Key highlights
- October was a tough month for technology stocks. Investors looked beyond the largest technology companies and rotated into other sectors.
- AI appears to have much further to run, but investors are becoming more selective about which companies could benefit.
- The global macro background remans supportive for equities, with earnings key.
- Sovereign bonds are also starting to look more attractive, but care is needed regarding duration.
- The Democrats have won majority of both houses but at the margin. This is unlikely to result in significant changes although it could be slightly supportive for markets.
- We may be in a corrective phase for equities, and especially technology stocks, but we likely remain in a bull market with changing leadership.
October was a tough month for technology stocks, including the mega-cap stocks that have driven US market outperformance over the past decade. This has fuelled concerns that the rapid growth in AI may have created a bubble that is now at risk of bursting. Investors are questioning whether big tech companies will generate sufficient returns to justify the huge sums being invested. Sharp falls in Nvidia (-14%), Meta (-17%) and Alphabet (-20%) have added to this nervousness.
In our view, both the AI capex cycle and AI adoption remain at very early stages and concerns about overinvestment are premature. The uptake of AI is comparable to the growth of broadband in the late 1990s and there are a number of positive signs suggesting that this long-term trend has further to run. For example, semiconductor prices have risen strongly over the past two years, but the increase has been far smaller than the seven-fold rise seen in the second half of the 1990s.
At the same time, rental prices for GPUs continue to rise, indicating demand for AI compute still exceeds supply. Despite borrowing becoming more expensive, there are few signs that supply is becoming constrained; US money market funds, commercial banks, US government and foreign investors and US businesses are among the many sources of potential funding.
In this environment, highly indebted AI companies may find it harder to maintain their current levels of investment, while those with lower debt and strong cash flows should be better placed to continue investing. There are signs that the AI-related profit surge is broadening out and, as a result, investors are becoming more selective in picking the winners over the losers, which is a healthy development for markets.
Whilst concerns around AI, rising bond yields and a widening of credit spreads need to be closely monitored, the broader macro backdrop remains favourable for equites. The global economy continues to grow, and growth outside of the US is poised to improve in the absence of fresh shocks. At the same time, government spending and central bank policy remain broadly supportive of economic growth.
Governments are likely to need to continue borrowing and spending to address a range of economic and structural challenges. Central banks, including the Federal Reserve (“Fed”), will need to balance keeping inflation under control with preventing borrowing costs from becoming too restrictive, particularly given high levels of government debt.
Longer-term, inflation may become much more problematic for major developed economies. However, there are reasons to believe inflationary pressures could ease over the next six to 12 months as energy prices fall and as the AI buildout slows. This will help the Fed and other central banks to be much more dovish than markets currently expect.
Earnings have been the key driver for the strong equity performance over the last two years and have been spectacular. After such an extraordinary rise, it is sensible that investors begin to reassess their earnings assumptions as the rate of expansion will inevitably slow. However, this doesn’t mean that earnings growth can’t continue to be a very supportive factor for stocks next year.
Encouragingly, there are signs that profit growth is spreading beyond the US and the technology sector, which could help broaden the market rally and make it more sustainable. At the same time, rising earnings have made valuations more attractive in some areas. If expected interest rate rises do not materialise and central banks begin cutting rates sooner than anticipated, investors may be willing to pay more for company earnings, providing further support for share prices. Lower interest rates could also benefit government bonds, which are beginning to look more attractive at current yields over the shorter term.
Regarding the mid-term elections, the Democratic party has won majority control of both chambers of the US Congress, the narrow majority is likely to make it difficult to pass significant new legislation over the next two years. From a market perspective, we expect little impact on the AI boom, a softer approach to Iran, lower oil prices, a more dovish Fed and minimal change to fiscal policy.
There are certainly plenty of reasons for caution at the current time and the risks need to be monitored very carefully, with changes to investment strategy required if events become less favourable. However, it is also important to stand back from the noise and look at the broader macro picture, which remains positive for markets beyond the near term. Equity market leadership is changing towards non-tech sectors and non-US markets – a positive development – and bond markets are more appropriately priced for the macro world we are now in. Sensible portfolio hedges exist in the form of commodities, and gold in particular, real assets and inflation-protected assets. With this in mind, we have made appropriate changes over the past few months and will continue to do so as events unfold.
