Wealth Insights | Weekly Market Analysis | Asset Allocation | Economy | Fixed Income
Weekly Market Analysis - Top Questions We’re Getting (With Answers)
Posted on3 Things to Know
The US Economy ISN’T at a Major Turning Point
For the economy, we do not believe we are at a major turning point. We have long stated that the growth rate of employment would slow. We do not think it is too late to avoid a recession because business output has been restrained. Interest rate-sensitive sectors have been weak already and are poised to recover as interest rates fall.
Stay in the Belly of the Fixed Income Curve
We believe that for their overall fixed income portfolio, investors should seek to maintain duration of around 5-6 years (the “belly” of the yield curve). While we think short-term rates will decline, longer-end Treasury yields may not move lower as quickly as intermediate Treasury yields once rate cuts begin.
Reaping the Fruit of AI Investment
We are beginning to see the fruits of AI investment in operating margins and revenues for cloud and search services. With that said, the acceleration of capex relative to revenue may pose pressure on free cash flows for the hyperscalers over the next few quarters. With capex still outpacing monetization, we continue to favor AI infrastructure stocks over services providers within tech.
Summary
In last week’s CIO Bulletin, we noted that financial market confidence tends to weaken in the few months before presidential elections, then recover when results are in. We believe some weak summer economic data – a recurring phenomenon – added to this trend in the week past. The timing also coincided with another pause from the Federal Reserve, accompanied by comments from Chair Jerome Powell consistent with a first easing step in September.
We believe summer market swoons aren’t indicative of full year returns, but with many investor questions swirling, we seek to answer some in the report below.
Portfolio considerations
We believe that for their overall fixed income portfolio, investors should seek to maintain duration of around 5-6 years (the “belly” of the yield curve). We continue to favor AI infrastructure stocks over services providers within tech. Amid recent volatility across AI leaders, however, valuations may return to more rational levels, potentially providing an opportunity for investors to build exposure to what we continue to believe will be a transformative technology.
Source: Bloomberg as of July 23, 2024. The proxy for intermediate duration IG corporates is the Bloomberg Intermediate Duration Investment Grade Corporate Bond Index. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
The US Economy ISN’T at a Major Turning Point
With a poor manufacturing reading and a below-consensus gain of 114,000 for US hiring in July, market fears of a new downturn have also resurfaced. While a “growth panic” is unnecessary in our view, we should be clear that market conditions have been ripe for a pullback for the reasons cited above. We continue to expect high single-digit EPS gains this year and next while US equities – particularly large cap tech – have delivered double digit gains. Geopolitical news and election uncertainty also provide excuses for short-term traders to shift.
For the economy, we do not believe we are at a major turning point. We have long stated that the growth rate of employment would slow. Job gains were strong even as business output languished. This was driven by the “late start” for broad services hiring delayed by the pandemic. We do not think it is too late to avoid a recession because business output has been restrained. Interest rate-sensitive sectors have been weak already and are poised to recover as interest rates fall.
Stay in the Belly of the Fixed Income Curve
We believe that for their overall fixed income portfolio, investors should seek to maintain duration of around 5-6 years (the “belly” of the yield curve). While we think short-term rates will decline, the pace of Fed rate cuts may be slower and shallower than expected if inflation does not decelerate as quickly as anticipated and economic growth remains buoyant, so longer-end Treasury yields may not move lower as quickly as intermediate Treasury yields once rate cuts begin. Additionally, concerns about potential US government impacts on inflation and future Treasury supply may arise depending on various US election scenarios, which could “steepen” the yield curve for longer-dated Treasury maturities. Indeed, this steepening is already starting to be reflected somewhat as intermediate bond yields have dropped more than longer term bond yields over the past few months, resulting in a more positively-sloped yield curve.
Additionally, intermediate bonds offer substantial premium over expected inflation (as measured by TIPS). The “real yield” of the 5y Treasury, for example, is almost 1.70% above expected inflation. If an investor were to hold investment grade bonds with this average maturity, that yield differential jumps an additional 80-90bps, nearing a 3% difference over expected inflation.
Reaping the Fruit of AI Investment
After the initial optimism on AI since early 2023 and a 28% rally in mega-cap tech and semiconductors YTD, investors are asking how much AI good news is already priced in. Investors have been increasingly focusing on whether these companies can convert eye-watering spending into actual revenues. Admittedly, the rapid development of AI hasn’t yet led to an explosion of productivity across industries. However, we’ve seen early monetization success among the largest three cloud providers who have embedded GenAI into their current enterprise cloud solutions. Essentially, companies that are using these cloud services are able to utilize AI to drive better business outcomes and productivities across sectors. This has in turn translated into incremental growth of their cloud and even core services. For example, advertisers using Google’s profit optimization and smart bidding have seen a 15% lift in profit on average by engaging AI tools.
According to management comments during the latest earnings season, AI demand has been the main driver for cloud growth YTD. We are beginning to see the fruits of AI investment in operating margins and revenues for cloud and search services. Both have been accelerating consistently since the AI revolution took center stage in early 2023. The average operating margins on AI-powered cloud reached 34% in the latest quarter, higher than the peak levels seen during the pre-AI era. It’s likely that AI monetization will continue to gain traction as companies complete AI infrastructure buildout and transition from model training to integration with core services.
