Over the space of eight days, former President Trump was shot, the Republicans held their convention and picked a populist to run to be Vice-President, and President Biden announced his intention not to run for reelection. At the same time, equity markets went on a wild ride, largely unrelated to the political landscape. Massive rotation to small cap stocks and serial underperformers away from the tech leaders of the past 18 months sent the S&P 500 down 2% and the NASDAQ Composite down 3.65%. Most leading semiconductor names fell closer to 7-8%. The VIX index that measures volatility rose to its highest level since April. The only sea of relative calm was the bond market with yields on 10-year Treasuries staying in the neighborhood of 4.2%.
There were a few obvious messages:
1. The tech leaders may have risen too far too fast. Thus, the move out of tech makes some sense. The outlier move into small caps makes a lot less sense. The Russell 2000 is a hodgepodge of yesterday’s failures sprinkled with a few exciting names. In 2023, approximately 40% of its components lost money. To me, that’s a totally unappealing alternative.
2. Markets have been forecasting Biden’s withdrawal for weeks since his poor debate performance. In today’s world one can invest in almost anything. There are betting sites that let you predict political outcomes. Last week, before the announcement, these sites gave VP Kamala Harris close to a 50% chance of being the nominee. President Biden’s odds were about 25%.
3. Fed Chair Jerome Powell continued to set the table for a rate cut in September. The FOMC meets this week. If there was a chance of a rate cut this week, the current political turmoil probably says wait until September. Whether there are two or three cuts this year is uncertain. The answer isn’t all that meaningful at the moment. As was the case with Biden’s withdrawal, Powell’s remarks were taken in stride as investors had already given a 90% probability to a September rate cut. Thus, little reaction from the bond market.
Investors must always remember that markets care about earnings and interest rates. Period. They only care about who might be President if such a decision affects earnings or interest rates. Despite all the public blather, markets assume that Trump or any of the possible Democratic nominees are destined to spend beyond their means. With that said, Trump and the Democrats get to similar deficit numbers in different ways. Trump would lower taxes and increase tariffs. The two likely wouldn’t offset, leading to expansive fiscal deficits. Leading Democrats have a laundry list of programs they might want to fund, from student debt forgiveness to expanded entitlements. They would fund these with higher taxes, something the next Congress is unlikely to do. The high ongoing deficits of either choice are likely to keep upward pressure on both inflation and long-term interest rates.
Trump loves low rates. He doesn’t fear debt, at least until possibly forced to by markets. Democrats have embraced a modern version of monetary policy that espouses that the advantage of being the reserve currency allows the United States to print the money needed to fund socially valuable programs. Of course, even then there are limits, but those embracing this theory suggest they are far away.
When Trump was President, the nation was still recovering from the Great Recession. Inflation was low because there was still plenty of slack in the economy. Manufacturing utilization was still below 80%, and there was capacity in the labor force for more workers. Deficits were below $400 billion per year when his term began. They were over $3 trillion in 2020, inflated by costs needed to support an economy largely shut down for a time during the Covid pandemic. In the past two fiscal years of the Biden administration, debt service as a percentage of GDP rose to 7%, more than double what it was when Trump took office. Both parties to date have said entitlement reform is off limits. Deficits don’t matter until they matter. Trump or his ultimate Democratic adversary are likely to test that conclusion.
As I noted last week, the simplistic assumption that a Trump win would be good for investors (lower taxes and less regulation) may have been too simplistic. Both Biden and Trump last week talked in different ways of expanded restrictions on high tech sales to China. If there is one constant beyond spending with abandon, both sides view China as a persistent and increasing long-term economic and political threat. To date, demand for advanced semiconductor chips to customers other than within China have been so great that companies like Nvidia# have continued to flourish. But the salad days of mega growth in capital spending to support increased AI demand cannot go on forever. Last week, cries that the boom might end sooner rather that later were heard sending semi stocks reeling. Reports of robust earnings and orders from Taiwan Semiconductor, the world’s largest producer of those chips, fell on deaf ears.
This week we move into the heart of earnings season. We have heard from a small fraction of S&P components so far. The results have been predictable as companies beat earnings forecasts. But most warned that headwinds might slow growth looking ahead. The banks were focused on lower net interest margins and rising loan charge-offs against a backdrop of a slowing economy, the exhaustion of excess savings built up during the pandemic, and high interest rates. Airlines had great second quarter profits but warned that supply growth in the third quarter would likely exceed demand growth. That means lower fares and profits, at least for the third quarter. Netflix had great earnings growth but its stock barely budged. When stocks stop going up on good news, that is often a warning sign. The rest of the large cap giants will report this week and next. How investors react to their earnings will tell the tale for stocks in the weeks ahead.
August through mid-October is seasonally the worst month for stocks. Mid-October to year end is often the best time. This year could play out that way. Growth is slowing. There is a lot of political uncertainty. Big cap tech may have gone up too far, too fast. A 5-10% correction for the market and a 10-20% correction for the leaders would be healthy and would leave long-term technical factors in place to support a further advance next year. A catalyst for this kind of correction may lie in the earnings outlooks companies will issue as they report earnings over the next two weeks.
