AI Risks and Resilient Stocks: Morningstar’s EMEA CIO on the Global Market Outlook

Key Takeaways

• AI fears appear overdone amid strong earnings, but diversification remains key.
• Inflation looks set to remain in check despite continued Iran war flare-ups.
• Emerging markets appear attractive as European stocks continue to play second fiddle.

From elevated equity valuations and bumper artificial intelligence investment to evolving central bank policy and persistent geopolitical shocks, investors are navigating powerful structural forces. Building a resilient portfolio is key. To discuss the global market outlook, the role of diversification, and how investors can position themselves for the years to come, I’m joined by Morningstar’s chief investment officer for EMEA, Mike Coop.

Karen Gilchrist: Let’s kick off with equity markets. Investors have enjoyed solid returns so far in equity markets, despite continued uncertainties around policy and politics, as well as persistent AI jitters. How do you rationalize this resilience so far, and what risks could investors be underestimating?

Mike Coop: I think it has been a surprise just how well markets have performed this year, given everything that’s happened. When we look back, there were probably two things that have really helped markets.

Firstly, the inflation fears the market had in that first Iran war outbreak earlier in the year, when oil prices shot up, haven’t really flowed through to the economy. They haven’t been sustained.

Secondly, all the fears about spending on AI and how that was going to dilute the profitability of businesses, we’re not really seeing that. If anything, the earnings results were probably a bit better than expected.

So those two things have really pushed up equity prices. But it’s fair to say we’ve also seen a rise in speculation. And that’s what you’ve really got to keep your eye on.

AI Concentration Risk Calls For Greater Diversification

Karen Gilchrist: How concerned are you about this concentration in AI and mega-cap tech stocks? And how do investors know if they’re well enough diversified in the face of that?

Mike Coop: It has been quite surprising how this thing has spread. It reminds me quite a lot of 1999, when we had three industries that were previously quite separate kind of start to merge in terms of how they behave: the media, technology. and telecoms. So this time around, it’s information technology, communication services, individual companies that are quite big in consumer discretionary, and even some of the utilities firms that are strongly linked.

We’re also seeing the global supply chain mean that certain companies—Dutch company ASML ASML, Taiwan Semiconductor TSMC, SK Hynix 000660, and Samsung 005930 in Korea—are linking up across geographies and different sectors. So, that question about diversification does need to be looked at seriously.

We’re trying to find industries that march to the beat of a different drum, in terms of not being so impacted by AI spending. Secondly, things that are growth-oriented or can hold up if economic conditions toughen are quite important. That’s our test for whether they can bring something different to the party. So in our portfolios, we’ve had things like healthcare, which we think has been undervalued. Earlier in the year, consumer staples.

We look at other markets we feel have been unduly discounted, like Brazil. That’s where we’re seeing some of the newer opportunities—and indeed, also consumer discretionary, where they’ve been hit by fears about spending in China dropping off.

Central Banks Wagering Against Severe Inflation Spike

Karen Gilchrist: Turning to inflation, we’ve seen the Fed hold interest rates, continuing this trend at major central banks overall. And now expectations are pushing potentially to the end of the year before they could hike. Yet we still have uncertainty around the Iran war and the depletion of oil reserves. How surprised are you by the hold-off in any inflation surge so far, and what’s the risk that will hit us down the line?

Mike Coop: There’s no doubt about it, these are really tough things to forecast. So we think of it in terms of probabilities. What are the ranges of feasible scenarios, how likely are they, and how is that probability shifting as events unfold?

What we knew earlier was that the energy markets are fundamentally changed, partly in response to the last big spike in energy prices after the invasion of Ukraine in 2022. It actually increased supply, because the spike in prices made some oil and gas exploration economical. That’s led to an increase in supply for both. It also made people think, ‘Perhaps it’s economic for me to switch to another energy source,’ and it’s incentivized people to have more renewables in their energy, both transport and electricity.

Those two things have meant the economy is a lot less sensitive to a spike or short-term supply constraint, which is what we’re really talking about with the Iran war. And all that Russian energy didn’t actually go away after the invasion of Ukraine—it ended up being sold, effectively almost on the black market, to India, China, and other countries. So on net, things are better than they might first appear in energy markets.

AI is undoubtedly having more of an impact as all of us try to work out how to use it. It’s kind of equivalent to an increase in the supply of firms or people, because of what it allows us to do that we couldn’t do before. All of those things are capping inflationary pressures from labor markets and letting firms potentially increase their profit margins, even if they’re getting an increase in supply. So on net, it’s helping contain inflationary pressures, the productivity gains, even though in the short term, it’s pushing up the demand for things like data centers and sources of energy.

When you net all those things out—plus China expanding and effectively increasing its exports with low prices overseas and heavily subsidized industries—they’re capping inflationary pressures. So we don’t see a high risk of inflation taking off, and we think central banks are aware of this and being measured.

Auto and Luxury Stocks Remain Opportunities in Subdued European Markets

Karen Gilchrist: Finally, closing in on Europe and the opportunities that might be there. What do you see as the outlook?

Mike Coop: European markets have played second fiddle, frankly, to what’s happening from a global industry and AI perspective. The localized theme has been the uptick in defense spending (especially from Germany), but more generally, it’s how all the countries want to lift their spending, how that’s going to be done, what they’ll end up buying, and who makes that. So that is ongoing, but it’s a long-term process and a bit company by company. But people have expected that to have some benefit for growth.

We felt that European markets were pretty fully valued, so we weren’t seeing many great opportunities. We think emerging markets are actually better. But high-quality fashion names and some automobile companies looked attractive to us. They’d been heavily discounted, based on Chinese companies competing more aggressively in the auto space and some luxury names struggling more in China, which we think were overdone. So we have taken positions in the portfolio based on that.

We did feel for a long time that the UK market was also underappreciated. We think over time, it has quietly been re-rated. M&A has gone on. It offers a different sector mix. But we feel it’s not as wildly attractive as it was maybe three or five years ago. So for us, Europe isn’t a land with lots of opportunity; it’s quite select.