American equities, inflation linked bonds, healthcare and consumer staples. We are also seeing the benefits this year of liquid alternative strategies that can profit from dislocations but do not move up and down directly with equity and bond markets. These have performed well in the face of shocks hitting equities and bonds.
This month we are making changes to portfolios in response to recent market moves and our ongoing assessment of how the AI boom is playing out. These add new sources of return, but they are also designed to tackle head on the challenge of finding diversification when one factor – AI – is driving so many parts of the equity market.
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