Market Matters 28 May 2024

After such a strong run-up over the last few weeks, the financial markets were due a breather, and we duly got one – well, sort of. US markets fell sharply on Thursday but proved to be very short-lived as the market rallied sharply on Friday, with the Nasdaq setting another closing high. It would seem that investors are becoming even more impatient. Instead of waiting to ‘buy on the dip’, they are now ‘buying on the blip’ judging by the speed of turnaround in the US. Back home, Sunak surprised us with news of a July election as the rain poured down in the UK.

UK financial markets seemed underwhelmed, and elsewhere, it was a soggy week for global equity indices and bonds as animal spirits temporarily deserted investors. The cause of the disappointment was good economic data. Yes, that’s right, the data was better than expected. We remain in limbo land, where good macro news is bad news for financial markets and vice versa. But there was one giant, very bright ray of sunshine in the form of the Nvidia Q1 earnings report. The report was arguably even more important than any big macro news, with the AI titan blowing past market expectations, suggesting the AI revolution still has much more room to run.

First, a quick recap: the Goldilocks scenario is one where the economy runs appropriately this year (not too hot or cold), and inflation slowly decreases to nearly 2%. This allows the Fed to cut interest rates, and (all things being equal) this narrative is a very favourable backdrop for both bonds and equities. At the beginning of the year, the primary concern was that Goldilocks would be spooked by an economy that might slow to a stall. Latterly, the concern is that the economy might be running too hot for inflation to fall, scuppering the prospect of interest rate cuts. So, news that S&P Global’s (PMI) for US combined manufacturing and services had reached its highest level in two years (too hot) left investors concerned for Goldilocks’s well-being.

By itself, the PMI data might have been treated kindlier by investors, as after all it is genuinely good news for this economic cycle. But it was accompanied by strong weekly jobs data and, perhaps more ominously, the release of the latest FOMC minutes. Here we found that the meeting hadn’t been quite as dovish, as J Powell had initially portrayed straight after the meeting. Many Fed officials expressed uncertainty about how much policy is restraining the economy, and some doubted that current monetary settings are restrictive enough. Policymakers also suggested it would take longer to achieve the 2% target confidently. This was slightly at odds with Powell’s prior summary and led traders to revise rate expectations to ‘higher for longer’. Unsurprisingly, debt investors didn’t like what they read, nor did the PMI help matters, and bond prices fell, causing yields to back up. Equity markets might have sold off a lot more too, had it not been for another astonishing earnings report from Nvidia.

This AI Titan has rapidly evolved from a niche video game chip supplier to the leading provider of AI accelerators. Its recent earnings report surpassed expectations, with revenue more than tripling to $26 billion during the first quarter. It also delivered a bullish sales forecast. To further help matters, it announced a 150% dividend boost and a 10-for-1 stock split.

Whilst there may be echoes of an earlier internet era in terms of hype and share price surge, there the similarities end, as this business is delivering on earnings. Instead of cash burn, there has been massive cash generation, with a 2,000% surge in net income over the last two years. Its customers are an ever-swelling rank of businesses still ploughing billions of dollars into this new technology. Their hope, my hope and the market’s hope is that this investment will help them reap the productivity gains that AI promises.

Dubbed the ‘new electricity’ of commerce, AI’s reach spreads beyond the apparent industries like autonomous vehicles and copywriting. In case the insidious creep and usage of AI might not be that obvious at surface level to you (and by way of emphasising that point) I asked Chat GPT for more information. Its response is below…

‘Businesses are leveraging artificial intelligence (AI) in some surprising and innovative ways to boost productivity. Here are a few notable examples:

• Rescue Missions: AI is being used to assist in search and rescue operations by analysing aerial footage from drones to locate disaster victims quickly, significantly cutting down the time it takes to find and rescue people in emergency situations.

• AI-Enhanced Brushes: Companies like Kolibree and Oral-B have developed AI-powered toothbrushes that analyse brushing habits and provide personalized feedback to improve dental hygiene. These brushes use deep learning algorithms to adapt to individual brushing styles and even engage children through games to ensure they brush more effectively.

