The rally in tech, that began in January, now has a new justification: generative Artificial Intelligence (AI). As the ‘higher for longer’ interest rate scenario looks increasingly probable, the enthusiasm for this sub-sector of tech appears unsustainable. Valuations are rich and tech traditionally performs badly when money becomes more expensive.
Should the AI/tech rally go into reverse, there will be an impact on the broader S&P500, given the large market capitalisation of some of the companies caught up in the AI investment theme.
Last week’s resolution of the debt ceiling crisis will help the Fed in its fight against inflation. The deal reduced planned federal spending by around $136bn. over the next two years.
But, this will be small comfort to Fed policy makers. Recent macroeconomic data suggests that the Fed’s widely expected pause in interest rate hikes, at it June 13/14 meeting, will represent a ‘skip’ rather than marking the end of the current cycle.
The two-year Treasury yield, considered by some to be the most sensitive to rate expectations, has risen approximately 50bp (to 4.54%) over the last month, as the prospect of a further interest rate rise has grown. This reflect recent core inflation and non-farm payroll data being stronger than expected.
Given that a ‘higher for longer’ interest rate environment is normally bad for risk assets, particularly growth stocks, it seems odd that the S&P500 is up 12% this year and up 3.5% over the last month, despite the jump in Treasury yields.
Moreover, the S&P500’s gains this year are represented almost entirely by tech stocks. The NASDAQ -a tech heavy index- is up 27.5% this year, and 8.2% over the last month. Yet tech should be amongst the most negatively affected sectors, as interest rate expectations rise, given tech companies’ reliance on fresh capital to develop their products.
Indeed, the tech rally of the second half of 2020 through to late 2021 was in part driven by the sudden fall in interest rates and bond yields, in response to the Covid pandemic.
A bubble?
Why the enthusiasm for tech this year and now AI-related stocks? A cynic might say it is a bubble, that reflects still-loose monetary conditions. After all, despite the substantial interest rate hikes since last March, real interest rates, as measured by the difference between the Fed Funds target rate of 5%-5.25%, and April core CPI of 5%, are around zero.
A long-term investor, anxious to manage risk as much as to achieve positive real returns, might well be cautious without necessarily buying into the argument that it is a bubble.
For most of the spring it was the prospect of a pause in Fed rates that justified the rally in tech. As that now looks less likely, as ‘skip’ has entered the lexicon of Fed-speak, investors have switched to the artificial intelligence (AI) theme, after strong results a fortnight ago from Nvidia.
This could be dismissed as a rarefied field of interest, sub-sector of a sub-index of the S&P500.
Except that it involves some of America’s largest companies. Small in number, but massive in their market capitalization: Microsoft owns nearly half of OpenAI, the creators of ChatGPT, while Apple, Amazon, Alphabet all have plans for their own AI -driven products.
Nvidia, which became a trillion-dollar market cap company last week and trades on a historic price/earnings ratio of 202 times, is prospering by making the hardware for AI. If analysts are correct and it meets targets for sales growth of its market-leading $40,000-a-go AI microprocessors, the price/earnings ratio falls to around 40 on next years earnings. High octane stuff when compared to the value-heavy FTSE100 index, which trades on a historic PE ratio of 14.4 times.
One’s instinctive reaction should be to be wary of investment fashions such as this, in particular one that is so narrow in scope and not supported by macroeconomic fundamentals. While no one can doubt the transformational potential of generative AI on our lives, we can doubt the intelligence of bidding expensive growth stocks ever further upwards.
Importantly, how defendable is the lead of these companies in their AI technology? Leadership in tech is notoriously difficult to maintain and those companies that have maintained their leadership over recent decades have done so by changing their product mix rather than relying on patent law.
The ‘higher for longer’ argument gets stronger
And what of the macroeconomic, inflation-related data, that surely undermines the rally in tech? Ten days ago, the Personal Consumption Expenditure (PCE) index, for April reported core inflation to be higher than expected, on both a month/month basis (+0.4%), and a year/year basis (+4.7%). *
Friday’s non-farm payroll data confirmed the picture of a still-strong economy. It showed 339,000 new jobs were created in May, well above the 190,000 estimate.** Sure, a rise in unemployment was reported, from 3.4% to 3.7% – but this hardly reflects slack in the labour market, given that the driving force was new entries into the labour market.
The Fed will have taken some comfort from a stabilising of average hourly pay growth – though at 4.3% year/year.
The upward move in two-year Treasury yields is telling us, at the least, that interest rates will be higher for longer than the market was expecting a month ago. This is not the time to be chasing dreams of future AI-generated earnings.
Investors would do best to remain diversified across asset classes and by sector and region.
Source Material:
* https://www.bea.gov/news/2023/personal-income-and-outlays-april-2023
** https://www.bls.gov/news.release/empsit.nr0.htm
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