Tuesday Digest

Posted 28 May 2024

Nvidia versus the Fed

Having had recovered to previous highs, markets were mostly flat to slightly down overall this week. Despite the surprise election call dominating our headlines, global markets were preoccupied with Nvidia’s corporate earnings and the US Federal Reserve meeting minutes.

In fact, the FTSE 100 barely reacted to the election news at all, with global trends seen as more important for UK stocks than domestic politics. In part this is because little is expected to change. A Labour victory is a practical certainty, but the party’s self-imposed spending rules will limit the economic effects. There may be a small boost to growth from public investment, but the policy change that would actually help – significantly improving trade and customs relations with the EU – is still unlikely. The Bank of England’s interest rate cuts, which will be unaffected by the election, are more important for the medium-term outlook.

In the US, Nvidia’s incredible six-fold jump in profits showed the AI boom is still going. The chipmaker’s earnings were eagerly anticipated, but in the end drowned out by dreary reminders from the Fed that growth brings inflation. The minutes from the Fed’s May 1 meeting noted that “Various participants mentioned a willingness to tighten policy further should risks to inflation materialise in a way that such an action became appropriate,”

This spooked investors, but shouldn’t really be a surprise. We know that inflation is a natural consequence of US strength. Price data since the meeting has been more encouraging too, and no one really thinks the Fed will tighten again soon.

Growth and inflation are acting like checks and balances on markets at the moment. Investors naturally get excited about strong business sentiment and profits, but these come with inflation pressures and ‘higher for longer’ prospects for interest rates. The Fed doesn’t actually have to do anything to keep markets from overreaching; the push and pull of growth and inflation expectations does it for them. Decent stock returns, underpinned by earnings growth, are likely in this environment – but melt ups are not. To us, that seems like a reasonable trade-off.

AI Trade Broadening?

“Nvidia day” has become a globally watched event, and the AI chipmaker didn’t disappoint. First quarter revenues were up 262% year-on-year, boosting its stock yet again, taking the world’s third biggest company to an incredible $2.5 trillion market cap. Nvidia is the undisputed champion of the AI craze, jumping from a $1tn to $2tn market cap in just nine months.

This stellar price action has some investors worried about Nvidia – and AI stocks in general – being overvalued. Despite being a landmark year for the company’s earnings growth, for example, Nvidia’s 2023 profits were still below Home Depot and only slightly above Russia’s sanction-hit Sberbank.

A couple of things need bearing in mind. One, stocks can be overvalued even if they possess great underlying potential and their products are genuinely transformative – as exactly happened during the dotcom bubble. And two, overvalued doesn’t always mean a bubble. Stock market bubbles are characterised by exuberance, which in general requires loose financial conditions – and those we don’t have currently.

AI stocks have high valuations, but so do many fast growing US companies – where the popular AI investment plays are. These valuations don’t seem unreasonable compared to the lofty predictions made of generative AI (Goldman Sachs think it will add 7% to global GDP over a 10-year period) and the profit growth already shown by the likes of Nvidia.

Investors are clearly focused on how these technologies will turn a profit, and not just sensationalism. Already we are seeing a broadening of the AI investment theme to second-round beneficiaries, like the materials or energy providers needed for large data centres. Goldman Sachs estimate that power demand from data centres will more than double by 2030, benefitting utilities and those financing power purchase agreements. Investors are focused on long-term opportunities and not just buzzwords. Working out what those profit opportunities are is crucial.

US election: it’s politics, stupid

Despite strong US growth, Americans are unhappy with President Biden’s handling of the economy. 58% disapprove of his policies, according to a Financial Times poll, and only 28% think he has benefitted the economy. Inflation is the biggest concern, as the less well-off are struggling with prices and interest rates more than anyone else. This inequality is one of the reasons many are unhappy despite strong aggregate data.

Another reason could be politics itself. There is a strong correlation between US consumer sentiment and party political allegiance. This is not just about votes, which might flock to whoever is considered to bring the better economic prospects, per the old adage “it’s the economy, stupid”. Party allegiance is much less likely to change – particularly in the polarised US – and it seems to have a big effect on what people think about the economy.

The divide between Democrats’ and Republicans’ economic outlooks more than doubled between the Obama and Trump presidencies, shrinking a little under Biden but staying much wider than before. Year-ahead inflation expectations is the biggest dividing line. Democrats were scared about inflation under Trump but now seem sanguine, while Republicans were completely relaxed until Biden came in and are now very worried about inflation.

Rather than votes being decided by how people feel about the economy, Americans’ views on the economy seem to be about who is in office. Maybe “it’s politics, stupid”. To make things more complicated, the US economy itself is hard to interpret at the moment. Growth and inflation is strong, but rates are uncertain and the signs are hard to put into a consistent narrative.

The political divide in economic sentiment is yet another complicating factor. Republicans are likely to see good news as bad news – fearing growth is inflationary – as we head into November, while Democrats will likely see good news as good news.