‘Goldilocks’ nightmare: The big bet that could get very ugly

When the technology-dominated Nasdaq exchange announced last week that it planned a rebalancing of its index to “address over concentration in the index” by a handful of mega-cap tech giants it could have been interpreted as a signal that the US stockmarket’s apparent resurgence this year is based on a deception.

To a degree that’s true. Nasdaq’s best-ever first half was driven almost entirely by the performance of a mere half dozen or so big tech stocks whose share prices have been boosted quite dramatically by the excitement around artificial intelligence generated by the launch of ChatGPT late last year.

Markets have had a very rosy outlook for what the future holds.
Markets have had a very rosy outlook for what the future holds.Credit: Reuters

Where the S&P 500 has risen just over 17 per cent this year, the version of the S&P 500 that gives equal weight to all the companies in the index, and which therefore mutes the influence of the mega-caps, has (like the technology-light ASX) flatlined for most of this year.

More recently, however, the base of the market’s run has been broadening beyond the big end of the tech sector, with nearly a third of the stocks in the S&P 500 hitting 52-week highs.

In the past 10 days the S&P 500 has risen almost 6 per cent against Nasdaq’s 3.1 per cent. (The ASX, without the big tech stocks, had been languishing by comparison with the US market until it joined the outbreak of global optimism with a bounce of nearly 4 per cent last week).

Last week, of course, the latest US inflation data showed a headline rate of only 3 per cent, its lowest level since March 2021, and the “core rate” that excludes volatile energy and food prices was, at 4.8 per cent, also its lowest in two years.

The surge in the overall market indices that began late last year was driven by two quite disparate influences.

The mega caps surged on the tide of enthusiasm for AI that has seen the market capitalisations of the so-called “FANG” stocks – Facebook’s parent Meta Platforms, Amazon, Apple, Google’s Alphabet and other big tech stocks – rise almost 60 per cent this year.


The rest of the market, however, has been constrained for most of that period by the rise in US interest rates as the Federal Reserve responded to the worst outbreak of inflation in decades with a series of rate rises. The Fed has added more than five percentage points to the federal funds rate since March last year and has been signalling at least two more 25 basis point increases before the end of this year.

That spelled recession and a lot of pressure on rate-sensitive and economic growth-dependent stocks.

The bears in the market embraced that view of the outlook and have regarded the dominance of the megacaps as a bubble that, if and when it burst, could bring the entire market down.

The bulls have been at odds with the Fed, believing there would be only one more rate rise this year, at worst, and that the Fed would be cutting rates late this year or early next year to avoid a significant recession.

At this point, while the outlook for the market remains very exposed to the performance of the megacaps, the bulls would claim to be vindicated.

Inflation is subsidising steadily even though unemployment remains exceptionally low and economic growth solidly positive, albeit likely to slow.

A “soft landing” for the US and some other advanced economies remains possible, with the risk of a severe US recession receding. Europe, given the war in Ukraine, may not be so fortunate and China’s domestic structural challenges remain a cloud over the global economy.

It is conceivable, of course, that the Fed and its peers elsewhere will overplay their hands and, in their determination to ensure they have control of their inflation rates, raise interest rates beyond the levels necessary to bring inflation down to their targeted ranges over time.

Rate rises beyond those priced into the markets could puncture the megacap “bubble” – tech stocks are particularly sensitive to rates and highly leveraged to their movements – and chill the economy and the market more broadly.

The US has embarked on another round of corporate earnings reports – the big banks began reporting last Friday – that will provide a better insight into what’s happening at the coal face of the US economy.

The US dollar has been slumping over the last month.
The US dollar has been slumping over the last month. Credit: Getty

There is an expectation that earnings overall will be significantly down for the first half of this year, with a potential recovery towards the end of the year if the Fed doesn’t kill it off.

If those expectations were realised, the sharemarket could continue to perform positively, provided the enthusiasm for AI doesn’t wane, which probably means the megacaps will have to begin articulating how they will turn potential into earnings in the not-too-distant future.

Playing a significant role in the soft landing scenario is what happens to the US dollar. It’s not just US markets that will be influenced by the dollar’s direction but interest rates and economic activity in most other economies, particularly (but not exclusively) developing economies.

The dollar has been depreciating. Since early March it has fallen about 5.4 per cent against the currencies of its major trading partners and is trading at its lowest levels for more than a year as currency traders make their own bets that the US rate cycle is peaking and rate cuts are on the horizon, of not this year then next.

The flow-on effects from a weakening dollar are reduced commodity prices and lower debt-servicing costs for developing economies and stronger currencies, reduced levels of imported inflation and lower interest rates in advanced economies outside the US.

US companies’ exports would be more competitive and the companies, multinational and domestic, more profitable, albeit that a substantial depreciation could provide a strain of imported inflation.

There are some big bets being made on the “Goldilocks” outcomes for inflation, interest rates, the economy and markets in the US and, albeit of less global significance, elsewhere. While there appears a reasonable prospect that the ideal scenarios will play out as the markets expect, it’d be ugly if they didn’t.

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Source: Thanks smh.com