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Market Commentary
Summary
- Table 1 shows some pretty healthy 6-month returns, especially when you consider we had a war and a doubling of oil prices in March. The bull market has been built on solid, steady economic growth and a boom in AI driven investment.
- The first of these pillars looks to be still in place, especially when you allow for the fact that oil prices have normalised and bond yields and borrowing rates are now falling again after a sharp post-war spike.
- There is a risk, however, that the explosive boom in AI infrastructure investment starts to slow. We took some profits in this space in Q2 and think that UK and Europe should be something of a relative safe haven. That said, AI spending is driving up both emerging markets and small and mid-cap equities, so diversification is harder today than it has been.
- But before we turn too bearish, positive catalysts also remain possible for equity markets. US earnings growth was 27% year on year in Q1 and is projected to be 22% in Q2. As earnings have surprised on the upside, US equity markets have actually become cheaper on a price/earnings basis so far in 2026.
- Fixed income markets are still pricing in rate rises. That feels like an opportunity to us, particularly in the UK where slowing growth and falling oil prices should ultimately give the Bank of England some room to cut. We continue to like gilts.
- But if we are wrong, we need alternative assets that can make money if interest rates rise. Gold did the job in 2022 but then did not do the job in Q2 2026. As gold prices start to stabilise, supported by continued central bank buying, we think gold can become a diversifier for us once again.
- Our small absolute return investments did well in the US/Iran war sell-off, even as bond markets sold off. We are therefore looking to add a trend following fund in Q3 2026. This is not our base case, but if interest rates do trend higher again, we are optimistic they will be able to profit.
Equities
One day soon, this update might be written by AI. But, for now, all the spelling mistakes and missing commas are mine and mine alone. I offer this assurance because US firms are investing unprecedented amounts to try and bring about a world where AI will slowly takeover white-collar jobs. Just five companies are investing over $1 trillion over the next 3 years (see Chart 1) which is more than twice all UK private sector investment measured over the same period. And that expenditure is washing through business and markets, pushing up profits and revenues enormously for a few selected AI winners including chip manufacturers, power providers and networking businesses.
So, if you are wondering why equity markets are so strong, this is part of the answer. Equities are going up because profits are going up. US earnings grew 27% year on year in Q1 and are expected to grow 22% this quarter. As the S&P 500 Index was up (only!) 10% in the first half of the year, this means US equities actually got cheaper on a price paid for earnings received basis. And most of this earnings growth is coming from all that AI Infrastructure investment (see Chart 2). One of our core views has been that we need to maintain exposure to the US technology sector and US growth whoever might be in the White House. I feel like the first half of the year vindicated that view.
But, from here, things may get a bit harder for the AI theme. The first concern is that while those receiving that spend are outperforming, those doing the spending are not. The five Hyperscalers (Amazon, Meta, Google, Oracle and Microsoft) were actually down 5% combined for the first half of the year in a rising equity market. Part of this comes from the fact that investors worry these companies may in fact be over-investing as a group. This might eventually lead the Hyperscalers to be more selective with their infrastructure investments. This might help their share prices, but I fear the knock-on effects down the investment chain will be larger.
Secondly, it has become noticeably harder to diversify away from the AI investment theme. Just 3 semiconductor manufacturers (SK Hynix, Samsung and TSMC) make up over 25% of the MSCI Emerging Markets index for example. Steady global growth has of course helped Emerging Market performance over the past 18 months, but nearly all the outperformance has come from those three stocks. Similarly, small and mid-cap equities have lagged broader equity markets over the last decade. Chart 3 shows small and mid-caps are finally starting to outperform, at least in the US. But 40% of the year-to-date returns for the US Russell 2000 index come from AI infrastructure stocks. To like US mid-caps (at least relative to the broader market) from here you have to believe this surge isn’t about to reverse. The AI theme is harder to avoid than you might think.
