Chief Investment Strategist
As we described on Monday, a perfect storm hit the financial market due several factors hitting the market at a compressed time period. Markets take on their own life when volatility increases a lot because they suddenly deviate from fundamentals as risk reduction decisions become important. The important questions for markets in the medium-term are whether we get a recession or not and whether AI spending is sustainable.
At this point our view is that the US economy is not approaching a recession and we put the probability of this scenario at 25-33%. High frequency economic indicators such as the Dallas Fed Weekly Economic Indicators are still suggesting 2% real GDP growth and is not reflecting a significant deterioration in the economy that warrants a big selloff or at this point a 50 basis point cut in the Fed’s policy rate at the September meeting. It requires a big negative shift in macro indicators for the Fed to do 50 basis points, because if they do 50 basis points and the economic indicators are not weak enough it will send a signal that they are panicking, and that in itself will make the market panic.
The sustainability of AI spending is still very much an opening question and a key debate that has been raging during the Q2 earnings season. This is because investors are beginning to worry that AI investments are too high relative to what they can generate in revenue and profits.
Around 90% of S&P 500 companies have reported Q2 earnings and the aggregate figures show a +0.8%-points and +3.9%-points surprise on revenue and earnings respectively. The big winner on a sector level has been utilities which have seen the largest positive price reaction around earnings but also driven by the largest aggregate earnings surprise. Electrification and the boom in electricity demand from AI datacentres definitely play a role in this surprise. The consumer discretionary sector has seen the worst price action around earnings releases while information technology has delivered the second-worst aggregate earnings surprise which is also explaining the decline we have seen across technology stocks. Across single stocks some of the biggest surprises on revenue have been Eli Lilly (reported yesterday), Ford Motor, Albemarle, First Solar, and Devon Energy.
Financial Times is running a story today about how Perplexity popularity is surging rapidly this year as more and more people use AI systems such as Perplexity as a substitution for Google search. Recently Perplexity has opened up for running advertisements on the platform for non-paying users putting the company at more direct competition with Google. Alphabet (Google’s parent company) shares are down 15% from the peak in July and while the company is still doing well it is worth paying attention to Perplexity and the changing landscape around search engines as Google advertising revenue tied to Google search was 57% in 2023. One of the drivers behind Perplexity is reports of Google search deteriorating in quality and the irony is that generative AI will pollute the Internet to a degree where it becomes increasingly more costly for Google to maintain high quality searches.
Macro will dominate next week’s trading action and below we highlight the key events to watch.
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Chief Investment Strategist
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