US midterms and market volatility

It’s been a noisy couple of days in markets especially for the investors in the AI theme, however, this has spread into a broader sell-off. The US midterms raised the prospect of a more interventionist attitude from the US government in time, and despite some volatility on the night of the vote counting, the results were greeted with a positive response from markets the following day. That has now decidedly shifted as volatility has engulfed broader markets; with a fall in equity markets accompanied by a falling gold price and rally in government bonds.

This swing is a reminder of how hard it is to trade on elections and the wider factors that interact with markets on a day-to-day basis. For example, there are reports that some large hedge funds have been caught out by the volatility in semiconductor stocks, and their deleveraging may be exacerbating the market moves. These technical aspects of positioning in markets can quickly override any initial story leading up to volatility.

The midterm results

Democrats will hold a simple majority in the House and Senate by January. While this is not enough to overrule a presidential veto, Republicans will need to be prepared to make deals across the aisle to pass legislation and indeed, raise the US debt ceiling. The historic congressional swing also sets the scene for the 2028 election, which could have significant implications for the tech industry.

Equity markets are paying particular attention to how the Democrats intend to regulate the AI industry, as they have so far been less focused on seeing it as an ‘arms race’ with China. Given the dominance of US AI companies in both their domestic and global equity markets, this raises interesting questions about portfolio positioning.

In the long term, this is not necessarily a negative for markets. Upfront and gradual legislation around AI could prevent rushed policy down the line that has a more dramatic market effect. Political pushback against an incumbent administration is also a familiar feature of the midterm cycle, and attention should return to inflation, interest rates and corporate earnings. Many of the largest US companies earn revenues worldwide, so their prospects depend on global business conditions as well as domestic policy.

Funding the AI build-out

The shift this year in how AI capex is being funded is notable and contributing to growing investor concern. The top companies in the US have significantly reduced their share buybacks and have switched to raising large sums from equity markets, in addition to large issuance in bond markets.

Meta made its first foray into the European bond market this week, issuing a $15 billion five-part bond offering on Monday, followed up with a €9 billion bond sale on Wednesday. Last week, the company increased its ongoing equity offering to $98 billion. It’s also notable that Microsoft returned to the bond market for the first time in a decade to raise $25 billion. This comes ahead of IPOs in the pipeline that will raise more capital to fund the AI build-out.

Diversification enabling long-term thinking

Investors who reduced exposure into the midterms will have had mixed emotions over the last couple of days and are now faced with another problem; the market will not wait for them. Some of the best days in markets often follow the worst, and although for those that are patient long-term investors it is also a more uncomfortable time, we believe that the core principles of diversified portfolio construction will continue to serve us and clients well over the longer term.

For the AJ Bell portfolios, those principles remain: a long-term outlook, diversified positioning across regions and sectors and avoiding making knee-jerk decisions. More specifically in terms of portfolio positioning, equity weightings to the US are less pronounced than in global indices and are combined with the use of US sectors across Healthcare, Energy and Utilities. More defensive markets, such as the UK, and these sector positions have helped manage the journey through periods of volatility in equity markets, enabling us to stay focused on the longer-term outlook.