By Ellen Hazen, CFA®, Chief Market Strategist

May Takeaways:

• The Federal Reserve kept short-term interest rates at 5.25%-5.50%, while announcing a slowing of the pace of shrinking its balance sheet holdings. This was widely anticipated with recent economic releases showing continuing inflation
• Equity markets rebounded. After a decline in April, most equity markets appreciated in May, with the S&P 500 Index up 5.0% and the International MSCI EAFE Index up 4.0%. Growth companies have continued to outperform Value companies, outperforming in four of the five months this year
• Headline inflation stabilized at 3-3.5%. The Consumer Price Index (CPI) has ranged between 3.0% and 3.8% for the past year, with the most recent reading at 3.4%. The Core Personal Consumption Expenditure Index (PCE) has continued to decline, with the most recent reading at 2.75%
• Bonds appreciated. The Bloomberg Aggregate Bond Index appreciated by 1.7% in the month of May, cutting year-to-date losses from 3.3% to only 1.6%. The shorter-maturity portion of the bond market has done better, with the Bloomberg Intermediate Government Credit Index down only 0.3% through May
• Corporate earnings showed decent growth. Q1 2024 earnings growth ended up being +5%, mostly due to +4% revenue growth. Analysts expect earnings to accelerate to first 8% and then 13% later this year

What We Are Watching in June:

• Credit spreads are very tight. Right now, the excess yield over Treasurys required by bond investors to hold BBB-rated corporate debt is at the narrowest level in nearly 40 years. Bond investors are expressing remarkable comfort with credit risk, implicitly saying they are not concerned about possible corporate defaults. Bond investors are often the first to spot deteriorating conditions. We are watching to see if their skepticism increases and credit spreads widen
• Equity broadening? In May, the largest companies again outperformed smaller and mid-sized companies. The Technology sector was the best-performing sector in the month. Given the acceleration of relative Q3 and Q4 earnings growth in the non-tech sectors (e.g., earnings in the Healthcare sector are forecasted to grow 17% in Q3 and 24% in Q4), we expect equity market returns to broaden beyond the tech sector in the coming months, within the large-capitalization universe. We still do not favor the small-capitalization universe as it is disadvantaged in this higher interest rate environment
• Fed meeting June 11-12. We expect the committee to hold the overnight rate steady at 5.25-5.5% at the June meeting, given that recent economic data has shown consistent (albeit modest) deceleration. We expect no change to the pace of balance sheet runoff for the same reason
• Nonfarm payrolls for May will be reported on June 7. The current consensus is for 185,000 new jobs to have been created in May. Recall that given expected economic growth, the economy requires about 170,000 new jobs to be added each month
• Inflation. Current expectations for the May inflation measures (which will be reported in mid-to-late June) are 3.4% for CPI and 2.8% for PCE. We expect CPI to trend lower in the second half of 2024. Recently, the observed asking price for rent (rent is an important component of CPI) has trended lower, and we expect this to make its way into the CPI calculation

The US equity market has been the best-performing large market in the world for the last decade. This has been powered by the large-capitalization segment, which in turn has been driven by technology and technology-related stocks. A decade ago, this was epitomized by the famously coined “FANG” stocks: Facebook, Amazon, Netflix, and Google. A few years later, Apple was added, creating “FAANG,” then Microsoft, creating “FANMAG.” These companies had always been high-growth, but this growth was turbo-charged during the pandemic, when people stayed home and increased their consumption of technology. Starting in 2023, optimism for artificial intelligence (“AI”) adoption led to a new moniker, the “Magnificent Seven,” which swapped Tesla for Netflix and added NVIDIA, the chip producer at the heart of generative AI training and inference.

Artificial intelligence has captured the imagination of the public and corporate management teams. A glance at the mentions of AI and its synonyms on corporate conference calls tells the story: our analysis of Bloomberg earnings transcripts shows that mentions have more than quadrupled, from 950 in the second quarter of 2019 to over 4,200 in the second quarter of 2024.

