Monday digest

Posted 12 February 2024

Overview: are US stocks bubbling up?
Last week, the US large-cap equity market shook off the rest of the world, and the S&P 500 marched to another new milestone, trading above 5,000 for the first time. But the stand-out performer of the week was a homegrown success story. ARM Holdings PLC, the world-leading designer of computer chips, listed with 10% of the company value since last autumn on the US NASDAQ exchange in the form of American Depository Receipts (ADRs). Last Thursday, ARM’s share price rose 50%, following its fourth-quarter results. Its projected revenue for the current quarter is over $850 million, way above analyst projections of $778 million. Meanwhile, fellow AI microchip company Nvidia threatens to overtake Amazon as the fourth-most valuable US company. Its market cap is now $1.72 trillion, with Amazon at $1.76 trillion at Thursday’s close. Nvidia has added $600 billion in the past two months alone, about the same as Tesla is worth in total.

So is this a repeat of the bubble of 2000? The first thing to note is that contrary to back then, ARM’s rally was based on hard revenue and profit, and both are growing extremely quickly. Nvidia is doing the same. Its expected next 12 months’ earnings are almost four times the level of one year ago, and that was already after the release of ChatGPT demonstrated to the world the potential of artificial intelligence (AI) and saw Nvidia become the main provider of the required computer chips. The other thing to note is that, unlike the bubble, there are few stocks involved. The rally in the ‘Magnificent 7’ has been responsible for almost all of the performance of the US stock market this year. Indeed, the group seems to have become the ‘Magnificent 6’, with Tesla doing rather poorly.

Positivity about the mega-caps and AI stocks in the US (and that small number listed outside the US, like ASML and ARM) seems unshakeable, but of course, one might think that this makes these companies dangerous to invest in, given the high valuations. Can earnings growth that is currently expected to be sustained for quite a while justify those valuations? And, even if they cannot – as Tesla is finding out – can people believe so for long enough as they did in the late 1990s? What should one do if this is another asset bubble? We will delve into this conundrum further over the coming weeks.

Bad news for banks as US commercial real estate loan losses continue
Following the collapse of several regional US banks last year, many investors started to think that after the clear-out, life would get easier for lenders. However, as we noted last week, recent events have delivered a reminder that, for some, trouble still lies ahead. New York Community Bancorp (NYCB) made international headlines after it announced a surprise Q4 2023 loss, cut its dividend, and set aside $500 million to cover potential loan losses. Markets sent NYCB shares down 44% in two days and tried to guess who else might be in a similar position. Japan’s Aozora Bank said it expects a $191 million loss for the current financial year, while Deutsche Bank lifted provisions for loan losses tied to US commercial real estate to €123 million, up from €26 million a year ago. Share prices fell for both banks. The fallout continued when analysts at Morgan Stanley recommended clients sell senior bonds issued by Deutsche Pfandbriefbank AG, triggering losses in most real estate bonds from German lenders.

Global trends and accounting timelines mean it is no surprise banks far and wide are facing issues simultaneously. And naturally, when multiple banks start failing all at once, people get very concerned. Just like last year, when the demise of Silicon Valley Bank and Signature Bank spread shockwaves across the Atlantic, talk of financial contagion and flashbacks to the 2008 global financial crisis has been prominent in the last two weeks. But problems with a common cause are not the same as systemic weakness, much less contagion. Commercial property across the Western developed world is ailing because the trends underlying it – digitalisation of the workplace and a sharp increase in interest rates – are global. This is without mentioning China’s longstanding property woes, albeit with different origins.

Overall though, the specific US commercial real estate issue may exist because the US economy is extremely dynamic. The ‘old’ is failing faster there because of rapid investment in the ‘new’; new homes, new ways of working, new plant and machinery. It is important to note that the available balance sheet reserves outweigh the current losses (and the US is helped by the fact that losses are also borne by capital from overseas). Meanwhile, the investment is creating significant growth. The dangerous period comes not now but when investors in the new want to see that new investment come good.

Will South Africa decide on a change for the better?
South Africa has long been a key Emerging Market (EM) destination for international investors. But it is also a classic EM for all the wrong reasons: widespread corruption, institutional instability, and extreme economic and financial volatility have blighted it for a decade. South Africa’s issues have become progressively worse over recent years. Jacob Zuma’s presidency was one of outright corruption and cronyism, which clearly eroded the state’s capacity to provide public goods and services. Indeed, corruption at all state levels has continued or even worsened under Zuma’s successor, Cyril Ramaphosa, leading to the state’s incapability to fulfil some of its most basic functions. It is not uncommon to hear – anecdotally and in the media – that South Africa is close to being a failed state.

There are opportunities for change, however. South Africa faces another general election this year and, for the first time since the democratic version of South Africa was born in 1994, the African National Congress (ANC) Party is unlikely to win a majority. Current polling puts Ramaphosa’s party at 42% of the national vote, which will likely mean some form of power-sharing deal. However, it is unlikely that the ANC would share any power with its closest competitor, the Democratic Alliance, which is still seen as a predominantly white party. The most worrying outcome, at least for EM investors, would be if the ANC chose instead to share power with one of the more militant populist parties, such as the Economic Freedom Fighters (EFF). The EFF’s involvement in a coalition government looks unlikely, but the risk is there and will be pored over by markets in the run-up to the elections.

But we should remember that the time when things look bleakest is sometimes the time of maximum opportunity. If newer parties can come in – albeit only as junior coalition members – and improve the state’s capacity, that would go far in unlocking South Africa’s growth potential. If they could tackle the underlying exclusion and inequality, it would go even further. In that case, South Africa would start to look extremely attractive to foreign investors.

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