Quarterly market update: Looking beyond AI's biggest winners

AI leadership narrows

The strong performance of artificial intelligence (AI)-related companies continued throughout the quarter despite uncertainty surrounding the US-Iran conflict. While we believe AI offers long-term opportunities, market leadership has become increasingly narrow in certain areas. This prompted us to diversify part of our exposure into areas where we continue to see attractive earnings growth potential, while also improving diversification and reducing concentration risk.

Our response: Within Emerging Markets, we reduced the overweight position that we had built during the market weakness at the onset of the US-Iran conflict. While we remain constructive on the region's long-term prospects, performance had become increasingly concentrated in a handful of companies tied to the AI supply chain, most notably TSMC, Samsung Electronics, and SK Hynix. Our conviction in the region remains positive, supported by a weaker US dollar and ongoing AI-driven demand, but we have taken the opportunity to diversify our equity exposure and reduce the risk of portfolios becoming concentrated in one sector.

We redeployed some of this capital into our thematic allocations, including World ex-US equities, World Industrials, and World Materials. These areas should continue to benefit from a backdrop of resilient global growth, while providing a broader set of return opportunities beyond the dominant AI-related winners.

In the US, we also trimmed exposure to a manager that had a significant overweight position in AI-related stocks and had delivered particularly strong returns. The proceeds were reallocated to an equal-weighted S&P 500 strategy, which reduces reliance on the largest technology companies and provides greater exposure to a wider range of businesses across the US economy. We believe the drivers of company earnings are becoming more diverse. While technology companies have led the market, increased spending on infrastructure, energy, manufacturing, and industrial projects is creating opportunities across a wider range of businesses.

Overall, these changes were designed to broaden the portfolio's sources of return, reduce concentration risk and maintain exposure to areas that we believe can perform well if economic growth remains supportive. We remain invested in the AI theme, but in a more balanced way that does not rely as heavily on a small number of stocks driving performance.

Importance of diversification

While the global growth backdrop remains supportive for risk assets, geopolitical risks increased during the quarter following the escalation of tensions between the US and Iran. Events in the region highlighted how quickly market sentiment can shift and reinforced the importance of maintaining a well-diversified portfolio that is resilient across a range of outcomes.

Our response: To help protect the portfolio against further escalation in the Middle East, we added exposure to energy markets. Oil prices are typically one of the most immediate market beneficiaries of geopolitical disruptions in the region, particularly given the importance of the Middle East to global energy supply.

Alongside these changes, we shifted capital within our hedge fund allocation to a strategy that has historically exhibited low correlation to equities and complements our existing alternatives exposure. This helps diversify the portfolio further during periods of increased market volatility.

Removing a bond hedge

Earlier in the year, we held part of our global bond exposure in euros as we believed the European outlook was improving and the currency could benefit relative to sterling. During the quarter, however, that view became less compelling. Falling energy prices have reduced inflation risks in Europe, while growth remains relatively subdued, leading us to reassess the potential benefits of maintaining the position.

Our response: We removed the euro hedge on our global bond allocation and returned the position to sterling. The position was originally introduced because we believed the euro could benefit from a more supportive backdrop in Europe and relatively higher interest rates. Since then, a decline in energy prices reduced inflation pressures across the region, lowering the need for interest rates to remain elevated for an extended period, although more recently we have observed further volatility in local energy markets.

As we believe the euro is now less likely to outperform, we decided to simplify the position and bring the exposure back into pounds. This change reduces reliance on a specific currency view and allows our global bond allocation to focus on its primary role within the portfolio, which is to provide diversification and help support returns during periods of market volatility.