Global equity markets continued to move higher in the past month, as very strong corporate earnings are the overriding theme in equity markets right now, which continues to outweigh any geopolitical or macro-economic uncertainty.
Oil prices and bond yields are declining on hopes that the U.S. and Iran have reached a preliminary framework for opening the Strait of Hormuz, in line with our view that some sort of agreement to end the conflict is likely in the near term. As it is clear that both the U.S. and Iran would like to see an end to the conflict.
Nevertheless, the outcome of negotiations remains uncertain and both sides are unpredictable. That is why we take a balanced view on equities, rather than being outright bullish, when a global recession could ensue in the event the strait of Hormuz remains blocked into summer.
While it makes sense that the bond market has reacted more adversely than the equity market, it also means that equities may have less to gain from a reopening of the Strait, given that they appear to have assigned a considerably higher probability to that outcome.
We do expect that the IPOs of SpaceX and Anthropic in the coming weeks will boost short-term sentiment, enabling the equity market to absorb new supply without creating a setback. It remains to be seen whether that momentum can be sustained once the IPO lockup period expires later this year, potentially increasing the supply of shares available to the market.
But over the coming months, we expect equity sentiment to remain positive, as the second-quarter earnings season is likely to be strong again. And if the Strait of Hormuz fully reopens, it will provide another positive impetus to global equity markets.
Income tax cuts and abundant oil and gas reserves have helped shelter the U.S. economy from the conflict. The Eurozone economy faces a much more challenging outlook than the U.S. economy, which appears to be gaining momentum. Europe is struggling with inflationary pressures at a time when economic growth is extremely weak. This raises the risk that Europe could see an economic recession in the coming months. Especially if the Strait of Hormuz does not open very soon, and energy prices come down.
The good news is that long-term inflation expectations have remained well anchored despite the recent rise in 10- and 30-year Treasury yields.
- A Really Big Earnings Quarter
- A Bubble in Earnings, Not in Valuations
- Where is the Capital Coming From?
- Here Come the Big IPOs
- AI Will Not Replace Human Intelligence
- Bond Markets
- A Stronger Dollar
- Our Portfolio Positioning
A Really Big Earnings Quarter
The key reason equity markets have been ignoring all the geopolitical noise is that first-quarter earnings surprised to the upside. Equity investors are used to the earnings season song and dance. For years, companies have underpromised, guiding equity analysts to lower their estimates in the weeks before earnings announcements, and subsequently overdelivered, beating those estimates by 4 or 5%.
The first quarter’s S&P 500 16% EPS beat stands out for having generated the largest positive surprise since 1Q21’s 22%. We view the magnitude of the first-quarter beat as evidence of the robustness of the American corporate profit machine, or at least the enduring persistence of network effects and the moats around the mega-cap tech companies’ businesses, which may amount to the same thing.
Profit margins exceeded analyst expectations yet again, as earnings growth surprises continue to blow away revenue growth surprises, pushing S&P 500 profit margins ever closer to an all-time high. The current equity market backdrop appears to come down to earnings versus everything else as surging profits have given stocks license to look beyond the bottleneck in the Strait of Hormuz and the associated rise in oil prices, bond yields, and rate-hike probabilities.
Financial markets are forward discounting mechanisms. Once the Iran conflict was heading for a negotiated resolution, the S&P 500’s sprint off the March 30th wartime low to new all-time highs suggested that equities had been discounting too much bad news. The implied optimism fits with the idea that the U.S. economy’s natural tendency is to expand, so corporate earnings’ natural tendency is to grow. And as long as P/E ratios fall, equities’ natural tendency is to appreciate.
A Bubble in Earnings, Not in Valuations
Most stock market bubbles feature an unsustainable increase in share prices in relation to earnings. That was certainly the case during the dotcom bubble, when earnings growth was dwarfed by the rise in share prices. Sometimes, however, an unsustainable increase in earnings is the source of the bubble.
