Summertime is officially here with a vengeance as tens of millions of Americans are cooking under the heat dome currently covering the Southwest United States. Recreation and travel are in full swing as long, lazy summer days are being spent with friends and family, enjoying pool parties, cold drinks, BBQ and good guacamole. Markets are cooking too – with the first half of the year in the books, the S&P ripped nearly 16%, notching its 12th best first half return since 1926.
In a capital market-version tale of the Haves and Have-nots, if you were a stock that had any whiff of exposure to Artificial Intelligence (AI), you were a very happy camper in Q2. If you were any other sort of financial asset, you were left in the dust. Indeed, even a respectable 3.4% quarterly return on the Dow looked downright paltry compared to the nearly 13% quarterly return of the Nasdaq. As the chart below illustrates, there’s Tech and then there’s everything else.
Figure 1: Mega Tech and AI-Mania Dominate Q2 and Extend the YTD Lead
So what is all this AI-driven fuss about, and why are certain companies suddenly trading at sky-high valuations? In a nutshell, humanity has finally reached a point in computing power that enables vast amounts of data to be generated, consumed, and analyzed in an iterative process which allows for computers to reason, use logic and produce focused output that can help to solve the world’s problems. This is not a new phenomenon as machine learning and large-language models (LLMs) have been around for quite some time. What is new, in the context of capital markets, is the recognition of several use cases that can generate very large and sustainable profit streams for those companies that can harness the power of AI. The financial enthusiasm surrounding these exciting developments has been nothing short of spectacular, with the usual Tech suspects skyrocketing in value on a YTD basis.
Figure 2: S&P Concentration Levels Near All-Time Highs
We are still in the early phases of this AI-revolution, and people are still learning how to wield these LLMs effectively. Several use cases abound from enhancing computer programming and software coding, to speeding up vaccine and medical device development. Much to the delight of high school and college students everywhere (and to the chagrin of their professors) writing term papers has suddenly become much easier. On a whim, we thought we’d give ChatGPT a try and asked it to “write a 100-word market and economic summary for the past quarter.” Here’s what the Chat returned:
“Global economy and markets in Q2 2023 saw mixed performance. Economic recovery gained momentum with increased consumer spending and manufacturing activity. Inflation emerged as a concern due to rising commodity prices and supply chain disruptions, leading to potential monetary policy tightening. Geopolitical tensions impacted market sentiment, while the tech industry faced regulatory scrutiny. The renewable energy sector experienced significant growth as the transition to cleaner energy gained momentum. Stakeholders remain cautious amidst evolving policies and geopolitical developments shaping the future of the global economy.”
Meh. Not bad, but somewhat dated from early 2022, not a ton of context and fairly general comments. Robotic tone (not surprisingly). Looks like our Capital Insights writers’ jobs are safe for now. Perhaps we’ll be more concerned when the next iteration, GPT-4, comes to market.
Of course, there are implications that come with every technological development. Same as it Ever Was, as the band, The Talking Heads, famously sang. How will this technology be used for good? What happens when bad actors use this power against society? How will AI disintermediate labor and industries? Can our grandchildren expect a dystopian future run by Skynet and filled with Terminators trying to eliminate mankind? All good questions to which we will all have to wait to find out.
Advances in technology and robotics continue to shape and impact industries here and now as more companies are looking to cut costs in an era of persistent inflation and a higher cost of capital. As an example of the shifting landscape, Chipotle recently announced it is testing its new Autocado, a robot avocado-cutting machine that will help reduce their guacamole production time by as much as 50%. McDonald’s just recently announced its first automated drive through and Domino’s Pizza, Taco Bell and other major fast-food companies are all investigating ways to leverage technology to overcome worker shortages and rising wages.
Figure 3: Presenting the Autocado…Guacamole Will Never be the Same. Or Will It?
Earnings season is upon us once again and it is time for Corporate America to show investors their financial report cards. Earnings expectations guidance has generally been downplayed and because of the combination of the YTD advance in market prices, valuations are looking a bit frothy.
Figure 4: Price/Earnings Multiples Bubbling Up
It’s very clear that our economy is in a disinflationary trend, which is a good thing. The challenging part of the story is that the economy also continues to slow. As we wrote last quarter, we expect a recession to start to present itself later this year as the impetus of the interest rate increases and tightening of credit conditions work their way through the real economy. Given the rapid rise in equity prices and resilience of the labor market and consumer spending, there is more and more talk of a soft landing or a no-landing scenario – one in which inflation reaches a 2% level with limited adverse impact on the job market. That scenario would be lovely, but that’s not how the business cycle works. And just because a recession hasn’t happened yet, it doesn’t mean it’s not going to happen.
Figure 5: Leading Indicators Suggest Recession Towards End of ‘23
For now, consumer spending remains strong, and the labor market remains tight. Cracks are starting to form, however, as credit card balances and delinquencies are creeping up, wage gains are leveling off, employment postings are rolling over and unemployment claims are starting to tick up. Our sense is that elevated wages and payrolls are still too strong for the Fed and they will continue to hold rates higher for longer than most expect. This condition will ultimately usher in the next phase of the business cycle, and we expect volatility to pick back up in the financial markets later this year.
Regardless of the timing of events, we continue to caution clients against any urge to try and time markets. Very few, if any, strategists and economists saw this massive bull run in the first half of this year, and that occurrence highlights the importance of staying invested and sticking to a strategic asset allocation plan. An investor’s strategic allocation should be based on their long-term goals and objectives and the allocation should only be materially adjusted when the investor’s life circumstances or goals have changed.
In terms of our allocation models, we continue to remain invested with a slight tilt towards portfolio stability in expectation that conditions will get a bit more challenging in the future. Our clients have benefitted from this 2023 equity market advance, and we have managed to do so by generally taking less risk in their portfolios.
In our public equity profile, we favor higher quality companies, ones that can grow their earnings consistently and use leverage prudently. Those sorts of companies include large technology names as well as a diversified assortment of other excellent organizations from other sectors and industries. We have also increased exposure to international markets based on favorable risk/return metrics. On the public fixed income front, we have a neutral stance in terms of interest rate risk but favor government debt as we expect credit spreads to widen. We continue to favor private credit and private real estate as they are major beneficiaries from elevated interest rates and persistent inflation.
While the 1H eye-popping market returns of the Mega-Tech Titans have captured many of the financial headlines during this AI-led gold rush, there are several other ways to participate in these exciting developments. For example, the growth of social media, AI and electronic communication in general has created a nearly insatiable need for the storage and processing of these massive amounts of data. Data center inventory has nearly tripled since 2015 and is a direct beneficiary from the rise of these technologies. We expect this trend to continue as this critical infrastructure investment remains robust and are pleased that our clients who are allocated to our private real estate vehicles have a meaningful exposure to this growth sector.
Figure 6: Growth of Data Center Inventory
We shall see how the markets progress over this back half of the year and while we are glad about the strong returns from the first six months, we do expect volatility to return later this year. Until next quarter, we wish you a wonderful Summer, and hope you enjoy some chips and guac by the pool.
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