The need for all this AI infrastructure investment will, in turn, depend on how fast and how deep AI adoption is by the corporate sector. Outside of software development, my sense is we might start to see some sort of a pause in today’s exponential growth rates as businesses try to work out where they are getting most value add for all the dollars spent. Even software developers, today’s biggest users of AI, are starting to switch to cheaper Chinese open-source models to save token spend. We took some profits on one of our Asian focussed funds in Q2 in part because of its heavy semiconductor exposure. And when I think about risks going into H2 2026, this one feels front and centre to me.
What can we do to manage this risk? First, boring old Europe’s weakness is also its strength. Limited AI and technology exposure also means less exposure to any slowdown. And, in the meantime, European growth remains steady and government policy, particularly in Germany, is supportive. Europe’s Stoxx 600 index returned a healthy 9.6% in the first half of 2026 (almost keeping pace with the US) without too much reliance on AI data centre spend.
Secondly, the solid economic foundations that many equity bull markets are built on still look to be in place. The global economy has, I think, been remarkably steady in the face of rising interest rates, then rising tariffs and then most recently a war induced oil shock. Indeed, if you look at the New York Fed Nowcast (which takes in the latest data releases and uses them to project current growth rates) then all you will see is steady, slightly above trend growth (see Chart 4). So, even without the AI investment boom I think the global economy is providing a good platform for equity investors. AI has simply magnified the gains and concentrated them in a smaller number of winners.
Fixed Income
It took equity markets 6 weeks to recover the losses they took after the outbreak of the US/Iran war. For fixed income markets, the recovery has not been as smooth or complete. UK markets were expecting two interest rate cuts before war broke out at the start of March (leaving an expected 3.25% UK base rate). As I write they are expecting 1 rise (for a 4.0% expected rate). This is in spite of the fact that oil has almost completely round tripped and is now trading below 2024 levels (see Charts 5 and 6).
Part of this is because central banks are wary of repeating 2021’s mistake of letting inflation run away from them. But this also reflects the fact that if the US economy is so strong, why do you need to cut rates at all? This argument is particularly relevant today when inflation still sits above central bank target levels. But while the economy may be strong in the US, it is looking much weaker in the UK. One area we continue to like is UK gilts. Cheaper oil and weaker growth should, at some point, finally translate into lower UK interest rates.
Alternatives
Lower UK interest rates should also provide support for our UK investment trust assets (which include infrastructure and care homes). But it is also worth noting that for all the thoughtful paragraphs you can write for an investment outlook, it is usually the surprises that move markets. And the last two negative surprises we have had (tariffs and the Iran war) have both been inflationary. Inflation is still above central banks’ 2% target and governments, with their spending taps turned firmly on, are running large deficits. This means bond markets are much more sensitive to bad news on inflation than they were for much of the 2010s. And if bond markets can become the problem when bad news comes along, then there is some value to be had in diversifying away from them.
This has therefore been the recent focus of our alternatives portfolio and was one reason we added gold to our portfolios a couple of years ago. After a stellar run, gold is now down a little for the year and was noticeably weak even as war broke out in Q1. Part of this weakness was down to some profit-taking on winning investments (like gold) as other sectors (including equities and bonds) sold off in March. Our core thesis for buying gold was that non-US central banks would want to continue to diversify away from the US dollar. This they certainly have been doing (see Chart 7). And I expect central bank buying to remain steady. If it does, then gold should once again prove to be a diversifying asset for our portfolios.
Selected absolute return funds also look to be resilient too, and maybe even benefit from, rising interest rates. The absolute return sector under-delivered on our expectations for much of the last decade. There has, however, been something of a washout in that market and the funds that have survived look to be built on stronger foundations. We added a market neutral fund to our portfolios last year which proved to be pleasingly resilient in the March Iran war sell-off. We are now looking to add a trend following fund in Q3. Higher inflation and interest rates are not our base case for the second half of 2026, but if they do continue to be a problem we think this fund will be well positioned to benefit from it.
Chris Brown
Chief Investment Officer