• AI in Music and Art: AI systems are now creating music and art. For example, AI can compose classical and jazz music, and even generate digital paintings. AI algorithms analyse existing music patterns to produce new compositions, and tools like DeepDream and Artbreeder help artists create unique digital art.

• Smart Agriculture: AI is revolutionizing agriculture by providing solutions for soil and crop monitoring. Tools like Plantix use deep learning algorithms to identify soil defects and plant diseases, helping farmers optimize crop yields and manage their fields more efficiently.

• Wildlife Conservation: AI helps track and protect wildlife by analysing data on animal populations and migration patterns. It can predict poaching threats and assist park rangers in patrolling efficiently, thereby protecting endangered species.

• AI in Urban Planning: AI is being used to design and manage smart cities. It helps urban planners optimize land use, manage traffic congestion, and improve public transportation systems by analysing large volumes of data to find trends and anomalies’.

The list goes on and on of industries that will benefit. I asked ChatGPT to give me another 100 examples – which it provided in less than 30 seconds, which says it all. The world is going to look very different as this revolution evolves. I get particularly excited for financial markets, which impact productivity and are the go-go juice for share prices, as we can expect revenue to increase and profits as AI lowers wage costs. It is also quite deflationary and may prove more successful in delivering the Goldilocks outcome than the Federal Reserve.

In a dramatic scene, marked by pouring rain and the backdrop of a Labour Party anthem, UK Prime Minister Rishi Sunak announced national elections for July 4th. This early call for an election has left me scratching my head; why didn’t he wait for later in the year, as things do seem to be improving economically? As all media outlets are keen to highlight, the Conservatives are currently trailing in popularity and face a near-impossible task of overturning polls that show Labour leading by at least 20 points, but stranger things have happened in politics!

Regardless, I don’t think the election outcome will dramatically alter the course for UK financial markets. Both parties are broadly business-friendly, and there is very little wiggle room for any significant change in fiscal policy. Monetary policy is thankfully the domain of the independent Bank of England. If anything has changed from the news, it is probably less likely that we will see an interest rate cut in June, as that might risk the accusation that the BoE may have a bias.

That June rate cut had already looked more improbable after the latest UK inflation release on Wednesday, which came in a little higher than expected with CPI at 2.3% YoY – expectations were for 2.1% – and I imagine Rishi was hoping for a 2% print to go alongside his election announcement. Now, I think that a miss of 0.2% isn’t the end of the world but if you look at the accompanying chart, you can see that services inflation (the white line) is proving sticky.

There are various reasons why this might have been the case. You may recall that the minimum wage increased by nearly 10% in April, likely contributing to higher service prices. Regardless of the cause, this reading has led to the markets’ aggressive repricing of interest rate expectations. Before the data was released, markets estimated a 50/50 chance of a rate cut next month. They believe it’s almost off the table, and even August is no longer sure. Both equity and bond markets were disappointed by the news, and gilt yields have backed up to an attractive point, as I am still in the camp that sees the UK cutting more than market expectations.

We still have some data to come that could alter things with May’s figures for both wages and prices out before the next Bank of England meeting. In the grand scheme, it only makes a slight difference to people outside specific financial markets. It might mean the recent easing in some mortgage rates won’t continue for now, but we’re only talking about minor shifts anyway.

What’s genuinely encouraging is the robust state of the UK economy, a reality that’s bringing tangible benefits to consumers. UK GDP is surpassing expectations, and consumers are reaping the rewards of lower bills, higher wages, and tax cuts. The growing sense of optimism is not just a sentiment, but a reality, as the latest consumer confidence survey clearly indicates an upward trend.

Let’s hope the UK equity markets mirror this newfound optimism and that the recent stall is merely a pause before the next leg higher.

This content is intended for financial professionals only. These are the author’s views at the time of writing and may be subject to change. This content is not intended to provide the basis for any investment advice or recommendation. Any forecasts, figures, opinions, tools, strategies, data, or investment techniques are included for information purposes only.

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