Market volatility has returned, but the story beneath the headlines is more nuanced than a simple market pullback. Katrina Kruger, Senior Portfolio Manager at AMP, explains the forces shaping investor sentiment, the changing conversation around AI, and the themes likely to influence markets in the months ahead.

Markets are asking harder questions: What investors should watch next

After a strong run for global investment markets, volatility has returned. But beneath the headlines, the story is more nuanced than simply “markets are falling”.

Over the past month, investors have had a lot to digest: changing expectations for interest rates, political developments in the United States, questions about the enormous sums being invested in artificial intelligence (AI), and increasingly divergent performance across countries and sectors.

For investors, the key message is that uncertainty has increased, but the fundamental case for maintaining a well-diversified, long-term investment strategy has not changed.

What happened over the past month?

October was a mixed month for global markets.

Technology shares came under pressure as investors became more selective about some of the companies that had previously led markets higher. The technology-heavy Nasdaq 100 fell around 6% during October, while the Dow Jones rose around 1%, illustrating how differently parts of the US share market performed.

The pressure intensified in early November. On 5 November, the S&P 500 fell more than 4%, the Nasdaq Composite declined around 5.5%, and semiconductor shares were hit particularly hard. Weakness subsequently spread into several Asian markets but importantly, however, this has not resulted in a uniform global sell-off.

Different regions and sectors have behaved quite differently. The New Zealand share market for example has remained relatively resilient, while defensive assets such as government bonds have also benefited at times from investors seeking greater stability.

That dispersion is important because it demonstrates something investors can sometimes forget when one part of the market dominates the headlines: there is no single “market”.

From AI excitement to AI accountability

Artificial intelligence remains one of the most important long-term investment themes, but the conversation around it is changing.

Over recent years, expectations surrounding AI have helped drive substantial investment in semiconductors, cloud computing, data centres, electricity generation and related infrastructure. Companies positioned at the centre of this investment cycle experienced significant increases in earnings expectations and, in many cases, their share prices.

But now investors are starting to ask harder questions and rather than simply asking how much companies will spend on AI, markets increasingly want to know what return businesses will generate from that investment – that distinction matters.

Building the infrastructure needed to support AI is extraordinarily capital intensive. Data centres need land, power and water, while advanced semiconductors and computing infrastructure require enormous upfront investment.

The long-term potential of AI may remain considerable, but that does not mean every AI-related investment will ultimately prove profitable. The next stage of the AI investment cycle is therefore likely to place greater emphasis on earnings, cash flow, balance-sheet strength and the return companies generate on the capital they are investing.

In our view, that represents a maturing of the AI investment story rather than necessarily the end of it.

Interest rates remain critical

Interest rates are likely to remain another major influence on markets over the coming quarter. This matters because interest rates affect both the economy and the value investors place on financial assets.

When bond yields rise, investors can earn a higher return from relatively defensive investments such as government bonds. That can make highly valued shares comparatively less attractive which is particularly important for growth companies whose valuations depend heavily on profits expected many years into the future.

Conversely, evidence that inflation is easing and central banks have greater scope to lower interest rates, could provide support to both bonds and parts of the equity market.

For investors, this means economic news may continue to produce some seemingly counterintuitive market reactions. Strong employment or economic growth is fundamentally positive, but it can occasionally unsettle markets if investors interpret it as a reason for interest rates to remain higher for longer.

What could shape the next quarter?

We expect several themes to be particularly important.

First: corporate earnings will need to justify valuations. After several years in which expectations were an important driver of returns, markets are likely to become increasingly focused on evidence that companies can convert investment into sustainable revenue, earnings and cash flow.

Second: interest rates and inflation remain important. Markets are sensitive, not just to whether central banks cut rates, but to how quickly they can do so and where interest rates eventually settle.

Third: market leadership could broaden. Recent volatility has demonstrated that technology shares do not determine the performance of every market or asset class. Opportunities may increasingly emerge across different regions, industries and investment styles.

Fourth: political and geopolitical developments will remain a source of volatility. Changes in US policy, trade settings, fiscal policy and geopolitical tensions can influence inflation, currencies and investment confidence, sometimes very quickly.

Closer to home, New Zealand investors should also watch the domestic economic recovery and the effect that lower interest rates have on households and businesses.

What does this mean for investors?

Periods of volatility are understandably uncomfortable, particularly after markets have performed strongly but market corrections are a normal part of investing.

Investors receive a higher expected long-term return from shares partly because share prices can fluctuate substantially over shorter periods. If markets never declined, there would be much less reason to expect investors to earn a return above safer assets such as cash.

More importantly, recent market movements have provided a useful demonstration of why diversification matters. Technology shares, New Zealand equities, European companies, government bonds, credit and cash all respond differently to changes in economic growth, inflation and interest rates.

A genuinely diversified portfolio deliberately combines these different sources of return. That does not mean every part of the portfolio will perform strongly at the same time. In fact, if everything in a portfolio always moves together, it probably isn’t particularly well diversified.

For long-term investors, the objective should therefore not be to predict which market will perform best over the next few weeks. It should be to hold a portfolio capable of navigating a range of economic and market environments while remaining aligned with their investment timeframe, objectives and tolerance for risk.

Looking ahead

The next quarter could remain volatile. Markets are balancing relatively resilient economic activity against still-elevated interest rates, demanding valuations in some areas, significant AI-related investment and ongoing political uncertainty.

There are risks in that environment, but there are also opportunities. AI continues to have the potential to transform industries and productivity, but investors are becoming more disciplined about the price they are prepared to pay for that potential. Bonds are again providing meaningful income after many years of very low yields, while different equity markets and sectors continue to offer quite different sources of return.

That is why we believe the most important lesson from recent markets is not about predicting the next move in technology shares or interest rates.

It is about being prepared for more than one possible outcome.

For investors with an appropriately diversified portfolio, a sufficiently long investment horizon and an asset allocation that reflects their tolerance for risk, volatility should be expected rather than feared. Staying focused on long-term objectives remains more important than reacting to every short-term market movement.

If you want to see which AMP funds are available on InvestNow, plus read any other opinion or commentary pieces from Katrina and the team at AMP, please visit their page on our website.