Navigating the Obscurity of a More Normal World

Navigating the Obscurity of a More Normal World

Michael Grant

Summary Points:

• The odds favor an expansion that lives on and an inflation setting that is sticky. Renewed policy easing is unlikely until after the election. Central bankers may again fall behind the curve.
• The economic cycle is entering a period of obscurity with full employment and full profit margins. The distinguishing features of the post-pandemic era are fading, leaving investors to figure out what "normal" now looks like.
• History argues that the AI spending boom is unlikely to avoid the misallocation of capital that typically accompanies celebrated investment narratives. The AI boom could leave the stage with a whimper, not a bang.
• The performance divide between the S&P 500 Index, led by the concentration of mega-cap returns, and the broader equity universe points to a narrowing long opportunity. This is an ideal environment for our long/short approach.

Analyzing the economic cycle is a major part of assessing the outlook for financial markets. To correctly assess the economic cycle, investors need to consider the policy impacts of both central banks and fiscal authorities. Even then, the discipline of macroeconomics offers few precise answers. We suspect this imprecision will be felt more acutely in the coming quarters because the unusual features of the pandemic era are fading into the horizon.

For the past two years, we have pushed against the widely accepted discourse that recession was the "inevitable" consequence of higher Fed policy rates. Instead, we anticipated a resilient US economy benefiting from so much that was different. This started with the benefits of inflation for private sector incomes and balance sheets as well as the historic support of fiscal programs under both Trump and Biden.

Most have come around to our view that US recession risk in 2024 is negligible. Across equity and corporate bond markets, there is little anticipation of imminent stress. Investors have concluded they stand amidst an economic expansion of indeterminant length-a reasonable conclusion in the presence of friendly central banks. And yet, it is one underpinned by more obscurity and less coherence of economic and policy narrative.

Many of the drivers of this expansion appear to be waning. Employment markets are fully recovered, with consumer incomes more dependent upon wage inflation than job growth. Corporate profit margins are peaking but stable. Earnings can advance 5% or so in a not so terrible world of 5% advances in nominal GDP. Benignly, the landscape is moving beyond the unusual contours of the post-pandemic years, leaving a new debate about what is "normal."

Investor confidence in today's economy is supported by the favorable liquidity impulse of rising equity prices. The S&P 500 Index return through the first half of 2024 is one of the best for an election year, yet the performance of the average equity tells a different story.¹ Here, we see an equity cycle that climaxed in March and has been consolidating as investors grapple with what this post-pandemic normal really looks like.

Debates Rage On: Inflation, Politics and Gen AI

The path of US inflation in coming quarters feels unusually obscure. If disinflation is the new norm, nominal measures of economic activity will decelerate further into 2025. Little gas is left in the tank for the corporate sector where aggressive price hikes through Covid pulled forward much of this cycle's profitability. The concentrated focus on fewer and fewer outperformers in the S&P 500 Index makes sense in this context.

The Normalization of Nominal GDP = Muted Corporate Upside

Past performance is no guarantee of future results. Source: UBS

At the same time, service inflation is sticky² because labor is tighter than before the pandemic and growth is now skewed toward services. Adverse base measurement effects will emerge from the June CPI onwards. This implies core inflation could trend higher at the same time that many are heavily exposed to duration. Whether "complacency" or "obscurity" is the better description of where things stand, inflation risks appear skewed to the upside.

Encouraged by the Fed's carrot of imminent policy relief, investors have assumed that current policy rates are temporary. By taking advantage of the resulting inversion of yield curves, corporate borrowers are enjoying the growing divide between a restrictive policy rate and easy financial conditions. All of this supports a higher-for-longer policy narrative, ironically underpinned by the Fed's conviction that gravitational forces will pull inflation back to 2%.

Investors entered 2024 convinced the Fed was ahead of the policy curve, with an asymmetric reaction function embedded in their guidance. We see no policy easing until after the election and one wonders if central bankers could again slip behind the curve. The key surveillance metric is the US 10-year Treasury yield. Any move approaching 5% will signal that the contours of consensus assumptions are shifting, possibly in a profound manner.

US Elections: About to Get Interesting

Upcoming US elections are the obvious event risk of H2, with significant consequences for the macro setting into 2025 and beyond. These elections are set to shape trade, immigration, industrial and competition policies, and fiscal constraints. While Biden and Trump may be similar in age and golf handicap, their rematch points to different directions on material policy fronts.

So far, financial markets have appeared nonplussed. This might reflect voter familiarity with the candidates; or it may simply be early for investors to focus on the opportunities and risks. Stable and rising markets may be judging Trump (with his lead in the polls) as the more friendly outcome; he is an effective cheerleader for the grassroots economy and especially small businesses.

That said, businesses have played a key role in the current expansion through hiring and fixed investment. Trump's plans for a resumption of trade conflict may impact sentiment in the election run-up. In this respect, the latest dip in the June global PMI future output reading bears monitoring. The 2018-2019 trade war had large adverse effects on global business confidence and capital spending.

