Happy days? Or summer delusion?
Is it time to be bullish? Or at least is it time to stop worrying so much about big, bad things? The pandemic is a distant memory, arguably inflation was mostly a supply-side shock which is now fading and interest rate hikes are all but done. In a year’s time we might look back and think Federal Reserve (Fed) Chair Jerome Powell bagged another soft landing. And while there is bad stuff in the past, there are some exciting things in the future. Investors are seeing potential opportunities in the energy transition and the next technology revolution. And rather than technology stocks coming crashing back down to earth, what about cyclicals and consumer stocks catching up? Today’s market is pricing substantial net benefits from artificial intelligence (AI) and related technologies but there may also be scope for a more traditional cyclical recovery. It may pay to think twice about betting against these potential trends. Yet in the near term, central banks remain fixated on inflation – something which may temper, for a while longer, all-out bullishness.
The only real driver of sustained market losses tends to be monetary tightening. Yes, other shocks can create short-term losses – as seen during the early stages of the COVID-19 crisis – but it is tighter monetary conditions which tend to have longer-lasting, and meaningful, effects on economic fundamentals. When central banks are in tightening mode, markets tend to deliver negative returns - the story of the last year or so. But now, in the majority of people’s most likely scenario, the bulk of this cycle’s tightening is behind us. We may get a confirmation of sorts if the Fed chooses to hold its policy rate at its monetary policy meeting on 14 June. Right now, market pricing suggests a 40% chance of a hike.
Yet it may not be quite the time to call the peak in rates. Both the Reserve Bank of Australia and Bank of Canada raised rates by another 25 basis points (bp) this week. The message was quite hawkish, particularly from the Canadians. I feel sure that core inflation will ease in the months ahead, but central bankers don’t want to take any chances. It remains the case that growth is still strong enough to give them the cover to raise rates more if they feel that is necessary. This remains the key risk to current positive sentiment in equity markets in the short term.
If the Fed does hold, however, then markets are going to believe they are done. Returns will go up accordingly. Bond yields tend to fall after the Fed’s last hike of the cycle, so maybe the range that has been in place in 10-year Treasury yields (3.25% to 4% since last November) will be broken to the downside. The year of the bond is still with us.
Higher rates hit returns
When rates are going up, expectations about economic growth go down. Most recessions are caused by central bank tightening (although not all tightening cycles end in recession). Credit and equity markets react badly to recessions as they mean reduced profitability, credit problems and outright business failures. When markets have been driven higher by bubble conditions, the correction is worse. This was the case with the turn-of-the-century dotcom boom and the leveraged mortgage explosion which morphed into the global financial crisis of 2008/2009. Rates went up and burst the bubbles.
I may be wrong, but I don’t see much evidence of bubbles today (apart from West Ham ones). There has not been an excessive build-up in leverage. Indeed, strong nominal growth has allowed corporate leverage to come down. There is no generalised state of market euphoria. If anything, the prevailing narrative is that it’s only a matter of time before a recession hits, defaults rise, and we get the double-dip equity bear market. Money is not pouring into the market – data suggests that equity funds have seen net outflows in 2023. Money market funds and high-yielding short-duration fixed income strategies have been the main attraction. Cash has been, and still is, king (or queen). Talking heads can reel off a list of potential reasons to be bearish – higher rates; the fight against inflation; Fed balance sheet shrinkage; geopolitical tensions; and the narrowness of leadership in the equity market, but they might as well be shouting into an empty room (or Twitter). The market isn’t listening.
It’s not that common or popular but one can make a bullish case here and now. The pandemic, inflation and interest rate hikes are behind us while labour markets are more flexible since the pandemic. Companies are not reporting any big clouds on the horizon in terms of business sales. The OECD has said this week that global growth is slowing but there is not likely to be a recession. Geopolitically, there appears to be early signs of a thaw in US/China relations and the longer the Ukraine conflict goes on, the less of a broader threat Russia is.
