Market Matters: 26 February 2024

The Nvidia results took on the significance of some major macroeconomic data release! The resultant moves in global markets only confirmed their importance. The AI standard bearer did not disappoint, posting year-on-year revenue growth of 265%. That was enough to catapult the stock to yet another all-time high, with a staggering gain of 16%, which increased the company’s market cap by $273 billion in

one day, getting on for 2/3 of the value of the whole of the FTSE 100! This move also resulted in the S&P 500 reaching a new all-time high, with the Nasdaq now in touching distance of its November 2021 peak. Probably not coincidentally, the Euro Stoxx and Nikkei followed through the next day with new all-time highs. Amid all the drama, yields were broadly flat, Asian markets up slightly with gold, but oil finished a little lower.

Before looking at the Nvidia move, I wanted to give some air space to the Japanese Stock Market. Forgive me the indulgence, but it is not an overstatement to say that I have waited my entire investment career to see Japan achieve a new all-time high.

When I started working in this industry, it was for MIM Britannia Asset Management, the forerunner of Invesco. To say we were Japanese-influenced would be to underplay it.

We had the two best-performing funds of all unit trusts in the 1980s, both Japanese. Our Chief Executive, Nicholas Johnson, had been head of our Japanese desk, and our M.D. also hailed from the Japanese fund management team.

My first investment was a Japanese Warrant fund that had made me spectacular paper gains of more than 250% in 1989 before losing more than 98% in value in the following two years (lesson learned: less greed and remember to take a profit!)

Nippon Telegraph and Telephone, Japan’s domestic telecom giant, was worth more than the top eight U.S. entries – IBM, Exxon, General Electric, AT&T, Ford Motor, General Motors, Merck, and Bellsouth – combined – sound familiar to current mega tech comparisons?

So, I have always had a nostalgic love-hate relationship with this market. Having nearly hit 40,000 in 1989, the Nikkei was still below 10,000, not much more than ten years ago, before turning the corner in 2013 and not looking back until finally, on Thursday, hitting a new high. To put this into context, the Dow Jones Composite has risen more than 1,000%. My first cursory examination of the Japanese market had led me to question my boss as to why Japan was trading on a P/E of more than 60x earnings, only to be told this was justified by ‘Japanese exceptionalism’. Now, that does set off a few alarm bells as I hear talk abound on CNBC of ‘US exceptionalism’. Imagine if, in another 35 years’ time, an AI Fund Manager writes a similar report to this, only in reverse, talking about the strange environment in the 2020s when the US commanded a premium valuation just because it was the US!

Anyway, it would have been a bad mistake to have had most of your eggs in the Japanese basket and few in the US, so I do get a little concerned when I see so many model providers building their asset allocation based on MSCI Weightings, which skew the weightings so highly toward the US. That said, the higher valuation commanded by the US market at roughly 20x forward earnings is nowhere near that of Japan and arguably entirely justified by the ability of US corporations to grow earnings consistently. So, what have been the reasons behind the Japanese recovery, and can it continue?

When you can find seven good reasons, that’s always a good sign…

Corporate Fundamentals: Unlike global trends where 2024 and 2025 earnings projections have dropped, Japan stands out with increasing optimism in earnings per share, indicating growth potential. This optimism is supported by the fact that profits are still not at pre-pandemic levels, and the market capitalisation to GDP ratio is decreasing.

Corporate Governance Improvements: Implementing the “third arrow” of Shinzo Abe’s Abenomics, focusing on corporate governance, is finally bearing fruit. This is evidenced by record corporate buybacks, indicating that companies are taking shareholder interests more seriously, which is a positive sign for potential growth.

Value Stocks Rally: Japanese value stocks have seen significant rallies, contrasting with trends in the US market. This surge is partly attributed to the dominance of passive, overactive management in Japan, creating opportunities for value investors.

Healthy Companies: Japan’s corporate sector is robust, with fewer “zombie” companies than other economies. This financial health provides a safer margin for investors.
Economic Confidence: Corporate Japan is displaying optimism not seen since 1989, as shown by the Tankan survey of executive sentiment. This confidence is substantial in the services sector and is improving in manufacturing.

Labour Market and Wages: Japan’s unique “shunto” wage negotiation process suggests that wages with a significant bonus component are expected to see their most generous increase in over three decades. This could lead to inflation and contribute to economic optimism.

Yen Could Strengthen: The BoJ will likely need to reverse its ultra-loose monetary policy now that inflation finally seems to be picking up, and that should feed into a stronger currency.

Despite the obvious past disappointments, the current indicators suggest that the Japanese market is in good health and, regardless of the rebound, still undervalued, highlighting several solid reasons to anticipate further growth.

Much of the bounce in the Japanese market hasn’t translated into Sterling gains for us in the UK (unless you were smart enough to buy a hedged vehicle), but that may change.

Perhaps most of 2024’s potential gains might come from Yen appreciation as that would dampen index returns.