The poster child for artificial intelligence in the stock market is NVIDIA Corp, the semiconductor company whose graphics processing units (GPUs) power most AI training models. The stock more than tripled in 2023 and has appreciated by a further 120% in 2024. This stock appreciation has been primarily earnings-driven: earnings per share were $3.48 in calendar year 2022 and are expected to be over $33 in calendar 2024. So even as the stock has appreciated by tenfold over the past five years, the company’s earnings have increased by tenfold as well.

It’s not just NVIDIA and chips, though. The purchasers of NVIDIA chips are the large cloud providers: Amazon Web Services, Microsoft’s Azure, and Google parent Alphabet’s Google Cloud have spent $700 billion over the past few years on cloud computing and are expected to spend more going forward. The plan is to charge corporate customers for access to their large language models to get payback on this investment. One early example is Microsoft’s GitHub CoPilot—for a monthly fee paid to Microsoft, software programmers and their employers can dramatically reduce the time it takes to produce code, freeing up time and resources for higher value-add projects.

The first areas seeing AI-related growth are the technology companies that are enabling it: chips (and semiconductor capital equipment manufacturers) and cloud providers. But other areas of the market are seeing increased demand as well. More datacenters are being built, driving higher growth in some industrial companies and some real estate investment trusts. Even utilities are impacted. Constellation Energy, one of the largest utilities in the US, has seen its stock appreciate by over 70% this year, handily outpacing the S&P500. Mentions of AI on conference calls by utility company managements have increased by tenfold over the past year, and the US Energy Information Administration expects the US electricity use growth rate to double from 1.5% in 2023 to 3% in 2024, partially driven by increased datacenter usage.

The next phase of AI, which will become visible in 2024 and even clearer in 2025 and beyond, is that companies will start to report lower costs and increased productivity as a function of AI. This will manifest as lower costs to provide customer service, to generate text, to target advertising more precisely, to summarize documents, even to generate images and video. Companies are already discussing real-life examples ranging from supermarket Kroger to online retailer eBay to utility Edison International to drug distributor McKesson Corporation. Examples of use cases being discussed range from chatbots and financial fraud detection to education and biopharmaceutical development, and experts believe we have just scratched the surface of what will become possible.

Implications for Investing

As evidence mounts that companies aim to benefit from AI, investors have responded by increasing those companies’ valuations. Caution is warranted, however. The speed at which AI is developing – whether measured by AI capabilities or by NVIDIA revenue – has been breathtaking. Comparisons are often made to the Internet buildout in the 1990’s, when Cisco Systems was able to grow revenue by over 80% for 8 straight years. However, that was starting from a very small revenue base of under $100 million. NVIDIA’s 126% revenue growth in CY 2023 and anticipated doubling again in CY24 is starting from a base of $27 billion. Trees do not grow to the sky. When a transformation is this rapid, the cone of possible outcomes is much wider than in normal times, and thus investors’ expectations must be tempered with extra humility. Much could go wrong as this journey continues. Will the cloud and large language model (LLM) providers be able to charge corporate customers to cover the massive capital they’ve already spent on AI chips and hardware? Will those providers’ corporate customers be able to realize return on investment (ROI) on the money they will pay for access to AI LLM’s? Where along the value chain will the benefits – to the extent that they occur – accrue?

We believe that while the near-term impacts have been most visible in the technology sector (while the foundational models are getting built), in the coming months companies will find many ways to improve both revenue growth and profitability. Like the buildout of the Internet in the late 1990s, growth is likely to be first in the infrastructure buildout, and only later enabling entirely new business models. At some point, AI will likely be overbuilt – that is the nature of capitalism. We expect to see volatility as capitalism’s propensity to linearly extrapolate into the future confronts the wider cone of outcomes from AI, and we stand ready to invest where we see opportunities.

Disclosures