Stirred, not shaken?

Equity markets have continued to push higher over the past month, with strength in semiconductors and other AI-linked parts of the market more than offsetting concerns about constrained energy supply through the Strait of Hormuz. That has made for an unusual backdrop: Equities have set new highs even as one of the world’s most important energy chokepoints remains heavily disrupted, and as inflation concerns push bond yields higher.

Stock investors have stayed upbeat in part because the earnings picture, especially in AI-capex-linked sectors, has remained healthy enough to sustain risk appetite. US companies reported the best earnings growth in four years in the first quarter. Meanwhile, despite the geopolitics, oil prices are close to unchanged since the end of March.

This has validated our approach of remaining focused on fundamentals rather than being swayed by headlines. The S&P 500 is up 8% year to date, though strong earnings growth has meant equity valuations have not become significantly more stretched despite higher index levels. 

In this letter, I focus on three questions for investors. First, is the current surge in corporate earnings sustainable? Second, can markets continue to withstand elevated (or even higher) oil prices? And third, what does the recent rise in yields mean for the equity outlook?

Our view is that equities will likely move higher over the medium term, based on a combination of strong earnings, oil prices that stay contained enough to avoid a broader growth shock, and a Federal Reserve that remains supportive. But there are risks to each part of that view, and portfolios should reflect that balance. And in an economy and global market so complex, no single factor should be viewed in isolation.

In equities, we recommend staying invested but diversifying exposure beyond the megacaps. The Magnificent 7 index is up 6% year to date versus about 65% for the Philadelphia Semiconductor index, demonstrating the importance of broader diversification across the AI value chain. Regionally, we continue to view the US market as appealing, and also like Japan, Switzerland, and emerging markets. Although yields may remain volatile in the near term and longer-duration bonds bear elevated fiscal and inflation risks, we believe the risk-reward outlook for short- to medium-term quality bonds is attractive. We also continue to favor exposure to commodities and alternatives, alongside select hedging strategies.