Source : THE AGE NEWS
The US sharemarket hit another record overnight, even as US bond yields reached levels last seen in 2002. There’s something unusual happening in financial markets.
Share prices and bond yields generally have an inverse correlation. As yields go up, increasing the cost of credit and tightening financial conditions while producing near risk-free income streams, the appeal of riskier stocks and their dividends reduces.
That isn’t happening in the US, or at least it is not being reflected in the overall sharemarket indices.
The explanation is obvious. Investors are still piling into the stocks powering the boom in artificial intelligence investment.
The S&P 500 is up just over 14 per cent so far this year, but the more tech-laden Nasdaq index is up more than 18 per cent, and the NYFANG+ index, which reflects the performance of the biggest of the tech stocks, is up by about 25 per cent.
The significance of the AI-related stocks to the wider sharemarket’s performance is underscored by the underperformance of the S&P 500 equal weight index, which assigns every stock the same weighting, against that of the primary S&P 500 index, which uses their market capitalisation.
The equal weight index has risen 10.8 per cent this year and has actually fallen almost 3 per cent in the past month – the market might be at record levels, but its performance is very narrowly based.
Indeed, only four stocks – Nvidia, Apple, Micron and AMD – account for roughly half the S&P 500’s rise this year. If you look at the market’s performance since mid-August, had it not been for the performance of two of those stocks – chipmakers Nvidia and Micron – the market would have fallen from that point.
Last month, roughly three-quarters of the stocks in the S&P 500 fell.
Mid-August is an important reference point because it was from about that point that US bond yields started their recent climb, a shift that accelerated after the Federal Reserve Board chairman Kevin Warsh dispelled doubts about his inflation-fighting credentials by giving a clearly “hawkish” speech at the annual Jackson Hole conference of economists and academics.
The narrow base for growth in the economy and the sharemarket makes both extremely vulnerable to any adverse development or shift in confidence in AI.
The Fed followed that up last month with its first interest rate increase in more than three years.
Thus, while the index might suggest otherwise, most stocks in the S&P 500 are now going backwards, which is more in keeping with the normal relationship between bonds and shares.
Bond yields are being driven by a number of influences.
A US inflation rate of 3.4 per cent is the most obvious, but a budget deficit of $US2 trillion ($2.9 trillion), or 6 per cent of GDP, and gross government debt of more than $US40 trillion not only raise concerns about the sustainability of America’s finances and how the Trump administration might seek to stabilise them, but are swelling the supply of bonds the market is being asked to absorb.
The supply issue is being exacerbated by the increasing amounts of AI-related debt hitting debt markets and providing alternative investments to Treasury securities.
The AI boom has significance beyond the sharemarket. The vast amounts of investment being made are supporting the wider US economy, its solid 2.2 per cent growth rate and the stable jobs market.
The headline GDP numbers, however, contrast with what most Americans feel about the state of their economy, with consumer sentiment at record lows. The US savings rate is also at historic lows and consumer debt at record highs.
Consumer spending has, however, held up – strongly. That suggests that those wealthier households that are exposed to the AI boom, either directly or via the sharemarket, are feeling positive and are spending. There are wealth effects on the broader economy that flow from sharemarket gains.
Like the sharemarket, it would appear that America’s economic growth is also narrowly based.
Below the broad indices, only two of the 11 sectors in the sharemarket – IT and communications services – rose last month.
Higher interest rates, inflation, the surge in gasoline and diesel prices flowing from the conflict in the Middle East and the rise in input costs as a result of Donald Trump’s trade wars are having an effect on those companies not benefiting from AI.
An increasing volume of securitised corporate debt is now trading at material discounts to its face value – JPMorgan says there are about $US140 billion of loans trading at less than 80 per cent of their face value. Spreads and defaults in the leveraged loan and distressed debt markets have been surging.
While there might be a tale of two economies and two markets underlying the aggregated numbers, analysts remain bullish. Expectations for the third-quarter profit reporting season starting next week is that it will produce an average 25 per cent increase in earnings over the same quarter last year.
That, too, is deceptive. This year, a handful of the big tech stocks, notably Alphabet, Amazon and Meta, have accounted for most of the increase in the earnings expectations for the entire S&P 500, and their reported earnings – like those of most of the key players in AI – lean heavily on their investments in, and contracts with, other AI companies.
The narrow base for growth in the economy and the sharemarket makes both extremely vulnerable to any adverse development or shift in confidence in AI.
For the moment, investors are clearly capitalising an extraordinarily lucrative future for the hyperscalers and frontier labs and AI infrastructure providers into their valuations.
They don’t seem concerned about the impact of higher interest rates on companies increasingly reliant on debt to fund unprecedented levels of investment whose pay-off – if there is a pay-off – is uncertain and may not be known for some years.
There also appears to be some level of expectation (despite the evidence to date) that the war in the Middle East will end and that oil, gasoline and diesel prices will subside.
The bond market is volatile and signalling risk and concern.
The sharemarket, thanks to AI, isn’t.
While it is conceivable that the sharemarket could keep rising off its narrow base in the face of a continuing surge in interest rates, there would be a point where the resilience of the AI sector and its investor base was tested.
It probably won’t come this month – the odds on another Fed rate hike in October have been receding – but the market is pricing in another one for December and more next year.
Without a conclusive end to the war in the Middle East and a fall in oil, gasoline and diesel prices and with Trump continuing to slap new tariffs on America’s trading partners, the environment for AI, its backers and the broader sharemarket can only become more challenging and risky.
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