The chart below is the best that I have seen, highlighting what we have witnessed in recent gains from the Nasdaq. It may be a bull run, but it falls short of taking us into bubble territory for the whole index. That is not to say that we won’t enter bubble territory and that there are no bubble candidates; chief amongst those is arguably Nvidia, but we haven’t yet seen the explosive, crazy characteristics of a bubble. I know a lot of hedge fund managers were shorting Nvidia, and perhaps if they need to cover these shorts by buying back in, we might get the irrational surge higher. There are also anecdotal signs of a crazy country, not quite taxi drivers telling you what stocks to buy, but I did read with interest that teenagers are now getting back involved in buying stocks like Nvidia.

Contrary to typical bubble scenarios, this situation has yet to display the usual indicators of increasing leverage. In fact, margin debt has been on a decline recently. Similarly, the proportion of margin debt relative to the overall stock market size has also been decreasing…

To my mind, rather than getting drawn into a debate on whether this is the start of the bubble or if there is too much concentration in the Magnificent 7, I am much more interested in whether the ingredients are suitable for the US equity markets as a whole to keep going and here I find myself optimistic. Let’s consider the main macro drivers…

Inflation although stickier short term than the authorities would like, is still on a downward trend, and this should allow central banks to cut interest rates later in the year.

Economic growth particularly in the US, is robust and likely to strengthen further as we go through the year, aided by interest rate cuts.

The consumer appears to be in good health, confidence is high, they are seeing real wage growth, and with unemployment still low, they have the necessary job security to keep spending.

Corporate earnings are trending upward with margins just about holding, and (this is a biggy) – productivity gains are increasing. Productivity is the go-go juice for bull markets, as not only does it increase GDP output, but it does so without fuelling inflation and feeds through nicely onto the bottom line with enhanced revenue and earnings.

I think the most significant danger here for US markets is that we don’t get the rate cuts everyone expects. The markets could eventually digest this news, but not without some increased turbulence and perhaps as much as a 5–10% correction. How likely is this? Well, regarding the current stance of the FOMC, there appears to be a readiness on Jerome Powell’s part to aim for a soft landing, even if the economy shows signs of picking up speed. Indeed, during his recent press conference, the Chairman of the Federal Reserve made it clear that a quicker pace in GDP growth does not directly impact the FOMC’s core mission.

This openness to more robust economic growth will persist unless the labour market tightens again. A significant increase in labour demand, through either a surge in employment or a rise in job vacancies, would probably pose the most significant challenge to lowering interest rates. There’s no indication that such a shift is underway, but I think the Non-Farm Pay Rolls Data has become more critical than the inflation numbers.

I am not a political beast and do my very best to stay out of debating the pros and cons of policy decisions, and like most people, I would welcome a tax cut if it comes in the Spring budget. That is likely, and the economy would benefit from a bit of fiscal priming from the Tories as they attempt to win a few more election votes. However, I was alarmed to hear that the Government is considering offering a 1% mortgage option for first-time buyers. I wholeheartedly agree that we need to create a society where hard-working people can afford to own their own homes if they want to, but the latest scheme would be madness.

Now, if I got out my A-level textbook, it would highlight that if the price of a commodity were going up, to reduce the cost, you would need to either increase the supply or reduce the demand. So, just what is Jeremy Hunt thinking? Demand would explode if you could buy a £200k house with as little as £2k saved. There is such a well-trodden culture of ‘you have to own your own home in the UK’ that everyone would pour in, and starter home prices would soar, sending ripple effects up the housing ladder. A subsidy designed to help a limited number of individuals get a head start on home ownership ultimately disadvantages those who follow by making it harder for them to access the housing market. In addition, negative equity presents a significant risk for scheme participants. With only a 1% deposit required, a minor fluctuation in property prices could lead to homeowners owing more on their mortgage than their property’s value.

It’s important to note that while the scheme may ensure many more people can raise the deposit, it doesn’t alleviate the burden of mortgage repayments. Those on the scheme might incur a higher interest rate than others, as the guarantee typically only covers up to 80% of the property’s purchase value. Lenders bear the risk for the remainder, which will no doubt be factored into the price of the mortgages. Let’s hope this scheme will not see the light of day.

Finishing on some good news, as I would like, UK energy bills are set to fall to the lowest level in two years as wholesale prices continue to decline rapidly. According to figures published by regulator Ofgem on Friday, the price cap will drop 12% to £1,690 from April 1st. The pricing mechanism, set every quarter, limits how much suppliers can charge per unit of energy. Analysts expect bills to slide further in July, helping to ease inflation and providing relief to consumers. This is possible as wholesale gas and power prices have dropped rapidly in recent months as mild weather and low demand ease pressure on global supplies.

Now, that is great news on two fronts, as a fall in bills in April could help to drive inflation below 2%, compared with 4% in January, and provide the catalyst for the BoE to start cutting rates. The cost saving will also directly feed into the coffers of households, boosting confidence and spending power. Add in the expected tax cut, and the ingredients are suitable for a pick-up in economic activity later in the year.

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