The unbroken run of equity market gains since April’s Liberation Day sell-off continued into October, driven again by AI stocks. The MSCI World index returned 2.0% in the month, with the S&P 500 +2.3% and the Magnificent 7 (Mag 7) megacap tech stocks +5.2%. By the end of October, the market capitalisation of the Mag 7 represented 36% of the S&P 500 (and 24% of the MSCI World index), compared with 32% a year ago. Markets outside the US also produced solid gains, with Japan’s Topix index +6.2%, and the UK +4.2%, both in local currency terms. A continuing recovery in the USD from its mid-year lows, up 1.9% on a trade weighted basis in October, reduced returns in USD terms. Currency moves made the biggest contribution to returns in bonds, with the JPMorgan Global Government bond index -0.5%, masking falls in bond yields and a positive return on US Treasuries of +0.6%.
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Further signs of cooling in the US labour market, along with softer than expected inflation data, enabled the Fed to deliver its widely anticipated 25bps cut in interest rates, taking the Fed Funds rate to 3.75-4.0%, in turn underpinning a fall in bond yields. The Fed also announced an end to its balance sheet run-off (quantitative tightening) from 1 December, which will further ease financial conditions and liquidity. The 10-Y US Treasury yield fell to 4.1% at the end of October, some 50bps lower than its level in mid May, and close to the early April low when markets were building in expectations of a tariff-induced recession. However, there was a somewhat cautionary note from Chair Powell, who noted that a December rate cut is ‘far from a foregone conclusion’, leading to markets dialling back their expectations.
Also supporting markets was a US-China trade deal, extending their trade truce for a year, rolling back restrictions on rare earth exports from China, semi-conductor exports from the US, and retaliatory tariffs on both sides. While by no means a long term strategic breakthrough, and leaving US tariffs on Chinese imports at an average 47%, the deal nonetheless represents a major de-escalation of the trade war.
China’s economy continues to struggle, as a result of the damage to US exports from tariffs, continuing headwinds from its over-indebted property development industry and soft consumer demand. China is in deflationary territory, with the CPI -0.3% yoy and PPI -2.3% yoy in September. The stock market gave up some of its previous strength, with a fall of 3.8% in the MSCI China index in October, led by falls in some of its big tech stocks which had driven earlier gains in the market.
In contrast, Japanese equities had a very strong month, boosted by the election of new Prime Minister Takaichi who is seen as a fiscal and monetary dove and is expected to stimulate the economy. The Topix index gain in October took it to over 14% in the last 3 months, by far the best performer of the major markets. The yen, however, had a sharp fall, -3.9% in the month, taking it close to its lowest level of the year vs the USD, while against the euro the yen was at its lowest for 35 years.
The UK market was lifted by prospects for further interest rate cuts following a downside surprise to inflation, albeit still a high 3.8% in September; evidence of a weakening labour market, with unemployment rising to 4.8%, the highest since the pandemic driven spike; and a sluggish economy with growth essentially flat in recent months, all of which helped to push UK gilt yields significantly lower, the 10-Y gilt yield down by 30bps to 4.4% in the month. The equity market responded with a gain of over 4% in the broad index, although the gains were primarily in the financials and big international stocks; the more domestically biased mid-cap index managed a gain of less than 1%.
The most significant developments in the month, however, came in the broad AI infrastructure ecosystem, that has dominated markets for much of the past 2 years. Megacap tech companies in the US drove index returns as the Q3 earnings season highlighted strong profitability and the durability of AI investment and cloud computing demand. Microsoft, Amazon and Alphabet all reported strong results on the back of cloud services growth, while Apple was boosted by unexpectedly good iPhone sales. On top of that was a string of huge deals, involving multi-billion dollar bi-lateral investments and partnerships among the major players in the AI boom including Nvidia, Microsoft, OpenAI, AMD, Broadcom, Samsung and SK Hynix, illustrating the durability of the capex spending boom underway. Results announced by Microsoft, Alphabet, Amazon and Meta showed aggregate capex in Q3 up almost 70% yoy to $97bn, with firm commitments to continue at pace. During October Nvidia became the world’s first $5tn market cap company, having crossed the $1tn mark in June 2023, while Microsoft and Apple reached $4tn.
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The concentration of S&P 500 and MSCI World indices in a handful of stocks is at levels rarely seen. The sheer size and dominance of these companies, along with valuations which have risen significantly in the past 6 months as earnings have not kept pace with share price moves, and doubts about the increasing circularity of deals in the AI ecosystem and returns on the huge capex underway, are giving rise to worries that the boom is extending into a bubble. While we do not believe we are in bubble territory, the risks of disappointment have risen, as was evident in the Meta Q3 results, which were good but raised investor concerns about their capex programme and led to an immediate drop of 12% in the share price.
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The AI driven investment spending boom along with cuts in interest rates, taxes and regulations should ensure continuing growth in the US. But there remains uncertainty about when and where the costs of tariffs will ultimately fall, and their impact on growth and inflation, as well as questions about the ultimate returns on capital from the huge AI investment spending underway. Rumbling concerns about the risks in the $3tn private credit market and debt sustainability in several major economies are hurdles which add to the uncertainty. This all comes when valuations of equity markets have risen significantly after the strong rally since April, in some cases to levels which leave little room for disappointment and require continuing strong earnings growth to be justified. Furthermore, the Fed’s anticipated rate cuts are largely discounted in markets, leaving some risk of negative surprises. A period of consolidation is overdue, and a degree of caution is called for shorter term. But the foundations are firm enough for us to remain constructive about markets in the medium term, and to seek opportunities to add to risk, albeit with a degree of patience in the short term.
