Tom Stevenson, Investment Director at Fidelity International comments as markets reach a watershed, with earnings soaring on the back of continuing AI investment but the persistent Middle East crisis casting a cloud over the economic outlook.
Investors are at a fork in the road. With stock markets standing close to all-time highs in many cases, it is unclear where they will head next. On the one hand, an ongoing surge in AI-related capital expenditure is helping fuel an earnings boom, albeit a narrowly focused one. In the background, though, is the intractable crisis in and around the Strait of Hormuz.
AI-driven growth or energy market shock?
At the heart of that debate is what the oil price is telling us. Currently the forward price (down in the mid-$70 range) is lower than the spot price (persistently above $100). That says that investors believe the market is currently stressed but will in due course return to the levels we have become used to.
“That could be right, in which case the economic impact might be contained. Or it could be too optimistic, in which case we should expect a spill-over into most asset classes – shares, bonds, commodities – and to the broader economy and into monetary and fiscal policy.
“It’s really a question of whether this is an echo of the 1990 first Gulf War – over quickly and back to normal – or a re-run of the 1970s oil shock, which led to recession and inflation – the dreaded stagflation.
“As we stand today, the market is making a big bet on the former. Stock markets have weathered a number of short-lived squalls since the three-and-a-half-year bull market got going in October 2022. With a fall of only around 10% in March before a rapid recovery, this latest correction looks on the face of it like it was just another buying opportunity.
“That positive short-term view paints the recent rally as just the latest upswing in a now 17-year bull market that emerged from the financial crisis of 2009. That long bull market has taken shares from well below their long-term trend to safely above it. That by itself is reason for caution.
Positive earnings outlook
“But the glass half full crowd has plenty to latch onto currently. Notably the progression of earnings expectations, which have shot through the roof in the past couple of weeks. Forecasts tend to rise as we move through an earnings season, and results come in ahead of expectations. But this time they have accelerated higher at an unprecedented rate. That’s common coming out of a recession, but this far into the cycle it is unusual.
“The consequence is that forecast earnings growth for the 2026 year as a whole is now above 20%. That would be the third year in a row of double-digit growth and around twice the rate of growth achieved in 2024 and 2025.
“It’s worth noting that this is quite a narrow earnings surge. It is the consequence in large part of a massive boom in AI-related capital expenditure, which has soared since the launch of ChatGPT three years ago.
Market leadership trends
“The current market shows some similarities to the late-1990s technology cycle, particularly in terms of momentum and earlier corrections, although the environment today differs in important ways.
“A key difference between then and now is that the economic backdrop today is clouded by what is going on in the Gulf.
“The big concern is that the spike in the oil price persists for longer than hoped and the damage to the economy is greater. An inflation shock similar to that in 2022, or worse still to the one in the 1970s, is just not priced into today’s optimistic markets.
“And, as in both 2022 and 50 years ago, a stagflationary shock would be bad news for both shares and bonds. That makes it hard for investors to find a safe haven, especially if gold continues to underperform in a higher bond yield environment where the opportunity cost of being in a non-income-paying asset increases.
“So, this is a tricky time for investors. Investing for the long term, buying the dips and ignoring short term corrections works most of the time. But when it does not – as in 2000-2003 or during the financial crisis in 2007-2009, being out of the market and in cash is really the only defence.
“What matters when making this decision is your timeframe. Long-term investors may be happy to accept a big correction if the oil crisis overwhelms the AI boom. Anyone with a shorter time horizon may be excused a greater degree of caution.
UK market dynamics
“Overall market dynamics in the UK are in focus this week, with upcoming local elections contributing to a degree of uncertainty for investors. Gilt yields have edged higher after the long holiday weekend, with the UK’s 10-year government bond now yielding just over 5% – a level that makes it harder for the FTSE 100 to make progress as bonds become increasingly competitive relative to equities.
“With many markets closed for extended May Day holidays, including in Japan, South Korea and China, there is an element of ‘wait and see’ for investors. With little in the way of economic data this week, earnings and geopolitics are likely to remain the main market drivers.”
