When 7 becomes 2 and 6 becomes 3 - then what?

If you were at one thousand feet looking down on global equity markets at the dawning of 2024, the two biggest themes - dwarfing everything by some ways - you would have observed; the phenomenon of the Magnificent 7 (Mag 7) and the future for official interest rates on both sides of the Atlantic. In the case of the former, it was a question of how long their dominance would (not could!) last, and for the latter it was not if interest rates would be cut but how soon would the forecasted six cuts start happening.

It’s been four-and-a-half months since the November US Federal Reserve (Fed) announcement that sort of kick-started the ‘everything rally’, and nearly a year since the Nvidia earnings release that unleashed the Artificial Intelligence (AI) frenzy that has powered explosive returns for a large but narrow cohort of the US equity market.

If a week is a long time in politics, then a quarter is an eternity in financial markets – and as we leave the first quarter of the year behind, the themes may not have changed on the surface, but underneath, things do look very different.

Listen to what I say...

The release of the Federal Reserve (Fed) minutes in January offered few hints that the central bank was inclined to cut rates in the relatively near future. This was followed by the latest labour market data, which remained consistent with full employment and showed that there are still more open jobs than available labourers, meaning that wage growth was also solid. However, it took several members of the Fed engaging in ‘Fedspeak’ to try to cajole the market out of the dogged determination.

Not to be left on the sidelines, members of the European Central Bank (ECB) were equally vocal when it came to ‘correcting the markets’ misconceptions’. ECB Chief Economist Philip Lane may have got the ball rolling with his thoughts, but he was joined in the concerted effort – when asked if cuts were likely by the summer, ECB President Lagarde replied ’I would say it’s likely too,’ acknowledging that she has to be reserved due to data dependence and uncertainty. She also alluded to market current pricing as “not helping our fight against inflation".

Going, going... but not gone!

But it took hard data to really convince investors. The US Consumer Price Inflation (CPI) report for February provided a sobering reality check for financial markets, perhaps justifying the Fed’s reticence to rush into rate cuts. The long-awaited drop below 3% headline inflation failed to materialise, and the core reading surprised to the upside too. When the March reading for CPI proved that February’s wasn’t an aberration, then markets were forced to sit up and think.

The main area of concern remains the Fed’s so-called ‘supercore’ measure of services excluding shelter. ‘Supercore’ matters to the Fed because it is particularly sensitive to wages. The salary bill is a large part of a service company’s budget, much of it paid to relatively lowly paid workers. The concern as inflation took hold in 2021 was that the fast inflation of the goods that people needed to buy would prompt stronger wage demands. That would push services inflation upward and risk embedding higher expectations.

The upshot of all of this has been a repricing of forecasts for interest rates going forward. Gone is the talk of six rate cuts – we are now closer to three by year end – with the expectation of the first cut gradually moving out to mid-year, or perhaps deeper into the second half of the year. Not surprisingly, the evidence clearly points to the fact that central bank decisions are very data-dependent, and therefore a continuation of recent data might see investors ponder the possibility of no rate cuts at all – heaven preserve us!

What happens when darlings disappoint?

Meanwhile, in ‘Mag 7’ land, things have been changing too, as the dominance has been even more concentrated down to a ‘Desirable-Duo’. Now to be fair, this duo has been joined by some ‘new entrants’ on the market’s Love Island, but what can’t be escaped is the fact that market direction is being dictated by fewer rather than more companies.

Recent weeks have seen the first potential cracks in the near messianic following of these stocks, and whether that heralds a broader correction is of course a key question. While it is always dangerous to read too much into one or two days of price action in a stock or a market, the fact that some of the eye-watering factoids on the future of AI revealed by the Nvidia CEO at a keenly followed conference didn’t spark rampant gains as in the past, may prove more pivotal.

That said, of greater significance may be the fact that we are rapidly approaching what could be the biggest market event of the year - the company’s first guidance that sees a deceleration in growth fundamentals. When the most important growth stock in the market starts to decelerate, investors tend to pay attention, as periods of deceleration are tough. They were for Apple during the 2010s, when it was the most important stock in the market, and for Cisco in the 1990’s, when it held a similar mantel.

Hey Siri … what does it all mean?

As an investment story, AI has just about everything you want - except validation in actual economic data. Now, it is obviously nonsensical to claim that AI hasn’t had a profound impact upon financial markets, because it clearly has; the evolution of Nvidia’s market cap alone would qualify as ‘profound’ by just about any definition. Moreover, there is plenty of narrative about how AI has already transformed business X or activity Y - no less an authority than Jamie Dimon, CEO of JP Morgan, has claimed that the technology could have an ‘unbelievable’ influence on banking.

Much of the focus so far has been on the so-called ‘picks and shovels’ in this potential gold rush, but the firms making AI products have had more indifferent success, with numerous examples of AI output going awry. But as all the talk of benefits from AI has ramped up, have we seen a similar growth in company investment in the technology? The simple answer is no – or at least, not yet. The combined contribution of intellectual property and information processing investment in national accounts looks more consistent with a recession than a boom – a contrast to the macroeconomic backdrop seen during the buildout of the Internet and the dotcom era.

That’s not necessarily a reason to go short any of the high-flying AI names, but it calls for some scepticism about the sustainability of current valuations barring a more notable presence of AI investment in the macro data. There is the longer-term question of what AI will mean for productivity and therefore trend growth, interest rates and the like. It is certainly possible, indeed easy, to envisage a world where AI is a significant positive lever for all companies to improve their operational efficiency. Indeed, many are already using (and have been for many years) some form of AI to achieve these productivity gains. Time may prove that it is the companies that deploy AI rather than develop it that are the real winners.

Of course, there is still a long road between us and that vision of the future. Real life isn’t a science fiction novel, and you can’t wave away technological challenges with a clever plot device. None of this will stop Nvidia stock on a dime, nor will it stop the social media-driven ‘fear of missing out’ (FOMO) frenzy behind so much of the AI and crypto hype. But as the next few months play out, expecting things to stay the same, probably means they will change even more.