View From The Top: Hot times

View from the very top: In frenzied conditions, stay cool. A fragile Middle Eastern peace deal may have been struck. This can help lower inflation expectations, boost consumer and business sentiment, and keep corporate earnings growth moving upwards. However, investors still need to contend with the dual fear of colossal AI spend and the prospect of higher interest rates. With the entire investment universe becoming increasingly interconnected around the hopes and dreams of artificial intelligence, what will make or break this cycle could be determined by what happens to the cost of capital. Infrastructure build is expensive and requires ongoing investor buy-in via the issuance of new equity and debt. Returns need to be made. For now, the cycle rolls on. If economic growth slows or inflation does not, then we may have a problem. Our best counsel is to stay nimble and keep diversifying, both across and within all asset classes.

Asset Allocation:

Equities: The MSCI World Index has gained 20.0% over the last year and 8.9% year-to-date. For the rally to be sustained, earnings estimates need to continue to surprise to the upside. After a strong first quarter season – the best in five years, according to Bloomberg – the bar is set increasingly high for the second quarter. FactSet is calling for 23.1% year-on-year growth for S&P 500 Index earnings. While the rate of upgrades is currently outpacing downgrades for each market sector (based on work compiled by Goldman Sachs), we expect market rotation to remain an increasingly important dynamic. Just as the AI bubble has made some segments highly exposed to valuation sensitivities, other sectors have become correspondingly undervalued. Continue to diversify, by size (we favour small and mid-cap over mega-cap), region and style. Active managers look particularly well-placed.

Fixed income/ Credit: The yield on 10-year US Treasury debt has fallen from its 2026 peak, but yields remain higher than they were a year ago. New Federal Reserve Chair Kevin Warsh has signalled that he intends to be credible when it comes to fighting inflation, even if there may be no immediate need to raise interest rates, particularly should falling oil prices help lower inflation. The more important dynamic at work for us is that year-to-date geopolitical events have demonstrated again how Treasuries (and other government debt) have become increasingly less reliable shock absorbers during equity market drawdowns. We continue to favour only limited exposure across the credit spectrum. At the same time, we are also monitoring the growing risk of potential defaults within private credit.

Currencies: After a major drawdown in 2025, the DXY Dollar Index is currently close to a 12-month high. For us, this demonstrates not only ongoing US exceptionalism, but the importance of mean reversion when it comes to considering currencies. The Dollar’s strength is inevitably linked to perceived Fed hawkishness. With the prospect of near-term interest rate cuts off the table, the Dollar may be poised for further gains, at the expense of other major crosses.

Gold: The lacklustre performance of gold in 2026 partially reflects its inverse correlation with the US Dollar but needs to be seen in the context of an almost doubling in the price of the precious metal over the past two years. Despite recent price volatility, we continue to see gold as a crucial long-term core asset and portfolio diversifier. Central Banks operate with a similar perspective. Their gold reserves are at record highs, according to the ECB.

Alternative assets: Hard assets perform an equally important role in portfolio diversification, in our view. Not only do they offer income-generating characteristics, but they provide resilience in the face of uncertainty. It is important, however, to remain selective across this asset class, favouring quality. Our focus is centred particularly on uncorrelated strategies.

With the mercury reaching elevated levels on both sides of the Atlantic, it is understandable that investor sentiment has become somewhat frenzied. Market participants have been pulled between optimism and angst. Just as the heatwave cannot endure, so current volatility is not sustainable. As readers should be aware, the more time spent in the sun (literal or metaphorical), the more it will hurt later.

The appropriate counsel, then, is to stay cool. Take a step back (spend time indoors – air-conditioned if possible) and survey the landscape. Recognise that all rallies are non-linear. Setbacks create opportunities. Within them, sector rotation is normal. It is almost impossible to time markets accurately, so instead, favour patience and continue diversifying.

The issues facing investors are inevitably interconnected. They can be best summarised as how will the market manage to digest the dual fear of colossal AI spend and the prospect of higher interest rates. Embedded within these concerns are the debates over the stability of near-term earnings estimates and the credibility of terminal value assumptions. Both are hypersensitive to any perceived change.

No-one can say with any certainty whether there is an AI bubble in the stock market, but almost everyone is looking for one. Wherever we may be in the cycle, current levels of expectations at least leave investors open to the potential risk of an accident. How to reconcile that 80% of Fund Managers polled by Bank of America believe that long semiconductors is the ‘most crowded’ trade in the market, yet only 50% believe we are still in the ‘boom’ phase of AI?