The risk of a US default has passed. A default would have been very unfortunate but now the US should be seen for what it really is – the most dynamic economy in the world with the greatest potential for continuing to deliver higher returns to investors. China is clearly a threat but recent data from China has been disappointing and, moreover, the longer-term prospects for Chinese supremacy are severely curtailed by negative demographic trends. This year’s performance of US mega-cap technology stocks is the poster child for US exceptionalism – despite what many think about its politics. A couple of weeks ago I wrote about the technology sector being responsible for all the gains in the S&P 500 this year. The situation hasn’t changed with stocks like Nvidia and Apple reaching new highs and more and more being written and discussed about AI as the driver of a new technology age. Just this week there are some signs the outperformance of technology might be coming to a temporary hiatus, with stock market rotation benefitting those sectors that have been left behind recently. Industrials and consumer discretionary stocks have had a good month.
The robot question
Is AI a bubble? Investors willing to be invested in the equity market are looking at ways of getting exposure, either directly or indirectly to AI. At the same time there is a lot of discussion about the need to regulate AI research because of the fear that machines will become more intelligent than humans, posing a threat to the very existence of humanity. I think the issue is that AI is hard to price. Think of all the potential benefits and all the potential risks. The benefits to AI’s further evolution and adaption across a broad range of sectors and industries could generate huge future gains in economic wealth. What if AI accelerates the development of early cancer detection? What about AI contributing to climate change solutions through the optimisation of power supply grids, home energy usage and transport systems? What about putting AI to work to reduce biodiversity loss through more intelligent use of land, optimising crop yields and dealing with waste? I cannot contemplate all the potential uses for AI, but a quick Google search shows its applications include, among many others, automation, transport, health, food, education, marketing, legal work, entertainment and security. The launch of Apple’s Vision Pro headset is an example of the commercialisation of the coming together of AI with virtual reality in a device that transcends social media, entertainment, and productivity.
But there are risks. The process of machine learning can be used for malevolent purposes. Rogue robots could be used in warfare, terrorism and in undermining freedom and democracy. This is a theme taken up by George Soros on the Project Syndicate website this week (see here). He calls for policymakers to quickly develop a regulatory framework for AI research, something which would require all the big technology firms to be on board. The US Congress has taken aim at the technology sector before and AI looks certain to attract a lot of political attention, given the risks.
Trying to calculate the net present value - the balance of potential future benefits (economic and social) and risks from AI - is impossible. My optimistic self likes to think the benefits will outweigh the costs, as all other major technology revolutions have done. The rise in US technology stock prices in recent weeks, along with the strong performance of the Korean and Taiwanese markets, suggest more investors are betting on the upside - at least until the downside risks become better articulated and more present. Even then, regulation won’t stop the legitimate use of AI across the broader economy. While the rest of the stock market languishes amid concerns about further declines in earnings, could it be that the AI revolution means the US avoids a recession and the bears will be disappointed? I am sure there is more economic weakness to be revealed by the data in the coming months – a softening of the labour market maybe, weaker housing data perhaps – but so far, the typical reaction of the US economy to a 500bp increase in official interest rates has not been overwhelmingly obvious. The momentum of earnings forecasts from equity analysts has become more positive in recent weeks (more upgrades than downgrades for the market as a whole and certainly for the tech sector). Manufacturing looks to be a little in the doldrums (after what have been two strong years between mid-2020 and mid-2022) but even indicators like the new orders index from the Institute for Supply Management look closer to the bottom of the cycle than the neutral 50 reading.
It's hard to be bullish when money supply growth is collapsing, when forecasts are for below-trend GDP growth and when there are global concerns about fiscal policy needing to be tightened. There are always storm clouds for markets. Yet maybe we are in a period of reassessment. Some big bad things are behind us. Inflation will slow, central banks will pivot, and a soft landing might not be that fanciful. The pain trade, as I discussed with a good contact at one of the investment banks last week, might be that markets keep performing. If you are short, that hurts.