AI is for real. It will impact almost everything you and I do. AI can develop cogent first drafts, do simple animation, build better budgets, and enrich the consumer experience. AI won’t supplant humans; it will improve the experience building on a richer base of facts. I will no longer be a senior male worth X dollars living wherever. I will be identified beyond that as an active investor, a lover of physical activity and travel, a parent and grandparent of many and a lover of historic fiction who loathes science fiction (today’s world is weird enough for me!).
AI didn’t just start last year. Generative AI that can write legitimate first drafts, enrich what’s already published, create realistic images from scratch or develop robust computer code builds upon that.
Let me give an example comparing Amazon# to Macys. It is quite obvious that Amazon has taken significant share. At first it did it by price. But its real success is built on customer service. I can buy almost anything on Amazon with just a few clicks and have it delivered to my doorstep within a day or two. Try doing that on a Macys website. But it gets worse. Macys and Bloomingdales, which it owns, has all kinds of loyalty reward and point offerings for its best customers. With that said, try to go to one of their stores on a big sales day and take advantage of the sales price, your loyalty rewards, discounts, and your accumulated points at checkout. That could take 10 minutes, 30 minutes or more in some cases. Simply said, the best customers struggle to complete a transaction while the person who wants to buy a $10 item with a credit card has no problem, assuming they can find a sales person to check them out. Huh? The problem at Macys and Bloomingdales is that the only weapon they still have is price because customer service has deteriorated. But discounting is something high quality vendors want to avoid. Thus, many leading brands won’t sell to these stores. Those that do require the stores to exempt their products from sales.
Macys new management is closing lower performing Macys stores and focusing more on higher end Bloomingdales expansion. It won’t work if it can’t fix its customer service function. That’s were AI comes in. If I were a big customer of theirs, whether I wanted to buy in store or online, I should immediately be identified not only by name, address, and loyalty point totals, I should be identified by all my historic needs and purchases. Amazon already does that.
AI will enhance everything we do. Keyboards will be replaced by speech as computers understand words and accents better. Passwords will give way increasingly to biometrics. Your email and text messaging systems will better filter junk. Think of that “spam risk” message on your phone disappearing because every telemarketer you don’t authorize will be blocked before your phone even rings!
There is no doubt that AI capex may get in front of capacity utilization and lead to a quick slowdown in the buildout. But this isn’t a repeat of the bursting of the Internet bubble in 2000, at least not in the public markets. That’s due to a different and more complex regulatory environment, young startups simply cannot afford to go public. The SPAC craze of 2021 tried to work around that but regulators caught up with that. The bubble burst quickly. That hasn’t stopped venture capital and private equity from investing in moon shots, but it takes a lot of money to compete with the hyperscalers of today. I doubt anyone will. Thus, the focus instead will be on chip design and vertical markets. AI for retailers and AI for software developers will be very different. Both will be large and lucrative opportunities. Thus, look for a 10-20% correction in these stocks as an entry opportunity.
Simply said, our world has gotten to where it is today based on one simple item, the semiconductor chip. As it gets ever more powerful, we can do more and we can do it faster and easier than before. That simple conclusion isn’t about to change.
I want to switch gears and comment briefly on how the Democrats will pick a candidate and my reaction to the CrowdStrike snafu last week. Starting with the latter, a self-inflicted technical glitch took down most of the free world’s airline systems and the London Stock exchange. It closed courts, disrupted hospitals, and caused unknown havoc. Imagine what a targeted hack might do if undetected. It’s testimony to CrowdStrike and other cyber security firms that we don’t see disruptive hacks very often. But they do occur, pointing to the constant need of business to stay ahead of those threatening malice. Hackers will always seek the weakest point of entry to disrupt the electric grid or air traffic control. As our world becomes more dependent on technology, the need to prevent the evildoers only gets greater. Last week’s inadvertent accident is a warning sign.
As for the Democrats, it seems to me they have two choices. If leadership quickly coalesces around VP Kamala Harris, the path to her nomination would be straightforward and the least disruptive path to follow. But if leadership allows or seeks a more open process, it will be more contentious. But more voices will be heard, the released Biden delegates will have more options to consider, and the net result may be a slate that has a better chance of victory. The odds still favor that such a slate would have Ms. Harris at the top of the ticket.
Voters nationwide loathed the thought of a Trump-Biden rerun as many disliked both choices. There are four weeks until the Democratic convention begins in Chicago. Wouldn’t it be nice if the elected Democratic delegates at least had a few weeks to consider options rather than close ranks quickly, simply to present a false façade of unity? The outcome may be the same but the path getting there would be more appealing, at least to me, if a couple of weeks could be spent exploring all options.
Today, England’s Prince George is 11. Selena Gomez is 32. John Leguizamo turns 60 while Danny Glover is a mature 78.
James M. Meyer, CFA 610-260-2220