Jeremy Richardson from the RBC Global Equity team discusses why valuation discipline and diversification remain essential in today’s economic climate.
Highlights:
Market-cap weighted benchmarks amplify expensive AI stocks, creating concentration and abandoning the diversification that active managers usually prioritise.
Geopolitical risks continue to undermine valuations, risking prolonged high energy costs, driving persistent inflation, and rising interest rates that increase discount rates and reduce the future value of expensive stocks.
Strong first quarter earnings have fuelled near-term AI optimism, but escalating inflation and interest rate risks create a fundamental tension. How this resolves will be critical for investors choosing between chasing concentration or maintaining disciplined diversification in 2026.
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Jeremy Richardson:
Hello. This is Jeremy Richardson from the RBC Global Equity team here with another update.
Now, if you ask most people, I think, about whether or not they feel happy owning an overvalued asset, they might have something to say about that. Similarly, ask them if they want to put all of their eggs in one metaphorical portfolio basket, they may also feel a bit uncomfortable with that. Yet the benchmark, the market capitalisation weighted benchmark, which so many of us actually regard as being sort of the low-cost, lower risk alternative way of investing, actually loads on many of these types of ideas because the more expensive a stock is, the larger it is as part of that benchmark. When at the moment we're seeing the market being driven higher by increased levels of focus and attention on artificial intelligence-driven stocks, many of which are larger, many of which are actually more expensive, you can see how the market can become more concentrated and give up on diversification.
Now, these are challenging concepts for active managers because we care about valuation and we care about diversification, but these are not characteristics that appear to be being rewarded at the moment. It works for investors in those market capitalisation weighted benchmarks so long as these trends remain in their favour. That's what we've been seeing up until this particular point. But of course, things don't always work in the same way all of the time.
The questions have to be, what is going to disrupt this? Now, over the course of the last recent period, we've seen the emergence of new concerns within the market, not necessarily within the equity market, more within the bond market.
President Trump has returned from his trip to China without a deal from the Chinese, without any assistance from them to put pressure on the Iranians to resolve the situation in the Middle East. That's made the market concerned that actually high energy costs will remain with us for a longer period of time than we anticipated. This obviously increases the risks of high inflation and interest rates, and you're beginning to see that play through in terms of rising bond yields.
What does this mean for shareholders and investors in equities? Well, the discount rate matters because of valuation reasons. If the discount rate goes up, then the future value of those cash flows will actually reduce. So we end up now with a situation where there is sort of like a tug of war going on between the optimism around the artificial intelligence thematic, supported by continued strong earnings momentum.
The first quarter earnings were terrific with regard to the broader technology trade, and that's still giving us a degree of positive short-term sentiment. On the other hand, there are clouds forming on the horizon if energy costs stay high, if inflation continues to be a persistent threat, if that leads to higher interest rates. And how these two countervailing forces resolve themselves will be a key question for investors over the course of 2026. As active investors, we're looking at this developing market situation with great interest, but I promise you we're not going to be giving up on both of those two tenets of actually caring about valuation or sensible risk management to ensure that we don't have all of our eggs in that one basket. I hope that's been of interest, and I look forward to catching up with you again soon.
