Chief Investment Strategist
Performance the past week, including the last week’s Friday session, underscores the concept of the “two-lane economy” where one part, the one immune to high interest rates, is doing great, and another part is struggling with high interest rates and inflation. Information technology stocks rose 5.3% while every other sector was down underscoring the extreme skewness we observe in markets with AI being the underlying driver of this dynamic. The biggest story in technology this week was Apple announcing a partnership with OpenAI integrating ChatGPT into its ecosystem of products with payment through distribution and not cash. This means that OpenAI is likely going to get access to a new and vast dataset that could accelerate and improve its models even more in the future widening its moat in generative AI.
Across geographies the US equity market was also the strongest up 1.5% while the European equity market was down 1.6% as political uncertainty has been injected as French President Emmanuel Macron has called for a snap election after his party suffered bad EU parliamentary results last weekend.
The 2% decline in the energy sector has increased the expected real returns for energy stocks to 6.9% annualised which means that energy stocks remain the most attractive. The strong performance in information technology has lowered its expected returns to 4.8%. If one compute the expected real rate return based on the information and estimates we have today then it is 4.4% for the MSCI World Index. Is that good or bad? It depends on the investor’s risk profile and tolerance for drawdowns. The alternative is US 10-year government bonds. They have a yield of 4.2% and with the 10-year inflation at 2.5% (basically the market’s expectation of inflation over the next 10 years) then the expected 10-year real rate return is only 1.7% annualised.
The big news this week was the weaker than expected US May inflation figure with the supercore inflation measure (core services less housing) printing its first negative MoM figure since late 2022. The US services sector inflation less energy (a different core measure) saw 0.22% MoM gain, the weakest since September 2011, lowering the 6-month average MoM rate to 0.44% or 5.5% annualised. As they say in statistics, one is a change, two is a trend. The inflation report was encouraging, but with annualised measures of core inflation still remaining way too high it will take time before the Fed feels confident enough to cut the policy rate. Especially, because their inflation models have been wrong for a year now. While the US inflation report suggests that the US economy is cooling the Dallas Fed Weekly Economic Indicators rose last week to 2.73% estimated real GDP growth up from around 1.7% back in April suggesting the US economy is actually accelerating. Data is still very noisy.
This week delivered strong earnings and outlooks from Oracle, Broadcom, and Adobe. The red thread behind all the results was strong demand for AI. Oracle’s new partnerships with Google Cloud and OpenAI are driving infrastructure demand leading analysts to expect revenue growth to go from 3.3% YoY in the previous quarter to 11.6% in four quarters from now. More importantly for shareholders, Oracle also expanded its operating margin by 170 basis points. Broadcom signalled a cyclical bottom in some of its businesses and pointed out that its AI chip segment will see accelerating growth. After three disappointing earnings releases Adobe finally surprised to the upside last night reporting better-than-expected revenue figures and especially the digital media business net new annual recurring revenue figure was strong.
It is difficult to see the US economy beginning to surprise to the downside when companies in general are upbeat on the future. There is an investment boom going on in information technology, health care, and communication services with investments up 50% over the past 3,5 years. The same growth rate in those three sectors was achieved over a period of 8 years leading up to this investment boom. In other words, corporate investments are going at twice growth today compared to the period 2012-2020. The utility sector is another sector that is experiencing a growth shift growing capital expenditures 23% since November 2022 when ChatGPT was launched publicly kickstarting growth in AI data centres and higher electricity consumption. Investments in the global utility sector had been unchanged in the preceding 14 years in nominal terms.
The fragmentation game, which we have talked about over the past two years, is a geopolitical dynamics that puts an end to globalisation as we have come to know it fragmenting the world economy into big blocs. As we have also been saying for quite some time is that the harder China pushes on its subsidy-driven export strategy to offset domestic weakness the harder the pushback will be from the US and Europe. In the short term, China’s export policy is deflationary, but longer term it drives tariffs and higher inflation. The EU decided on Wednesday, to put tariffs of up to 50% on Chinese EVs. China has already said that they will retaliate. Germany is of course reluctant to be too harsh on China because Germany itself is an exporting country and benefits from globalisation and less trade friction. Our view is that this is only the beginning and more tariffs will come against China with their e-commerce businesses such as Shein and Temu as next in line.
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