Sharemarkets are booming. Here’s why it may not last

Friday’s record close on Wall Street begs a couple of obvious questions. Why has the market boomed over the past three months and is that bull market run sustainable?

Since the middle of October the S&P500 index has risen 17.5 per cent. The more tech-heavy Nasdaq is up 21 per cent.

Wall Street is at record levels but threats are emerging.
Wall Street is at record levels but threats are emerging. Credit: Reuters

The New York FANG index of the largest of the tech stocks – stocks like Microsoft, Google’s parent Alphabet, Apple, Nvidia, Amazon, Tesla and Facebook’s parent Meta Platforms that collectively have been dubbed the “Magnificent Seven” – has soared more than 25 per cent.

While the past three months’ surge has been notable for its pace and extent, it owes something to an earlier run last year, between March and July, where the sizzle was provided by the excitement around artificial intelligence.

Nvidia, which dominates production of the graphics processing units essential for AI, has seen its market capitalisation soar from about $US565 billion ($857 billion) in March last year to $US1.5 trillion. Microsoft, which has a very big exposure to AI market leader ChatGPT, has (marginally) toppled Apple as the world’s most valuable company.

There is, therefore, an element of excitement about the transformative potential of AI to the market’s run.

There’s another, larger, influence, however, that has been the big driver of the market in recent months and which has amplified the performance of those big tech stocks.

As it became clearer that the US Federal Reserve Board had brought the US inflation rate, which topped 9 per cent in 2022, under control without breaking the US economy in the process, investors started looking towards, and pricing in, rate cuts this year.

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In fact, they were pricing in quite a few cuts, with the first of them in March. Futures markets in December showed investors thought there was a 90 per cent probability of a March rate cut, the first of what traders believed would be six 25 basis point reductions in the federal funds rate this year.

Just as rapidly rising rates were largely responsible for a 25 per cent slump in the US market through the first 10 months or so of 2022, the growing expectation of, initially, an end to the rate rises and, then, the prospect of them falling this year have underwritten its bounceback.

That has been particularly evident in the performance of the big tech stocks where the impact of the excitement around AI has been amplified by the prospect of lower interest rates.

The frenzy over AI has sent Nvidia shares soaring.
The frenzy over AI has sent Nvidia shares soaring.Credit: AP

Shares in the mega-tech companies, where the valuations are based on estimate of their long-term earnings, are extremely sensitive to changes in the discount rates used to calculate the net present value of those earnings. Lower interest rates lower the discount rate and increase the net present value of those earnings.

Most of what is now technically a bull market (a gain of more than 20 per cent) developed in a rush in the final months of last year when, between late October and end-December, the market rose more than 16 per cent.

Since the start of this year, however, much of that momentum has been lost. The market is up a more modest 1.5 per cent so far this month.

That’s because the investor confidence that rates would be cut early and often has waned. There is now perceived to be a less than 50:50 chance of a March rate cut and the number of cuts priced in for this year is starting to dwindle.

The view that the Fed might approach this phase of the interest rate cycle more cautiously than had been factored into the markets was buttressed last week when an influential Fed board member, Christopher Waller, said he saw no reason to move as quickly, or cut as rapidly, as the Fed had done in the past. Share prices slid and bond yields rose in response to his comments.

For investors and traders in markets that entered the year pricing for perfect outcomes on rates, the emerging view that the Fed will likely start the rate-cutting cycle later and make fewer cuts this year than they anticipated has tempered the animal spirits on display late last year.

Just as rapidly rising rates were largely responsible for a 25 per cent slump in the US market through the first 10 months or so of 2022, the growing expectation of, initially, an end to the rate rises and, then, the prospect of them falling this year have underwritten its bounceback.

There are, of course, other reasons for investors to be more cautious.

The US economy is expected to have slowed somewhat in December (we’ll get the data this week) which may suggest that the Fed is on track to have engineered an unusual outcome to this cycle of monetary policy, a soft landing.

That outcome – avoiding a recession – isn’t, however, guaranteed. If the Fed leaves rates too high for longer than necessary (a judgement that can only be made with hindsight) it could inadvertently engineer a hard landing.

There is also a host of internal and external threats to stability.

Domestic politics in the US are torrid and will become even more aggressive – and Congress probably even more dysfunctional, if that’s possible – as the November election looms. Donald Trump’s plethora of court cases by themselves could provide a destabilising flash point but even more threatening is the risk of the Republican majority in the House blocking funding for the US government.

Outside the US, the war in Ukraine, the spreading conflict in the Middle East, the increased tension of Taiwan after its recent elections, the continuing incidence of COVID, heightened trade tensions between the West and China and China’s spluttering and structurally challenged economy all carry latent risks to geopolitical, economic and markets’ stability.

The most conventional and predictable of those risks is the state of China and is reflected in the performance of its own sharemarkets.

The Shanghai Shenzhen CSI 300 index is now nearly 5 per cent this year and about 20 per cent over the past 12 months. Chinese stocks listed in Hong Kong are down more than 11 per cent so far this year and nearly 30 per cent over the past 12 months.

There’s been a mass exodus of foreign investors concerned by the apparently intractable structural problems exposed by the implosion in China’s property sector, the over-capacity and declining productivity of China’s factories and the increasingly authoritarian and statist nature of its economic policies.

China’s role as the major contributor to global growth over recent decades means that, with the US economy likely to slow (and required to, if the Fed is to cut interest rates) and Europe struggling, any significant question mark over its ability to generate decent growth rates has global economic and financial implications.

The late 2023 ebullience over the prospect of rapidly falling interest rates, combined with the excitement about AI, has given way this year to a more sober appraisal of what now looks like a tricky and potentially risky year for investors.

Thanks to that late 2023 run-up in the sharemarket, they are now exposed to any miscalculation of the Fed’s course, as well as to the market’s vulnerability to the impact of a miscalculation on the concentrated core of tech companies – the so-called “Magnificent Seven” –that have generated nearly 30 per cent of the market’s growth during this bull market phase.

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Source: Thanks smh.com