Equity Outlook: AI Enthusiasm Leaves Little Margin for Error

AI is creating opportunity, but risks abound. Investors should prepare for a range of outcomes.

Global equities rebounded in the second quarter as confidence in the AI investment cycle strengthened. As the third quarter begins, we believe markets have become priced for a smooth and profitable AI build-out, leaving little margin for error. June’s sharp sell-off in the Magnificent Seven stocks underscored how quickly sentiment can shift when crowded AI trades are priced for near-flawless execution.

It didn’t take long for equity investors to brush off the Iran-war oil shock of the first quarter. The MSCI ACWI Index of global stocks surged by 14.9% in US-dollar terms in the second quarter (Display), erasing losses earlier in the year to post an 11.2% first-half gain. Emerging markets and US small-caps outperformed. US large-caps ended the quarter slightly ahead of the global benchmark while European stocks posted solid gains but underperformed. 

The recovery, however, was uneven. Stocks weakened in June after rising through May, and volatility increased toward quarter end. We believe the erratic pattern reflects a two-speed equity market, as markets struggle to balance conflicting sentiment between macroeconomic caution and AI conviction. 

Energy was the worst-performing sector, reversing first-quarter gains as oil prices fell sharply on hopes that a US-Iran deal would open the Strait of Hormuz and unlock the energy-supply bottleneck (Display). Technology returns outpaced the market, even after the sector gave back gains in June, when a sharp Magnificent Seven sell-off reinforced our conviction in portfolios with broader market exposure. Style trends also reflected changing sentiment. Global growth stocks outperformed in the second quarter, but value stocks remained ahead for the first half. During most of the quarter, market volatility was relatively low, yet dispersion beneath the surface was elevated, indicating ongoing uncertainty.

AI Build-Out: Will Capex Create Profits?

AI enthusiasm drove the market for most of the second quarter and is lifting long-term macroeconomic growth expectations. Yet the build-out is also raising concerns. For investors, the fundamental question is: Will massive capital spending (capex) ultimately generate attractive returns? 

Mounting competition has prompted the US hyperscalers to put their full financial muscle behind efforts to secure advantages. The five biggest spenders—Amazon, Microsoft, Alphabet (Google’s parent), Meta Platforms and Oracle—are on pace to pump $1.0 trillion into AI-related investments in 2027, according to our research. That’s a 33% increase on estimated spending for 2026 and up from $96 billion just five years ago. 

In our view, market expectations already reflect new spending levels across technology industries. Yet we believe growth rates matter more for share valuations than absolute capex levels. Capex growth rates are poised to peak this year (Display). As spending growth decelerates, investors may focus more on whether earnings and cash flows can meet expectations. 

Cash flows are under pressure. Free-cash-flow (FCF) generation for the hyperscalers is poised to turn negative next year for the first time, according to our forecasts. Even fast-growing AI revenues will take time to offset the scale of investment. These trends could eventually erode profitability and challenge valuations. How each company manages these dynamics will determine whether they succeed or fail in translating the promise of AI into returns for investors. 

Record IPOs: Funding the Next Phase 

Investors are also scrutinizing a wave of AI-related initial public offerings (IPOs). Here, too, the key issue is whether future earnings justify expectations.

Anthropic and OpenAI, two leading AI technology firms, are expected to go public later this year and have no profits. Demand for these IPOs will indicate investors’ appetite for funding the next phase of the AI story. 

Two large share offerings in the second quarter showcased market sentiment. In early June, Alphabet (Google’s parent), raised $85 billion in a share offering partially backed by Berkshire Hathaway. As AI funding shifts to public markets, we believe financing discipline—and a credible story for investors—will matter as much as technology prowess. 

In mid-June, Elon Musk’s SpaceX raised $75 billion in a record IPO, after which the company’s market capitalization peaked at $2.6 trillion. The deal showed that investors are still willing to pay premium prices for transformational technology potential, even without tangible profits. But post-IPO trading volatility was a reminder of how quickly sentiment can shift.

Don’t Let IPO Excitement Override Discipline 

Investors are naturally drawn to marquee IPOs. But we think participation decisions should be grounded in a portfolio’s philosophy, disciplined research and an assessment of a company’s long-term merits. Different portfolios should assess share offerings through distinct investment lenses. Ultimately, the decision to invest should reflect whether the company’s fundamentals and valuations align with the strategy’s profile. 

