Taking stock

Since our previous Investors Quarterly in June, the mood in world equity markets has turned increasingly bullish and the tariff-inspired panic of April is now a distant memory. Robust corporate profits and ever-increasing and broadening enthusiasm for the AI investment boom have been the key drivers of returns. Risk taking has been generously rewarded.

Our portfolio team's view has become more cautious after these moves; only 9% of our investors are expecting above average gains in their markets from this starting point, down from 28% three months ago. We are optimists on profits but think valuations are becoming rather elevated— no immediate cause for concern but something to watch. In some corners of the market speculative activity is at already dangerous levels (for example in small caps, as we discuss below).

Earnings growth is accelerating again, and 2026 looks solid

Earnings expectations have been trending higher since May, with the technology sector leading strongly and forecasts slipping in Europe. We stick with our view that 2026 will be both a good year for U.S. profits and a year of broader growth. The 493 non-“Magnificent 7” companies in the S&P 500 are forecasted to grow profits by 12% after three years of very little progress. Meanwhile the growth of the Magnificent 7 continues at a healthy clip, and this group has been the source of most of the recent upgrades to near-term forecasts.

Outside the U.S. we see profits in the emerging markets growing 14% this year. Europe is a soft spot but the 2026 outlook looks better there as well. Solid economic growth, the fading of post-pandemic hangover effects, manageable tariff impacts, accommodative Federal Reserve policy, strong financial markets and of course the giant AI investment boom—all support an optimistic view on profits for most parts of the corporate sector.

Thoughts on AI investing, and the challenge of "memes and themes" stocks

The challenge for investors is that this positive outlook is now well recognized; global stocks have risen 35% from April lows, led by the riskiest names. AI enthusiasm has ratcheted higher, and at our Investors Quarterly we again vigorously debated the outlook for this key driver of so much in markets. In summary, we lean positive on the fundamentals of the AI boom. There is still much we don't know, but clearly the new technology has tremendous potential and the momentum of investment continues to accelerate.

However, valuations are much more demanding and some of the recent big stock moves in response to deal announcements look rather optimistic. Most of our investors now have a neutral view on AI overall and focus on adding value by identifying the relative winners and losers within the theme, while managing overall portfolio risk. Of those with a stronger opinion, two thirds are now negative and moving underweight, while one third remains enthusiastic about the broad opportunity.

Looking more questionable than the AI stars is the exceptional performance of very high priced small cap stocks with a good story but little else in terms of actual revenues, profits or cashflows. We refer here to so-called "memes and themes" stocks: the quantum computing, Bitcoin mining, new energy and drone/flying taxi companies that collectively make up almost 10% of the Russell 2000 index. Individual investors have driven these names up more than 110% this year, posing a serious headache for fundamentally orientated investors reluctant to speculate in unproven technologies (Exhibit 2).

Indeed, the performance of high beta and other risk factors in the small cap space has now exceeded 2000 dot-com bubble levels, ranking in the top percentile over the past 30 years. While it is very hard to see how this trend reverses, our experience strongly suggests that a fundamental approach will ultimately prevail. This bubble in expensive and speculative names likely ends badly, just as all previous episodes have done.

The renaissance in emerging markets looks set to continue

While the Magnificent 7 have once again dominated market headlines this year, there have in fact been substantial gains elsewhere in the world. Emerging markets are enjoying a strong recovery, up more than 30%, and for the first time in ages we are seeing growing signs of client interest in this space. We think that's justified. Earnings growth looks solid. Technology—the sector makes up 25% of the earnings base for emerging markets overall—is a big driver as the AI boom spills over into areas such as memory chips and the big Chinese internet names.

We find other drivers of growth as well. Improving capital discipline is a growing theme across Asian markets. If U.S. dollar weakening has only just begun, then history suggests this nascent positive trend in emerging markets has plenty of room to run (Exhibit 3). In this context we note that the MSCI emerging market index is only just back to levels first reached in 2007, before the GFC. After many years of dull returns many clients are under allocated to emerging markets and we see plenty of potential for that to change. Neglected laggards, high quality growth stocks and many Latin American financials all offer good alternatives to balance the technology winners in our portfolios.

Exhibit 4 shows the views of our team members. Many favor quality and value stocks, while avoiding names that demonstrate too much unsupported AI enthusiasm, or more speculative themes.

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