Weekly Investment Commentary: Cracks appear

Weekly economic update from Rupert Thompson, IBOSS Chief Economist, part of Mattioli Woods, where he analyses market reactions to recent events and identifies upcoming market trends in global markets, including in equities, fixed income, FX, etc.

In today’s piece, Rupert looks at:

• Global equities: The global tech sector was down 6.5% over the week with semiconductor stocks leading the decline with a fall of 10%. This unsurprisingly took its toll on global equities generally which ended the week down. There was, however, a big divergence in performance between regions with many of the trends previously in place while tech was outperforming going into reverse.
• AI stocks: There was no one big catalyst for the latest wobble, just a crystallisation of concerns which had been bubbling up for a while.  Still, IBOSS believe it is too soon to assume this is a precursor to a full-scale unwinding of the AI boom or possibly bubble. There are undoubtedly big question marks about how this all pans out longer term in light of recent trends. But the fact remains that AI will continue near term to power rapid gains in corporate earnings with the tech sector expected to drive two thirds of the 30% gain in US earnings forecast for this quarter.  Rather than being a reason to sell up and head for cash, the latest events just emphasise the need to have a well-diversified portfolio which will allow one to benefit if – as IBOSS believe – the market in time resumes its upward trend, while providing some protection on the downside.
• Bonds: Last week, bonds demonstrated they can provide protection from events such as the downturn in tech. US Treasuries and UK gilts both returned around 1% as yields reversed some of their recent rise. Bonds benefited both from the perception that yields have now reached attractive levels and reassuring comments from the US Fed. The net effect was that the market now believes once again that the Fed will hold off raising rates again until December and they should only be increased by 0.75% by next summer rather than 1%.
• In China:  Chinese GDP this morning was a touch stronger than forecast with growth picking up in the third quarter to 4.5% from 4.3%. However, the growth remains very lopsided with strong export gains offsetting continued weakness in consumer spending. The surge in exports is running into increasing resistance abroad and last week saw China agree to halve its exports of hybrid vehicles to the EU.
• UK Budget: It appears that capital gains tax rates will not be raised into line with income tax rates which had been a fear. The banks, however, are looking likely to see a rise in taxes. More generally, the Budget is being flagged as a ‘steady-as-she-goes’ affair with many of the tough decisions delayed – just for a change – until next year’s public spending review.
• This coming week: October business confidence numbers for the US, EU and UK out on Friday will be a focus as will the ongoing US earnings season with Meta reporting on Wednesday. Here in the UK, we have labour market numbers on Tuesday and inflation data on Wednesday.

Cracks appear

Last week was an eye-catching one with images ranging from a flying car in the US to burning cars in France. But for the markets, the most pertinent image is perhaps one of cracks appearing in the AI trade which has propelled equities higher over the last couple of years.

US inflation data and the earnings of the big US banks had been expected to be the centre of attention but in the event these were swamped by a bout of jitters over AI which led to tech stocks taking a pounding. The global tech sector was down 6.5% over the week with semiconductor stocks leading the decline with a fall of 10%.

This unsurprisingly took its toll on global equities generally which ended the week down 1.5% in local currency terms and a rather larger 2.5% in sterling terms as the pound perked up a bit against the dollar. But there was a big divergence in performance between regions with many of the trends previously in place while tech was outperforming going into reverse.

Emerging markets suffered most, falling 6% in sterling terms hit by a 15% drop in the semiconductor-dominated Korean index. But the US and Japan were also down 3% and 2% respectively. By contrast, Europe was up 1% and the UK gained as much as 3%.

The UK benefited from its lack of large cap tech stocks and relatively high exposure to the boring and much more defensive sectors, such as consumer staples and healthcare. As investors retreated to safety, these sectors which had been underperforming, showed their worth as a source of protection, gaining 5% and 3% respectively.

So, why the bout of nerves over AI and is it a dress-rehearsal for a full-scale bursting of the AI bubble?

