Monday digest

Posted 3 April 2023

Overview: Markets look beyond banking sector stress
March ran the whole gamut of emotions for investors, but for the average UK investor holding globally diversified risk profiled portfolios, Q1 still ended above where it began, even if the journey was rather bumpy. Bank run fears that caused so much March angst and downward volatility quickly abated, allowing markets to mostly recover into positive territory. However, just because stock markets have proved relatively resilient this time, we should not assume the episode will pass without further consequences. The global financial system’s ‘immune system’ becomes weaker after each attack, and right now the global economy is vulnerable and busy fighting off the ravages of inflation.

That said, the recovery rally in stock markets has told us that market liquidity remains reasonably healthy. It also appears that end-of-quarter rebalancing provoked some rather reluctant buying back of equities to cover underweight positions. Both government and corporate bond markets were eerily subdued as last week drew to a close. The week ahead could be fairly quiet too, and ahead of the Easter holidays, most of us would welcome that.

Banking scare meets inflation pressures
The banking sector is still scrambling to deal with the fallout from Credit Suisse’s forced sale and Additional Tier 1 (AT1) bond write-off. Credit conditions have become very challenging since several US regional banks collapsed, with lenders trying to reduce their risk exposure by handing out fewer loans. However, US bank failures, and subsequent turmoil in the financial system, have helped ease underlying concerns about the extent of further interest rate rises.

With the financial system effectively taking over tightening from the US Federal Reserve (Fed), markets now assume that policy rates may not need to rise much from here. Indeed, investors have built in expectations that rates will fall by the end of the year. However, given that corporate credit has two components – the ‘risk free’ rate of government bonds and the credit spread – this has eased conditions for companies with higher credit ratings, but worsened them for those with lower ratings.

The cost of both long-term and short-term borrowing has increased dramatically, and all maturities of borrowing are now well above the ten-year historic cost of corporate borrowing. Many companies will have no choice to refinance some borrowing, but most will also choose to cut back spending elsewhere. In essence, the US economy (and indeed the wider global economy) is going through a deleveraging process – which usually leads to lower growth prospects. That might not be such a bad thing for long-term stability, but lower growth means weaker credit metrics for many companies, particularly those at the lower end. We welcome the recent calm, but weaker credits are surely still in for a rough ride.

Is the microchip market heating up again?
The semiconductor industry has bounced between supply-demand extremes of late – and has experienced the ‘bullwhip effect’ post-pandemic. From its peak in late December 2021 to its early October 2022 trough, the Philadelphia Semiconductor Index (SOX) fell 47%, significantly sharper than the 26% fall in the wider US stock market. But since the end of last year, chipmakers have been on a roll. Cyclical adjustments are no doubt part of the story, but the current trend kicked-off with a sharp rally in early November. This was around the time OpenAI released the prototype of its ChatGPT program for general use. The chatbot’s ability to write detailed, knowledgeable and readable content on any given topic has gathered a lot of attention in the media. It also dramatically pushed up the estimated valuation of OpenAI and similar companies, as well as driving substantial investment toward artificial intelligence (AI) in general.

The fact that big tech companies are investing heavily in AI and advanced computing techniques is nothing new, so in itself the release of a new chatbot should not drastically increase demand for chips. Optically, though, it is a huge boost for the tech industry. For the last few years, those in the know have been critical of stagnation in the industry – not in terms of revenue, but in terms of genuinely transformative innovation. The accusation has been that many of the biggest players had effectively run out of new ideas and investor attention has waned as a result. The visibility of innovations like ChatGPT is therefore extremely valuable from an investment perspective, as it reaffirms the industry’s long-term growth prospects.

While it is unsurprising ChatGPT prompted a rally in chipmaker stocks, it is equally unsurprising this occurred while government bond yields were stabilising and investors were getting excited about the prospect of looser monetary policy. Certainly, the political appetite for public policy involvement in the tech sector has grown dramatically as tech has become synonymous with society’s security. Moreover, we already have seen high profile calls for tighter AI regulation or even pausing its development, including an open letter signed by Elon Musk and Steve Wozniak, among others. This is a battle set to run and run and as a result, investing into chipmakers at these sky-high levels may prove the sole preserve of tech optimists.