Has the AI equity rally got further to go?

With the US government still shut down, official data is on hold. That puts third-quarter earnings front and centre as investors look for clues on the health of the US economy. The Q3 earnings season kicked off last week, with the largest US banks delivering strong results. A few regional banks flagged credit quality issues, but those seem isolated. With interest rates likely heading lower and economic growth holding up, we see little reason for broad credit stress ahead. 

The real spotlight is on mega-cap tech later this month. AI excitement has some investors flashing back to the dot-com bubble. There are a few similarities, such as market concentration and heavy capital spending, but we believe there are many more significant differences.  

First, the success of the dominant US tech companies has been mostly driven by strong earnings growth, not just soaring valuations. Second, while valuations are high, they are still far from the extremes seen at the peak of the dot-com era. And, third, unlike the late 1990s, so-called AI “hyperscalers” like Amazon, Alphabet and Microsoft are funding AI from cash flow, not debt. 

For these reasons we wouldn’t characterise the current environment as dot-com style speculative hype, though we acknowledge that market expectations for future AI revenues are high. Any hint of slower AI monetisation could hit valuations, so investors will be watching those earnings calls closely. We believe investors should stay exposed to AI trends while diversifying portfolios across geographies and asset classes to capture other sources of return and mitigate risks. 

Global equity markets recouped some of their losses from the previous week, while US 10-year bond yields fell near their lowest level of the year, driven by concerns around US regional banks. US-China trade tensions have eased somewhat, with President Trump saying that he still wants to make a trade deal. We expect the US and China to eventually make a deal, but until then, the risk of escalating threats remains. 

Looking ahead, rate cuts and fiscal stimulus should support US growth into 2026, with AI infrastructure spending adding another tailwind. In Europe, while we don’t expect any more rate cuts, the European economy – Germany in particular – will benefit from increased government spending in defence and infrastructure. In China, too, government stimulus measures will continue to support the economy. 

Against this backdrop of positive economic growth and policy support from governments and central banks, we maintain our moderate preference for equities over bonds. But given lingering risks such as geopolitical headlines, we’ve diversified our portfolios across markets, regions, sectors and investment styles. We also hold protection against uncertainty and volatility through a variety of exposures, ranging from gold and the Japanese yen to selective “insurance” strategies that appreciate when US equities fall (where client knowledge and experience, and regulations and investment guidelines, permit such strategies). 

Within equities, we balance US exposure (where AI leadership comes with rich valuations) with opportunities abroad. Emerging markets look attractive, helped by a weaker dollar. Narrowing rate gaps and softer demand for “unhedged” US assets (where the currency impact is included) should keep the dollar under pressure. 

As for bonds, we continue to prefer high-quality government bonds over riskier ones. US Treasuries don’t pay enough for the risks brought by the high US budget deficit, so we lean toward European markets instead. 

The delayed US inflation report for September is the big one (Friday). It will shape expectations ahead of the Fed meeting, where we see another quarter-percent rate cut. Eurozone and UK purchasing managers’ indices (PMIs), also out on Friday, offer an early read on October activity. On Thursday and Friday, watch UK and Japan inflation prints, respectively. 

The earnings season also ramps up with Tesla, Netflix, P&G, GE, Coca-Cola, IBM, Intel and Lam Research in the US, plus SAP, Sanofi and Porsche in Europe. Guidance on AI spending and consumer demand will be key signals for markets.