The elephant in the room is the shape of fiscal policy. The election winners will immediately be confronted with the expiration of the most important provisions of the 2017 tax cut. Today's scale of fiscal deficit points to tensions between economic growth and taxes, and the monetary accommodation to smooth this over. Bond vigilantes have been few and far between, but the situation is ripe for a profound shift in market willingness to backstop Treasuries demand.

State of the AI Transition

Amidst all of this, financial markets have become enthralled by the AI narrative and its widely touted promise to transform "everything". The major technology leaders have responded with a ~$1 trillion spending plan on AI-related capex. Remarkably, it is unclear if there will be much to show for this spending as practical applications have yet to emerge. Investors and corporate spendthrifts alike have embraced the old adage, "If you build it, they will come."

History argues that today's AI spending boom is unlikely to avoid the misallocation of capital that typically accompanies celebrated investment narratives. The sheer scale of spending implies the eventual returns will need to be outsized. One early challenge is that the three main channels of payout -advertising, e-commerce and subscription fees-will require a material shift of consumer habits that is not yet apparent.

This monetization debate is ongoing. What is less debatable is that this is exceptionally expensive compared with prior technology shifts like the internet and personal computers. To justify today's costs, AI technology must soon solve complex and trillion-dollar problems. In contrast, prior technology cycles emerged in the wake of low-cost solutions with better understood roadmaps for future business models or paths to cost savings.

Crossing this chasm will occur only gradually. One hurdle is the intensive capital and power requirements of AI datacenters. Energy constraints will be the biggest bottleneck as big tech faces the same regulatory, interconnection and supply chain constraints as utility companies. The total capacity of power projects waiting to connect to the grid grew ~30% in 2023, with wait times between 40 and 70 months.

Bubbles Take Time

Investment bubbles can take a very long time to burst. Most burst because the cost of capital changes or final demand deteriorates, thus affecting the deployment of capital. In contrast, the companies leading today's charge are the largest, most cash-flush entities in the world. It is hard to imagine what will cool their enthusiasm. Sustained corporate profitability could allow sustained experimentation with negative ROI projects for some time.

And it is not clear that AI-related stocks should be judged "bubbly." One clear signal of a stock bubble is rising share price volatility as valuations become disconnected from fundamentals, leaving sentiment and momentum to dominate. In contrast, the shares of AI leaders have largely kept pace with rising fundamentals-prices appear high rather than extreme. Volatility measures across US technology have been flat to down-not up as in a typical bubble.

The key feature of today's AI narrative is the sheer scale of their market capitalizations relative to nominal GDP,³ which stands in contrast to historical experience. For example, the gains in market capitalization through the first half of 2024 exceed the aggregate gainof 1998 and 1999 combined relative to nominal GDP at that time. If an AI bubble does emerge in the coming year, the scale of liquidity creation could be unmanageable.

The Tail Is Now Wagging the Dog

Past performance is no guarantee of future results. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.

Any investor who lived through the internet bubble of the late 1990s will be inclined to draw comparisons. Do we stand at the peak like March of 2000? Or is March of 1999 the better roadmap when another year of enthusiasm lay ahead. One difference between then and today is the more robust health of the US corporate sector, leading us to wonder if the AI narrative fades with a whimper rather than a bang.

Investment Conclusion: CPLIX

The major contributors to benchmark performance in 2024 have been the AI winners, including Nvidia, Taiwan Semiconductor and the hyperscalers Google, Microsoft, and Amazon. From this point, we view the AI investment theme as more skewed to the downside. We have reduced fund exposures to the "picks and shovels" narrative, and semiconductors in particular.

The performance divide between the S&P 500 led by the concentration of mega-cap returns and the broader equity universe points to a narrowing long opportunity. Breadth measures of advances versus declines, or new highs versus new lows have been more negative than positive across the technology universe. It is easier to short a Nasdaq stock than to short the Nasdaq Index. We believe this is an ideal environment for our long/short approach.

Narrow Market Breadth:
It is easier to find Nasdaq shorts than it is to short the Nasdaq

Past performance is no guarantee of future results. Source: Bloomberg. The Nasdaq Composite Index is a market capitalization weighted index of more than 2500 stocks listed on the Nasdaq, with an emphasis on technology stocks.

Our interpretation of the average stock action is that equities climaxed in late spring. Markets are now stuck in consolidation until some fundamental light can pierce the clouds of obscurity. For this reason, CPLIX equity exposures are low relative to history and positioning is focused on the alpha opportunity (rather than market beta) to generate returns into autumn.

Our key message is that it is hard to have high conviction across many of today's debates. The odds still favor an expansion that lives on and an inflation setting that is sticky. The problem is the lack of humbleness across key parts of the equity universe-a complacency encouraged in part by central bankers.

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