Dispersion (between perceived equity winners and losers) may be at multi-year highs, but the broader investment universe has become, crudely, one big bet on AI. The largest infrastructure build ever requires significant underwriting by both equity and debt investors. Consider not just the pipeline of mega new initial public offerings – more on this below – but also the fact that the hyperscalers are issuing new capital. Even NVIDIA held its first bond sale since 2021 last month. Bloomberg estimates that at least 50% of all investment grade debt new issuance year-to-date has been AI related.

The poster child of the moment – which speaks to both speculative froth and questionable valuations – must be SpaceX. A firm with $19bn of historic revenues was valued (at peak) at over $2.8tr. SpaceX is a business that is burning cash and operates in industries which are both speculative and competitive. A flotation that raised more than ten times the largest new deal of 2025 (per Bloomberg) is indicative to us more of ebullience than what can be known about the future. It may not take long for the SpaceX party to be over.

There is more to come. Even if investors can manage to digest 2026’s new issuance, 2027 may be a different story altogether. SpaceX investors will see their equity lockups gradually expire. A similar dynamic would play out after the mooted listing of Anthropic and OpenAI. On calculations made by KKR, $1.2tr of equity and debt may be issued over the next 12 months. For context, this is equivalent to 3.5% of US GDP. That’s a lot to absorb.

Optimists will, of course, assert that the tech IPO rush is more a bet on compute than the top of the market. In other words, new issuance is a direct funding mechanism to enable build out. In contrast, to the dotcom boom, which was speculative and where build out occurred ahead of demand, AI infrastructure is already being deployed. Demand is currently overwhelmingly exceeding available supply. Against this background, the number one variable that may make or break this cycle will be what happens to the cost of capital. Higher interest rates may simply mean that funding dries up.

The contra-argument – which perhaps does not bear thinking about – is what happens if the AI ecosystem fails to make a return on capital. Maybe this time is not different. Perhaps AI is the collective hallucination for our time. A sudden collapse in confidence could trigger a market crash.

At the same time, a Middle East peace deal is unambiguously good for stocks and bonds. Even if the truce may be fragile and a long way from the “unconditional surrender” initially demanded by President Trump, falling energy prices can help extend the equity bull market by lowering inflation expectations, supporting both consumers and businesses, and boosting corporate earnings. Bloomberg data show that estimates continue to head up for both 2026 and 2027.

The economy appears to be in good shape and to have weathered the storm of energy disruption remarkably well. First quarter US GDP growth was recently revised up, from 1.6% annualised growth to 2.1%. The Atlanta Fed calculates GDP is currently growing at a 2.5% rate for Q2. The American economy has added an average of 114,000 new jobs a month year-to-date (in contrast to a 10,000 average per month throughout 2025), with new job openings – indicative of risk appetite – at their highest in two years. CEO confidence is at its most ebullient in four years, per Business Roundtable. Even the consumer sentiment data tracked by the University of Michigan has improved from its earlier 2026 lows.

Both last reported headline CPI inflation and personal consumption expenditure (the latter measure has been the one preferred by the Federal Reserve) may be at their highest since April 2023, but recent data have been no worse than consensus modelling assumptions. More importantly, there has been no change in core CPI inflation on both a rolling three- and six-month basis. Inflation is getting no worse and may even be getting better. Lower oil prices will be helpful, with per barrel prices down c40% from their 2026 peak. 2027 could even see a glut of supply, which would clearly be deflationary. Project further out and AI productivity gains can act as an additional deflationary kicker.

What about interest rates, then, if what happens to the cost of capital may make or break markets? For us, there is both the noise and the signal to consider. Even if the market is currently pricing a greater than 80% chance of at least one hike before year-end (based on forward interest rate swaps), there is no guarantee that rates will go up. New Federal Reserve Chair Kevin Warsh needs to be seen to be credible on the inflation threat. The Fed will “not give in to inflation” – even if it has been above the US Central Bank’s target for the last five years. Rather, the Committee will “deliver price stability,” per its most recent statement.

Mr Warsh will surely be aware that tighter monetary policy tends to precede stock market peaks. No Fed Chair is likely to want to be presiding over a slowing economy and deteriorating equity market with US mid-term elections just around the corner. With c60% of US jobs created by small businesses (per Alpine Macro), this fact alone might argue for caution over rates policy on the part of the Fed.

The prospect of conflict restarting in the Middle East represents another concern for this currently febrile market. Other geopolitical grey swans exist too. Were economic growth to slow or inflation not to, then investors would certainly have something to worry about. For now, however, there remains a plausible case for making more metaphorical hay, while the sun is still shining.

Alexander Gunz, Fund Manager