The Dilemma of Yields

Recently, the stock and bond market suffered a blow due to the ‘hawkish pause’. On Wednesday, the US Federal Reserve (Fed) clarified its intention to maintain the interest rates at 5.25-5.5%, emphasizing its firm stance with sharp forward guidance. Jay Powell, the Fed Chair, reiterated familiar themes: a robust US economy, elevated inflation, and the impending necessity for a more stringent monetary policy. The Fed’s ‘dots plot’ projection highlighted a potential rate hike this year, followed by a plateau in 2024, underscoring Powell’s dedication to extended high rates.

This announcement led to a surge in bond yields. Notably, the ten-year US Treasury yield surpassed 4.5% in Friday’s early trades – a peak not seen in 16 years. As a consequence of this elevation in risk-free rates, stocks, particularly the S&P 500, faced a downturn. With equity valuations appearing precarious, especially given this year’s robust stock performance devoid of corresponding earnings growth, longer-term growth assets, which are typically more susceptible to interest rate fluctuations, find themselves at risk once more. Amid a global growth lull and the Fed’s ‘higher for longer’ stance, investors are speculating if bonds, now yielding lucratively, might offer better returns than stocks. Despite this short-term ‘negative carry’ challenge, seasoned investors recognize the historical trend where only risk assets have significantly outpaced inflation.

Oil Prices: A Marker of Inflation or a Temporary Surge?

The international Brent oil benchmark reached a remarkable $94 per barrel during the previous Tuesday’s trade, a height last witnessed in October of the preceding year during the aftermath of the Russian conflict. Escalated oil prices, though challenging under regular circumstances, pose a significant concern for central banks grappling with persistent inflation – a sentiment echoed by Christine Lagarde as the European Central Bank (ECB) upped its interest rates. Such oil price hikes burden both markets and policymakers, pushing headline inflation up at a time when it’s already at unsettling levels, effectively acting as a consumer and business tax for those unable to offset costs. Morgan Stanley projects that the recent $20pb increase could augment eurozone inflation by 0.5%.

With labour markets strained and high inflationary expectations, businesses and consumers are responsive to price hikes, with fuel prices being the most evident. The limited capacity across various economic sectors suggests that a ripple effect on inflation is increasingly probable. Central bankers, fully cognizant of the inflationary challenges, are taking note of the escalating oil prices. However, if these prices suppress consumer expenditure, it might diminish the Fed’s urgency to elevate or sustain high rates. The Fed’s studies indicate a 10% oil price surge could reduce consumption by 0.16% and GDP by 0.14%. Since the intent behind rate hikes is to constrict consumption and economic activity, rising oil prices might inadvertently be aiding the Fed’s cause.

Nevertheless, it’s crucial to tread with caution. The core US inflation was registered at 4.3% in August, which would surpass the Fed’s 2% goal if directly extrapolated to future inflation. Even though current indicators hint at a decline, the Fed remains wary of potential disruptions, such as elevated fuel costs. The crux lies in observing the broader impact of these oil price fluctuations on consumption, economic activity, and their role as consumer price indicators. The market’s anticipation is palpable.

AI: A Revolutionary Promise or Overblown Hype?

From an investment lens, the artificial intelligence (AI) narrative remains elusive. The looming question is whether these cutting-edge technologies represent a transformative force on the horizon or a potential bubble in the making. Although not at the zenith of dotcom mania, terms like ‘machine learning’ and ‘language models’ have infiltrated corporate jargon. The clear allure for businesses lies in the promise of productivity enhancements, a rare find in over a decade and often attributed as a factor for the subdued growth post the 2008 financial meltdown. Notably, even in the realm of big tech, which traditionally boasts staggering stock evaluations, there was a sentiment of innovation stagnation, particularly in stagnant sectors like smartphones. However, the AI wave altered this perception, even if tangible productivity gains are yet to be fully realized.

AI research has been a longstanding endeavour, and its vast potential was always in the limelight. Contrarily, most foundational AI elements are open source. The launch of ChatGPT and its generative language capabilities played a pivotal role in directing financial momentum towards AI. The game-changer wasn’t the tech evolution, but the altered perception of its capabilities and the proximity to transformative shifts.

Embarking on a new market with the overarching aim of redefining it aligns with the ‘Trojan Horse’ tactic. While there’s little doubt that AI innovations will pave the way for novel revenue avenues, it doesn’t automatically validate all market valuations, especially on an individual stock basis. Phrases like ‘generative AI’ have undeniably boosted specific share prices, yet the overall market enthusiasm remains historically moderate. This restraint possibly stems from the broader economic context. Rapidly escalating interest rates, coupled with diminished global growth and immediate demand forecasts, might be prompting markets to adopt a long-term perspective.

The persistent query revolves around the translation of these novel technologies into future profits. Identifying the companies poised for success in this endeavour would undoubtedly be invaluable. It remains to be seen who emerges victorious, whether traditional giants maintain their stronghold, or if newcomers can disrupt the stock market dynamics. Presently, the anticipation of a potential growth catalyst for the upcoming decade is a sentiment investors heartily embrace.

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This article is for information purposes only – should not be perceived as financial advice. We recommend you should always speak to a financial adviser before making any investment decisions.

Please note, past performance is not a reliable indicator to future returns. Your investment may fall as well as rise, and you may not get back what you put in.