Their new forecast suggests one rate cut in 2024, down from previous estimates of three, but with four cuts projected for 2025, up from three. The decision came after the Consumer Price Index showed a 3.3% increase in May compared to the same period last year, an improvement from April.
The Fed’s cautious approach to interest rate cuts comes amid signs of easing inflation while the labor market is healthy, with an unemployment rate of 4%. The Fed predicts that GDP growth will average 2.1% this year in a sign that economic growth is resilient despite the Fed’s restrictive policy stance. However, concerns remain about the impact of higher interest rates on both the commercial and residential segments of the real estate market. Banks face challenges related to maturing commercial loans attached to properties that have declined in value, while new homeowners are dealing with inventory shortages and high mortgage rates.
The real news came yesterday before the Fed meeting. Softer than expected inflation readings in yesterday’s CPI and today’s PPI have caused bonds to rally (i.e. lower yields) and stocks to trade higher. Investors now feel more confident in a September or November rate cut, so the market is making new highs again. The gains are being propelled mainly by some of the usual suspects: Apple, Microsoft, and Nvidia, which now have a combined market capitalization of roughly $9 trillion, or 20% of the entire S&P 500. Apple stock has climbed more than 10% since Monday’s close, and almost 30% since its April low, making it once again the world’s most valuable company. The recent leap higher was driven by what else, AI. Apple Intelligence will only be available to its iPhone 15 Pro/Max or newer phones, so investors now expect a much more robust upgrade cycle which will accelerate profit growth.
The 10-year US Treasury is now yielding 4.3%, down from 4.6% at the beginning of June. The positive inflation readings and strong demand from recent government bond auctions have supported the move lower in yields. This, in turn, combined with some strong corporate earnings reports from companies such as Oracle, has enable the tech-driven stock market rally to resume.
The S&P 500 equal-weighted index is up 5% YTD, as compared to the market cap weighted S&P 500 which has gained a robust 14% YTD. The Dow Jones Industrials Index is only up 3% YTD. We all know that diversification helps reduce risk. What diversification doesn’t do is help portfolio performance when the market becomes as concentrated as it is today.
We have seen this before. Microsoft, Cisco, and GE were the big darlings of the late 1990s. However, in 1999 it took the top 10 stocks to reach 20% of the total S&P 500 market capitalization as compared to the 3 stocks today. Back then, Microsoft, Cisco, and GE traded at forward looking PEs of 65x, 97x, and 42x, respectively, before they dramatically underperformed in the following decade. Today, Apple, Microsoft, and Nvidia trade for relatively high, but not as extreme, PEs of approximately 31x, 33x, and 43x, respectively. So, despite the concentration in the current market, it’s hard to say whether the enthusiastic expectations that investors have placed in these companies is misguided.
We are in the midst of the AI build out phase. We know lots of money is being invested in the hardware and infrastructure enabling AI to be deployed through various software applications and services. The big cloud providers such as Microsoft, Amazon, and Google are spending billions of dollars as they race to capture dominant positions. It is now estimated that these three hyperscale cloud providers have a combined 60% share of all cloud capacity. Moreover, industry experts project that cloud capacity will double every three to four years. All this investment will need to generate a profit in the future.
So, as we move forward, it will be important to closely monitor both revenue and profit margins of these AI-driven businesses if we want to avoid the reversals of fortune that followed previous technology booms. Monetization will require companies to deliver products and services that businesses and consumers are willing to pay for, not just use. AI has the potential to create new businesses while obliterating the business models of others. And, importantly, while portfolio diversification may be a drag on performance today, it protects portfolios when the enthusiasm fades and reality sets in.
Christopher Gildea 610-260-2235