Economy & Markets
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A severe case of COVIDIA: prognosis for an AI-driven US equity market
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After a +1% gain in August, the S&P 500 closed out its first week of September down -3%.
While September has historically had the lowest average monthly return over the last 30 years, we think there is a bit more to the story than seasonality. For starters, the September Federal Reserve meeting is less than two weeks away, and all eyes are on the labor market:
Elsewhere, a smattering of geopolitics, trade and commodity moves gave investors angst:
But it’s not all doom and gloom. In fact, we saw other pockets of the market excel despite the sell-off. That divergence is reminiscent of what we would like to call a “tale of two markets.” In this week’s note, we dive into the “haves” and “have-nots” in markets, and what it all may mean for your portfolio.
“It was the best of times, it was the worst of times.” While the opening of Charles Dickens’ A Tale of Two Cities may be a bit dramatic to use here, we think it is an apt description of what we saw unfold over the last few days.
1. The AI trade felt the pain. Nvidia fell more than 10% on the week and set the record for the largest single loss in market cap in history. Investors are starting to ask the same questions that our Chairman of Market and Investment Strategy Michael Cembalest started to ask in his latest note, COVIDIA. Here are a couple of factors:
We are believers in the long-term investment potential of AI. Bad days are to be expected, but over the next decade, we see AI-linked names outperforming the broader market. We think the questions surrounding stretched valuations and fears of AI overhype are healthy. Skepticism is a good thing, as it keeps markets in check, and last week’s price action seems to be a momentum story, not one of economic fundamentals. Investors today require companies to “show” and not just “tell.”
2. On the flip side, defensive and certain interest-rate-sensitive stocks shined. Enter the “boring is not bad” story. While the risks of an economic slowdown may make some investors feel that adding to risk is a not-so-good idea, opportunities across sectors still exist.
The Fed is prepared to cut rates this month, and this means the “Fed put” is in play. In other words, declining interest rates may support outperformance of more interest-rate-sensitive sectors.
Last week, only three of the 11 S&P 500 sectors landed in the green: consumer staples, utilities and real estate. While other traditionally defensive sectors such as financials and healthcare were down on the week, they outperformed tech by almost double. Defensive stocks, for example, tend to be less sensitive to the ebbs and flows of the economic cycle. This means they may have the ability to produce more durable cash flows and consistent revenues. Earnings estimates show the healthcare, industrials and consumer staples (to name just a handful) sectors growing into 2025.
Our base case still calls for a soft landing, but as economic activity inevitably slows to more normalized levels, we think it’s apt to examine sector balances and risk exposures in portfolios. For investors that are feeling “big-tech fatigue,” looking across more defensive sectors could be compelling. Take today as an opportunity to assess strong performance from year-to-date portfolio standouts, as they may have put portfolios offsides in terms of desired allocations.
3. Oil prices are off more than 16% from July highs, and are at year-to-date lows. Fears surrounding a reduction in Libyan oil production, Chinese demand concerns and a mixed narrative on OPEC+ supply levels sent oil prices lower last week.
OPEC+ said in June it would restore production to 2.2 million barrels per day starting in October after a period of cuts—but has waffled since then. Rumors mounted on Wednesday, followed by an official announcement on Thursday that the proposed supply increase would be put on pause until January.
We don’t think a two-month production delay takes away the fact that production will increase sometime this year. To boot, weak Chinese demand and oversupply elsewhere are likely to outweigh the measures. Thus, we see prices moving to $81–$86 per barrel by year-end. That said, factors such as unrelenting geopolitical tensions and the upcoming U.S. presidential election could spur price action.
4. Corporate credit had a banner week. Last week was one of the biggest on record for investment grade bond sales led by over 50 firms. September is typically a busy month for issuers as investors return from summer vacations, and the day after Labor Day is historically one of the busiest days.
On Tuesday alone, a record 29 borrowers, including Target, Ford and Barclays, issued investment grade bonds. Beyond seasonal factors, corporations are moving to lock in borrowing costs while yields are relatively low. First-time IG borrower Uber tapped the market on Thursday. Corporates are taking advantage of all-in investment grade yields that have come down from a year-to-date high of 5.85% in April to 5.04% as of last Friday.
We think credit is the foundation of markets. Borrower fundamentals look to be rock solid, and investor demand is strong. Five-year credit spreads across investment grade maturities remain tight relative to historical medians. At the same time, all-in yields are elevated, and that could create a compelling opportunity for investors to lock in yields.
Boring is not bad. Investors should take comfort in the fact that bonds are there to provide a buffer against the shorter-term volatility we might see in higher-growth investments (such as AI).
While each asset class has a distinct (and important) role in portfolios, both good and bad days are inevitable. The ultimate key to notching consistent returns over the long haul is diversification across asset classes and rightsizing positions.
As the Fed prepares to cut interest rates in the coming days, we encourage investors to review their asset allocations, particularly when it comes to excess cash.
For those looking to add to an already diversified portfolio or diversify further, we see opportunity in adding high-quality, income-yielding stocks and investment grade fixed income (including municipal bonds for U.S. taxpayers).
At the end of the day, sell-offs are a feature, not a bug of investing, and it’s important to keep it all in perspective.
While past performance is no guarantee of future results, the past 13 times the first day of the month was down 2% or more (as it was in September), the market was higher for the remainder of the month every time. Here’s to September being #14.
All market and economic data as of September 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.
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