Investment Viewpoint: Markets navigate Middle East tensions and AI optimism

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Markets and macro insights with Bernard Swords, Chief Investment Officer

Key takeaways:

1. Investor sentiment has been shaped by renewed tensions in the Middle East and ongoing debate around the scale and sustainability of AI-related investment.
2. While geopolitical developments have contributed to market volatility, investors currently appear to view a broader escalation of the Middle East conflict as unlikely.
3. Economic data remains broadly supportive, with the US economy continuing to grow, euro area inflation easing and central banks maintaining a data-dependent approach.
4. We continue to favour a modest overweight position in risk assets, with a preference for structural growth opportunities, particularly within technology-related sectors.

What has shaped investor sentiment in July?

• July has begun as a more challenging month for financial markets, with investor sentiment being shaped by two key themes: renewed tensions in the Middle East and ongoing debate around the scale and sustainability of investment in artificial intelligence (AI).
• The most immediate source of market volatility has been the Middle East. During the first week July, tensions rose again, reminding investors that the conflict has not yet been fully resolved. This uncertainty pushed the price of Brent crude oil from around $70 per barrel to above $80 within a matter of days. More recently, oil prices have eased back into the mid-$70s as markets have become more optimistic that recent developments reflect positioning and negotiation tactics rather than a significant escalation in the conflict.
• While the situation remains fluid and warrants close monitoring, investors currently appear to believe that neither side wishes to reignite a broader conflict. A more durable agreement would be positive for market sentiment and could help reduce pressure on energy prices.
• AI-related investment remains a second major theme for investors. While some have become increasingly focused on whether the substantial spending taking place across the technology sector can be sustained and ultimately generate attractive returns, the underlying data continues to point to strong momentum.
• Recent results from major semiconductor companies, including Samsung, highlighted continued demand linked to AI development. While sentiment towards technology and AI-related companies can fluctuate from week to week, there remains little evidence so far that the current investment cycle is losing momentum in any meaningful way.

What has this backdrop meant for markets?

• Against this backdrop, global equity markets are up slightly (0.7% in Euro terms) since the start of July. Bond markets, however, have had a more difficult period. Rising energy prices raised concerns that inflation could prove more persistent than expected, leading investors to reassess the outlook for interest rates.
• The euro area bond market, which had performed strongly in recent months, has fallen by approximately 1% since the end of June. While some consolidation after a strong period was always possible, the speed of the recent move has been notable. If Middle East tensions continue to ease, bond markets could recover some of these losses.

What picture is being painted by economic data?

• Economic data released so far this month has painted a mixed but generally reassuring picture. In the United States, employment growth came in below expectations, while business activity surveys softened slightly. However, job creation remains healthy overall and both manufacturing and services activity continue to indicate economic expansion.
• Financial markets actually responded positively to some of the softer data, as it may lessen pressure on central banks to raise interest rates further.
• In Europe, inflation data provided some encouraging news, with core inflation falling to 2.4%, continuing the gradual downward trend seen over recent quarters. While this is unlikely to dramatically alter the European Central Bank’s policy stance in the near term, it is a step in the right direction.
• China remains in a very different position, with inflation close to 1%, reflecting continuing weakness in parts of its economy, particularly the property sector.
• Comments from central bankers have also been relatively supportive. At the European Central Bank’s (ECB) annual conference in Sintra, ECB President Christine Lagarde noted the steep decline in energy prices while US Federal Reserve Chair Kevin Warsh highlighted the productivity enhancements expected from the deployment of AI technology.
• The minutes of the Federal Open Market Committee (FOMC) meeting were no more ‘hawkish’ than expected Indeed, the overall conclusion appeared to be that future policy decisions will remain data dependent. Markets have taken comfort from the fact that policymakers continue to focus on incoming economic data rather than signalling any immediate need for tighter monetary policy.

How do we expect markets to react?

• Looking ahead, we expect markets to remain somewhat volatile as developments in the Middle East continue to unfold. However, our central view remains that a wider escalation is not the most likely outcome.
• At the same time, economic growth in the US appears to be moderating rather than deteriorating sharply, while the AI investment theme continues to support long-term growth opportunities.
• As a result, we continue to favour a modest overweight position in risk assets, with a preference for structural growth opportunities, particularly within technology-related sectors.
• Within fixed income, we remain more constructive on corporate bonds and shorter-duration debt than on longer-dated government bonds, which remain more vulnerable to interest-rate volatility.

The week ahead: what to watch out for

The coming week will provide further insights into the health of the global economy, with important releases including US inflation, retail sales and industrial production data, euro area industrial production figures, and China’s latest Gross Domestic Product (GDP) and economic activity reports. These updates should provide valuable information on the outlook for growth, inflation and interest rates during the second half of the year.