Market state of play - and what to do

Well into the penultimate quarter of the calendar year, institutional and private investors face the paradox that record infrastructure capital expenditure, particularly by AI hyperscalers, coexists with heightened geopolitical risk, sticky inflation, and an apparent structural shift to the relationship between equities and bonds.

And if institutions are changing their asset allocations to reflect these shifts, should private investors do the same?

Key macro drivers & systemic trends

Global markets are simultaneously buoyed by and caught between the aggressive artificial intelligence (AI) infrastructure buildout – which demands unprecedented data centre capacity, specialised compute, and power infrastructure – and lingering geopolitical vulnerabilities in the Middle East.

Both dynamics act as structural inflationary drivers on raw materials and energy supply chains. And given stocks markets tend to do better when economic growth is accompanied by disinflation, rather than inflation, one starts to wonder how long the bull market can remain supported.

After 20 years of negative correlation, rolling 12- and 36-month stock-bond correlations have returned to positive territory. When market stress stems from monetary policy tightening, fiscal policy profligacy, persistent inflation, or high valuation multiples rather than growth shocks, equities and sovereign bonds tend to fall in tandem.

That’s significant because previously investors were advised to on simple 60/40 fixed-income duration to buffer equity drawdowns. Relying on the negative correlation is no longer the shortcut to adequate diversification it once was. Other solutions are necessary.

Figure 1. Positive equity/bond correlation erodes defensive role of fixed income

With inflation likely to hold more influence over economies and markets in the foreseeable future, simply having 40 per cent of a portfolio in bonds won’t provide the protection required.

“Genuine diversification means deliberately spreading risk across exposures that actually behave differently when it matters, rather than holdings that may be exposed to the same underlying factors.” Perpetual Private, August 2026

Another key driver of markets is market concentration, which has reached multi-decade highs. The top 10 constituents of the MSCI ACWI account for nearly a quarter of the total global index market capitalisation.

Again, this appears to be structural. Automated inflows to passive index funds continue to channel capital disproportionately into the mega-caps. And while this perpetuates the index’s outperformance relative to, for example, quality-based active fund managers, it’s also amplifying index-level volatility and single-factor risk.

Figure 2. Increasing global equity concentration. MSCI ACWI Top 10

1. Focus on earnings quality over narrative

Focusing on quality as a factor for stock selection has resulted in significant underperformance since the AI thematic gained momentum. The resultant outperformance of the major indices has, for example, even led to Berkshire Hathaway underperforming the S&P 500 over the last five years.

Now, the AI theme is transitioning from broad multiple expansion to capital discipline, as hyperscaler free cash flow yields plunge amid capital expenditure outpacing short-term earnings growth.

Figure 3. Plunging free cash flows

As Figure 4., reveals, the drop in free cash flows means the hyperscalers are forced to borrow to stay in the AI arms race.

Figure 4. Plunging free cash flows leads to rising debt

And while equity investors celebrate and cheer the epochal spending on AI infrastructure, irrespective of whether it is cash or debt-funded, credit default swap traders might be harbouring a different view.

Figure 5. Plunging free cash flows and rising debt, makes insurance traders nervous

The strategy of burning infinite amounts of cash and debt to stay in the AI race represents an ‘all-in’ bet that AI tools for individual consumers and enterprise customers will be sold at highly profitable volumes and prices – neither of which is certain.

There is, therefore, wisdom now in taking some profits from the AI winners, and refocusing on companies demonstrating tangible return on invested capital (ROIC) rather than pure cash burn.

And let’s not forget the disparity between tech sub-sectors is expanding. Capital markets are rewarding hardware infrastructure – semiconductors, specialised memory, power, and data centres – while software platforms face uncertainty about their monetisation timelines, and even whether they will be able to monetise at all amid the commoditisation of their tools.

2. Seek true uncorrelated diversification

With stock-bond correlations positive and equity indices heavily concentrated, portfolios require deliberate allocation to uncorrelated risk factors. Exposure to high-quality, for example – AA-rated, private credit funds, or energy infrastructure funds and assets, and relative-value, uncorrelated hedge funds such as arbitrage funds offers yield and diversification unlinked to traditional macro and market forces.

3. Maintain dry powder for volatility

While underlying economic growth remains resilient, market concentration, delays or setbacks to AI monetisation, geopolitical tensions and shifting central bank reaction functions create room for market dislocations. Maintaining liquidity (cash or near-cash investments) allows investors to capitalise on short-term mispricings when market valuations decouple from underlying corporate fundamentals, which, eventually, they will.

Learn more about private credit.

Alternatively, you can speak with David Buckland or Rhodri Taylor here at Montgomery on (02) 8046 5000.