The AI bubble is a different type of bubble. It is primarily an earnings bubble rather than a valuation bubble. Like all bubbles, the AI bubble will eventually burst. For now, however, our AI demand indicators do not suggest that this is imminent.
There is an old saying on Wall Street: “The cure for high prices is high prices.” Shortages lead to higher prices, which in turn lead to fatter profit margins. Higher profits incentivize investment in new capacity. Supply eventually catches up to demand, causing prices and profits to fall.
Most notably, AI hardware producers are booking huge profits on their sales, whereas their customers are largely treating the purchases as capex. Such transactions leave aggregate cash flows unchanged but still lift reported earnings. This has resulted in a paradoxical situation: Aggregate free cash flow among the hyperscalers is falling and could turn negative in 2027. Yet, reported profits are going through the roof.
Earnings bubbles can be dangerous for the economy if they leave an overhang of excess capacity in their wake once they burst. As a share of GDP, investment in software and hardware in the U.S. hit a record high of 4.9% in Q1 2026. A decline in tech investment could significantly reduce aggregate demand. And, likely, the bursting of the AI earnings bubble would negatively impact stock prices, leading to a wealth effect.
Where is the Capital Coming From?
Alphabet’s (Google) plan to raise up to $80bn of equity to fund an $180-$190bn AI infrastructure buildout this year reinforces that the AI capex cycle is maturing and highlights the risks of growing equity issuance reaching the market. While the overall equity raise is modest relative to its $4.5tn market cap, the absolute size is still significant and is comparable to the expected proceeds from the high-profile IPOs of SpaceX, OpenAI, and Anthropic.
Yet, the more important signal may be psychological. Equity funding suggests the AI capex cycle is entering an increasingly mature, capital-intensive phase, in which even cash-rich hyperscalers are tapping external capital.
The timing also matters, with Alphabet coming to market ahead of a potentially historic wave of high-profile IPOs, reinforcing the sense that leading AI companies are racing to secure public-market capital while investor appetite remains strong.
Here Come the Big IPOs
The upcoming SpaceX IPO, slated for June, and the Anthropic (the developer of Claude) IPO in July are currently dominating the news headlines. The question is where the capital will come from to buy the new issues. SpaceX is reportedly seeking to raise around $75 billion, and Anthropic $65 billion, both multiples of the nearly $30 billion and $25 billion that Saudi Aramco and Alibaba raised in the two largest previous IPOs. In an inflationary world, nominal amounts will always grow.
Although there’s no definitive answer to where the capital will come from, the question raises an important supply-and-demand issue. The supply of common equity shares is going to increase, and if demand doesn’t rise in step to meet it, equity prices could fall. If the new supply stokes animal spirits, thereby increasing aggregate demand for equity holdings, equity prices can rise.
That’s the way it will unfold if the AI boom’s IPOs behave like the dot-com boom’s IPOs. And if the analogy with the turn of the millennium holds, the supply-overhang risk will manifest itself when the lockup provisions for incumbent holders expire. If SpaceX raises $75 billion at a valuation between $1.75 and $2 trillion, it will be selling around 4% of the company. At some point, the holders of the remaining 96% may decide to monetize their stakes as well. It cannot be said conclusively that the end of lockup restrictions on the avalanche of dot-com IPOs was responsible for the bursting of the dot-com bubble, but lockup sellers were in the vicinity when it burst.
AI Will Not Replace Human Intelligence
Contrary to a dystopian vision, AI will not make humans obsolete. It might replace generalized intelligence, known as IQ, but human intelligence comprises the combination of IQ and emotional intelligence (EQ).
Nevertheless, AI will disrupt the economy because it will replace certain types of jobs and create others. Any job that relies mainly on IQ will eventually become obsolete. In other words, any job that just uses the neocortex that AI has in abundance. This applies to many entry-level jobs that previously required a university degree, because many of these graduate entrants into the jobs market are essentially selling their academic training in logic and reasoning, meaning their IQ.
