In this month’s Portfolio Perspectives, we examine three themes shaping client portfolios: the evolving investment case for Chinese equities, the implications of rising Middle East tensions for energy and inflation, and the divergence in economic performance between the United States and Europe driven by the artificial intelligence capital spending cycle.
Chinese equities: the technology has changed; the capital discipline has not
Chinese equities have attracted renewed interest, underpinned by a more contemporary argument than the straightforward growth story of a decade ago. China has made genuine advances across a broad range of technology sectors. Twice as many PhDs are now awarded annually in STEM subjects in China as in the United States. The country leads global research in 37 of the 44 technology areas tracked by the Australian Strategic Policy Institute. DeepSeek’s open-source AI model, high-speed trains, nuclear reactors, electric vehicles, and renewable energy are among the more visible examples of this expanding technological reach.
The case for treating this as a fundamentally new chapter for Chinese equities is, however, undermined by the persistence of an old problem: poor capital allocation. Chinese equities have systematically underperformed global markets for the better part of two decades, and the underlying reason has not changed. China has proved highly capable of mobilising savings and directing investment, but the returns on that capital have remained disappointing. The property boom and subsequent bust of the 2010s was the most conspicuous example, but the pattern extends into the newer industries.
In electric vehicles and batteries, capacity utilisation sits at just over 50 per cent. Chinese producers hold around 60 per cent of global EV market share, yet operating margins remain on average negative and returns on assets and equity are low by international standards. The solar panels sector presents an almost identical picture: a global market share of around 90 per cent, capacity utilisation of roughly 50 per cent, and operating margins now on average negative, with a return to profitability not expected for at least two years. A wave of government-subsidised entry, incentivised by local authorities offering free land and subsidised financing, has created the capacity surpluses that continue to suppress pricing power.
At the aggregate level, China’s shift towards a more technologically sophisticated industrial structure over the past decade has been associated with lower, not higher, productivity growth. Return on equity and return on assets for quoted Chinese companies have continued to decline, both in absolute terms and relative to global peers. Even in the IT sector, Chinese companies have materially underperformed their US counterparts on profits growth – yet the Chinese IT sector trades on a higher multiple than its US equivalent.
The structure of the Chinese equity market also retains an old economy character. The globally influential electric vehicle and solar sectors account for only around 3 per cent of quoted market capitalisation. Financials remain a material component. The top two stocks account for approximately 25 per cent of capitalisation. Government subsidies, estimated at around 5 per cent of GDP, appear to boost market share at the expense of profitability, and may inadvertently favour less productive, politically well-connected firms.
Saranac maintains a market weight in Chinese equities, implemented passively in multi-asset portfolios. We take positions in individual securities where we have confidence in the long-term return profile, but we are not persuaded that the case for a structural overweight has yet been made.
Middle East tensions: the risk of an oil price shock is rising
Financial markets have so far been relatively untroubled by the persistence of Middle East tensions, apparently reflecting a broad assumption that the conflict will prove short-lived. That assumption is looking increasingly difficult to sustain. Resolution does not appear imminent, and the risk of a significant oil supply disruption – and the inflationary consequences that would follow – is rising.
Oil market futures are already pricing in an expectation that elevated energy prices will persist into next year. Were that to materialise, the inflation outlook could deteriorate more sharply than is currently discounted in either market prices or central bank projections. The interaction between an oil price spike and a policy response – particularly in the United States, where the economy remains in a cyclical upturn – is where the most significant risks reside.
In response to this risk, Saranac has recently increased its exposure to inflation-linked bonds in the United States. We regard this as prudent protection against a scenario in which energy prices deliver a worse inflation outcome than is currently priced.
IT capital spending and economic divergence: US growth accelerates, Europe stalls
Global equity markets made strong gains in May, but the aggregate figure obscures a striking concentration of returns. The broad market advance was almost entirely attributable to a near-20 per cent gain in the IT sector. Most other sectors delivered broadly flat returns. While IT earnings growth has been robust, the price gains last month appear to have run ahead of earnings revisions. Analyst estimates of long-term earnings growth for the IT sector have reached elevated levels, setting a higher bar for the cycle to continue to deliver upside surprises to corporate earnings.
Beyond equity markets, the artificial intelligence capital spending cycle is now a central driver of divergence in economic performance. The United States is experiencing a cyclical upturn, in part sustained by AI-related investment flows, while European economies are contending with stagflationary conditions – weaker growth, stronger energy prices, and limited policy flexibility. A significant and widening growth differential has emerged between the two regions.
The picture within the United States is itself uneven. Old economy sectors such as construction are struggling, and lower-income consumers are under pressure. The strength in headline activity data is therefore not uniformly distributed. Nonetheless, the AI capex cycle has become sufficiently embedded in US economic activity that it is now a meaningful differentiator of relative economic performance globally.
The AI capital spending cycle is well entrenched, but the risk is that expectations have now moved to a level where only further positive surprises to earnings can sustain current valuations. We are monitoring the gap between price momentum and earnings revisions closely.
Read the June Outlook here.
This commentary is intended for information purposes only. It does not constitute a personal recommendation, financial promotion, or regulated advice. Past performance is not a guide to future returns. All views are those of Saranac Partners and are subject to change.