There was no one big catalyst for the latest wobble, just a crystallisation of concerns which had been bubbling up for a while. Worries have risen over a potential over-supply of data-centres and an over-reliance on debt to finance them and have taken a notable toll on some of the smaller companies involved, notably CoreWeave. The likening last week of AI investing to a casino by the CEO of the US tech company Broadcom also didn’t help. Still, we believe it is too soon to assume this is a precursor to a full-scale unwinding of the AI boom or possibly bubble.

There are undoubtedly big question marks about how this all pans out longer term in light of recent trends including: increased margin pressures on the hyperscalers behind this massive spend on data centres due to falling AI token costs and higher chip prices; growing competition from China both in terms of chip production and AI models; recent news of slower than expected growth at OpenAI & Anthropic; and rather mixed signals on the scale of AI adoption across the wider economy.

But the fact remains that AI will continue near term to power rapid gains in corporate earnings with the tech sector expected to drive two thirds of the 30% gain in US earnings forecast for this quarter. We have also seen on several occasions over the last couple of years a sharp set-back in one area or another of the tech sector, only for confidence to return subsequently.

Rather than being a reason to sell up and head for cash, the latest events just emphasise the need to have a well-diversified portfolio which will allow one to benefit if – as we believe – the market in time resumes its upward trend, while providing some protection on the downside.

Last week highlighted the ability of the more defensive parts of global equities, such as the UK and the consumer staples sector, to offset a downturn in tech. They also showed that bonds can provide protection in such an event – US Treasuries and UK gilts both returned around 1% as yields reversed some of their recent rise.

This positive return was achieved even though the key US inflation numbers came in higher than expected. The headline inflation rate rose to 3.7% in September from 3.4% while the core rate (excluding food and energy) increased to 2.6% from 2.4%.

Bonds benefited both from the perception that yields have now reached attractive levels and reassuring comments from the US Fed. Chair Warsh said he hadn’t changed his view as a result of these latest numbers and another key Fed governor stated that he saw the need for no more than one further rate hike. The net effect was that the market now believes once again that the Fed will hold off raising rates again until December and they should only be increased by 0.75% by next summer rather than 1%.

In other news, crude oil prices edged up over the week as Iran stepped up its attacks on shipping in the Strait of Hormuz, with Brent reaching $110 per barrel at one point. Gas prices also moved higher on worries over the relatively low storage levels ahead of the winter.

Meanwhile, Chinese GDP this morning was a touch stronger than forecast with growth picking up in the third quarter to 4.5% from 4.3%. However, the growth remains very lopsided with strong export gains offsetting continued weakness in consumer spending. The surge in exports is running into increasing resistance abroad and last week saw China agree to halve its exports of hybrid vehicles to the EU.

As for the UK economy, it continues to confound the bears. Rather than falling 0.1% as had been expected, GDP rose 0.1% in August to be up 2.1% on a year earlier, helped in part by a rise in AI-related investment. The IMF has even become a bit of a fan of the UK, revising up its growth forecast for this year and praising it for its plans to cut the budget deficit.

Talking of which, the Budget is now only nine days away and the Treasury has remained quite tight-lipped about its contents although a few steers have appeared in recent days. It appears that capital gains tax rates will not be raised into line with income tax rates which had been a fear. The banks, however, are looking likely to see a rise in taxes. More generally, the Budget is being flagged as a ‘steady-as-she-goes’ affair with many of the tough decisions delayed – just for a change – until next year’s public spending review.

A final very short word on the results of the big US banks which were somewhat mixed and rather a non-event with the sector ending the week broadly unchanged. Higher interest income and buoyant equity trading were offset by weaker fixed income revenues.

This coming week, October business confidence numbers for the US, EU and UK out on Friday will be a focus as will the ongoing US earnings season with Meta (Facebook) reporting on Wednesday. Here in the UK, we have labour market numbers on Tuesday and inflation data on Wednesday.