This largely explains why the ‘graduate premium’ versus those with lower academic qualifications is disappearing, and why the unemployment rate for graduates is now almost indistinguishable from that for non-graduates.
On the other hand, AI, which has no EQ, is much more powerful when paired up with a high-EQ human. Meaning that for many jobs, AI plus a human is more productive than AI alone or a human alone. The upshot is that high-EQ humans will be in high demand to pair up with AI. And many of these jobs will be middle-income jobs. For those jobs, AI will provide what Stanford economist Erik Brynjolfsson calls ‘Intelligence Amplification’, making these employees more valuable to companies. With human EQ in demand to pair with AI IQ, firms will be reluctant to fire workers they can pair with AI to boost productivity. This helps to explain the low rate of firing in the major economies, despite the rapid adoption of AI. By combining human EQ with AI IQ, firms can boost output without significantly increasing costs, which is good for corporate profits.
It also shows that different skill sets will become more valuable in the workplace. There are already examples of companies hiring linguists rather than computer engineers. In today’s world, being able to communicate clearly and logically with an AI coding model is more effective than knowing how to code.
Bond Markets
Global bonds sold off sharply alongside rising oil prices in the early days of the Iran war, making fixed income the worst-performing asset class this year.
The dominant driver of the bond selloff has been the same in both instances: a hawkish re-rating of central bank rate policy expectations. While we doubt that many central banks will deliver on the rate-hike expectations currently priced in by the market, we also don’t envision a full retracement to pre-oil-shock levels any time soon. We also think the Fed under new Chairman Kevin Warsh will be reluctant to raise rates. However, risks are tilted toward higher inflation, which could force a more hawkish Fed if market-based measures of inflation compensation continue to rise.
10- and 30-year Treasury bonds rose in May, with the 10-year yield setting a new near-term high around 4.67%, while the 30-year yield rose to 5.18%, its highest level since July 2007.
Nevertheless, long-term inflation expectations have remained well anchored so far despite the recent rise in 10- and 30-year Treasury yields. So, inflation expectations are not flashing a warning light. The modest rise in long-run expectations has tracked oil prices, consistent with historical patterns, rather than signaling deeper inflation concern. The recent remarks by various Fed Governors suggest that neither rate hikes nor cuts are likely in the next few months, leaving Treasury yields elevated but likely range-bound. In other words, we don’t expect yields to rise further, but we also do not think the 10-year Treasury yield will fall back below 4% anytime soon. The higher yields do offer a better entry point for anyone looking to add to fixed-income exposure.
A Stronger Dollar
As bond yields have risen across the G10, driven almost entirely by rising inflation. In contrast, the recent increase in U.S. Treasury yields has been driven by higher real rates, suggesting that markets are pricing a relatively more restrictive Fed policy stance and view the U.S. economy as resilient enough to absorb higher borrowing costs.
Given the greater exposure of the Euro area, the UK, and Japan to the energy-import shock, relative growth momentum is shifting in favor of the U.S.
Relative growth and rate dynamics should continue to move in the dollar’s favor over the near term. The U.S. economy remains better positioned than the rest of the world to absorb the energy shock, while relative growth momentum and policy expectations continue to improve in its favor.
Despite a more positive short-term outlook, the longer-term outlook remains asymmetric. While the dollar could edge higher over the coming months, uncertainty remains elevated and the dollar’s longer-term downside remains substantially larger than its upside. We therefore continue to favor a strategic bearish USD stance on a 12-month horizon.
Our Portfolio Positioning
Our core portfolios are performing well, supported by our overweight positions in global small-cap and emerging market equities. Even though overweight positions in more defensive allocations like global healthcare and Europe underperformed during the ferocious tech rally in the last two months.
Given the many uncertainties surrounding geopolitics, inflation, interest rates, and the AI investment cycle, we believe portfolio diversification is the best strategy at the moment.
DISCLOSURES
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The S&P 500 Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.