Large IPOs could also introduce benchmark considerations if new listings are added to major indices. In such cases, we believe underweight positions should reflect a balance between conviction in not holding the stock and the relative risk. 

Technical Market Risks Deserve Attention Too

Beyond stock-specific risk, the IPO wave may add technical risks to markets. For years, share buybacks helped absorb stock issuance and investor selling, which supported valuation multiples and damped volatility. As companies issue more debt and equity with declining free cash flows, net buyback activity could decrease. Substantial new issuance—from IPOs, follow-on offerings and the release of locked-up shares (180 days post IPO)—could force investors to absorb much more equity supply than in recent years. 

Over the long-term, market returns are usually driven by earnings and economic growth. But shifting supply and demand can affect market dynamics at turning points. If issuance accelerates while net buybacks slow, we believe equities could lose an important tailwind. A market with more sellers and fewer natural buyers could be more vulnerable to volatility, multiple compression and sharper reactions to disappointing news—even if fundamentals remain solid. 

Earnings Backdrop Remains Supportive 

For now, fundamental signals look resilient. Earnings growth has been strong beyond technology, including materials, financials and healthcare (Display). This is creating fertile ground for active managers to identify opportunities across sectors and regions. We believe broad exposure to high-quality businesses remains central to capturing long-term equity return potential and mitigating risk. 

We define quality as businesses that can durably generate returns above their cost of capital. That’s why competitive advantages, healthy balance sheets, pricing power and strong management teams remain the hallmarks of quality firms. However, the nature of companies that qualify as quality may be changing. For example, asset-heavy companies in sectors such as industrials and materials that were considered less reliable in the past are seeing their quality profile elevated by AI spending growth. 

Still, quality has to be bought at the right price. By quarter end, price-to-forward-earnings (P/FE) ratios were elevated across markets, especially in US stocks (Display, above). However, the equal-weight S&P 500, non-US developed stocks (EAFE) and emerging markets are more moderately valued. We believe equity portfolios must stay focused on valuations and be wary of crowded trades in expensive market segments. 

Macro Pressures Are Building

Meanwhile, significant macro risks remain unresolved. Even as oil prices fell, inflation pressures have yet to subside, the GDP outlook remains fragile and higher interest rates could challenge elevated equity valuations. While the US and Iran negotiate to end the Middle East conflict, geopolitical tensions and policy uncertainty continue to cloud the outlook. 

Recent economic resilience has been supported in part by rising asset prices. A sustained market correction could weaken the wealth effect and reinforce broader economic headwinds.

We believe successful equity investing is rooted in company-specific fundamental research. But investors cannot ignore the broader macro environment in which businesses operate, especially in today’s two-speed market. 

Allocate with Intent in Changing Markets

Despite recent market strength, investors should look ahead with caution. We believe equities are integral to long-term allocations—especially as inflation lingers—yet new risks deserve attention. 

In this environment, equity investors should be more deliberate about where they take active risk. The AI build-out is creating opportunities, but high valuations, rising issuance and monetary policy uncertainty leave less room for imprecision. Shifts in expectations could trigger volatility. And passive allocations with exposure to companies driving headline index returns don’t eliminate risk.

AI’s dominance shouldn’t lead to one-dimensional equity planning. In our view, portfolios should seek durable sources of returns without placing a binary bet on AI’s unqualified success. That means better managing benchmark relative risk and adding exposure to active strategies in markets with greater dispersion, less benchmark concentration and fundamental change beneath the surface. As for AI, we think companies should be assessed on their fundamental merits. Over time, we expect execution, capital allocation and earnings delivery will matter more for equity returns than ambitious AI spending plans.

Enter the second half with eyes wide open. Scrutinize a portfolio’s blind spots for potential risks instead of looking in the rearview mirror for tomorrow’s returns. That means stress-testing AI exposures, broadening beyond crowded trades and ensuring each portfolio has a defined role in an allocation. In a market with little margin for error, portfolios and allocations must carefully prepare for a wider range of outcomes rather than be positioned for more of the same.