These trends reinforce the need for regional diversification—with an eye on AI. While parts of the emerging markets—notably South Korean equities—are being driven by a small cohort of semiconductor and memory stocks, the broader EM landscape offers strong fundamentals and opportunities beyond AI that are less correlated with US markets. Similarly, in Europe, we believe quality growth stocks look attractive, with new opportunities surfacing in sectors such as industrials and financials.
Value stocks also offer exposure to industries that are more insulated from AI disruption—from aircraft manufacturing to agriculture—and a source of differentiated return potential. Several catalysts, including energy, increased defense spending and AI-driven capex across asset-heavy industries, have fueled value’s recent recovery. Rising interest rates could provide another catalyst for value stocks with shorter-duration cash flows.
Small-cap stocks also deserve attention. Despite a difficult third quarter, US small-caps have performed well year to date, supported by a broad-based earnings recovery. We believe smaller companies may also meaningfully benefit from AI adoption while offering lower correlation to the dominant AI trade than larger growth companies. This is because hyperscalers are spending free cash flow on AI capex, while select small-caps are well positioned to convert AI-driven productivity into cash.
Investors can also pursue diversification through portfolio design. We believe exposure to higher-risk AI beneficiaries can be balanced with defensive equity portfolios designed to cushion volatility, or with core strategies that seek lower tracking error. Quality companies play an important role in both approaches.
Rising Rates Sharpen Focus on Cash Flows
The higher rate environment makes the diversification challenge more acute. By quarter-end, a bond-market sell-off had pushed the average yield on global government debt to nearly 4%, its highest level since 2007, according to Bloomberg. In mid-September, persistent inflation prompted the Federal Reserve to raise policy rates by 25 basis points, while other major central banks are once again in tightening mode. US Treasury bond yields are unlikely to ease soon, given strong expectations for US growth and the rising debt burden.
A higher cost of capital has important implications for equity investors. When discount rates rise, markets tend to place greater emphasis on free cash flow, valuation and the durability of future earnings. Companies that consistently generate cash have greater flexibility to invest, return capital to shareholders and weather periods of economic uncertainty. Conversely, firms with weak free cash flow may struggle to sustain long-term earnings growth.
Mispriced Quality Stocks Are Worth a Look
Against this backdrop, we believe the key is finding quality companies capable of generating durable long-term returns above their cost of capital. Such businesses can be found in an array of industries, while earnings growth is more broadly distributed than headlines might suggest. This makes a compelling case for overlooked companies with durable business models, strong balance sheets, recurring revenue streams and strong cash flows.
Healthcare is a good example. The sector has historically exhibited relatively low correlation to the core AI trade but is a clear beneficiary of AI adoption. In our view, other attractive clusters with low correlations to AI include energy and chemicals as well as select financials and industrial firms.
Finding Balance in a Fluid Market
The past quarter offered an important reminder that markets are rarely as straightforward as dominant narratives suggest. We believe long-term investment success now hinges on finding attractively valued companies that can benefit from developments in AI while staying relatively insulated from crowded and risky AI trades. Diversification may be getting harder to find—but that only makes it more valuable.
