Investors now think the Fed needs to cut harder to guarantee no recession
Michael Hartnett, BofA strategist
The magic seven – Alphabet, Amazon, Apple, Microsoft, Nvidia, Tesla and Meta – remained the most popular trade in the market, even after the selloff, according to a global survey by Bank of America. “Core optimism on soft landing and US large cap growth stocks is unbowed,” strategist Michael Hartnett wrote in the note. But managers wanted more than just to have their proverbial cake, he noted: “Investors now think the Fed needs to cut harder to guarantee no recession.”
The Fed is looking at a broad spectrum of economic data, not including asset prices. But bubble-like behavior in the stock market might dampen enthusiasm for rate cuts that could stoke the trend. The US central bank raised interest rates 11 times between March 2022 and July 2023 to combat a huge surge in inflation. Since then, the federal funds rate, which sets the rate at which banks lend to each other, has stayed up at 5.25% to 5.50% for almost a year. That’s also keeping downward pressure on tech stocks, since tech companies thrive in a low rates environment where they are free to concentrate on growth at the expense of profits.
Only a few voices warn of an impending rout. Elliott Management, the respected hedge fund started by billionaire activist investor Paul Singer, reportedly told investors in mid-August that these stocks are in “bubble land” and Nvidia is “overhyped”. The fear is that AI will never be cost efficient, never work right, take up too much energy or prove to be untrustworthy – and therefore unusable.
But a lot of analysts – including those surveyed by Bank of America in August – think stocks will keep pushing higher. Which means this environment of high rates at the same time as a tech boom persists. That seems contrary to economic theory: over the last four decades, rates have fallen as wealth and productivity have risen. Low rates make sense in an environment where banks can lend safe in the knowledge that the money in the economy available for saving and repaying loans will keep rising. AI – like the iPhone and the web before it – has long promised gains in productivity, making everything from meeting minutes to car manufacturing more efficient. So why should the economy behave differently this time?
Some economists think it will. The AI boom, rather than prompting banks to cut rates, could end in rates staying higher for much longer – for the very same reason tech stocks are running hot in the first place. Tyler Cowen, professor of economics at George Mason University, says that AI will create huge demand for capital expenditure. Cowen also points out that productivity of capital could rise significantly due to AI, which would also push up interest rates.
The region is home to major data centers, and now needs the equivalent of several large nuclear power plants to meet projected energy demands
Tyler Cowen, professor of economics at George Mason University
AI comes with an ecosystem of expensive investments, from semiconductors, to real estate for data centers, to power plants to meet energy demand. “Northern Virginia, for example, is now facing a major dilemma along these lines, and not only because of AI. The region is home to major data centers, and now needs the equivalent of several large nuclear power plants to meet projected energy demands,” Cowen said.
Analysts at JPMorgan consider there to be two partial offsets to higher rates due to demand for capex. First, if AI results in longer retirement periods – either because of developments in biomedicine extending life expectancies, or because of automation resulting in fewer jobs – workers would likely have to hold more savings, resulting in lower rates. Second, if the AI boom shifts capital to owners, and away from workers, the rich would likely have more savings to live off, once again depressing interest rates.
Either way: AI looks set to continue its uneasy relationship with high rates. Analysts at Capital Economics expect the S&P 500 to end 2024 at around 6000, up from its current level of about 5,600, revising upwards earlier forecasts. And expectations of a rate cut have fallen. Markets, which were earlier betting on a half-percentage-point cut in September, are currently pricing around 70% probability of a quarter percentage point cut, according to Reuters.
Any rate cut could add fuel to an AI boom which has yet to reveal its full potential. That leaves many investors overweight. In a note dated August 12, Blackrock said: “Rather than dialing back risk, we lean into our highest-conviction ideas.” And: “We stay overweight US stocks and the AI theme.”
But it may be that the opportunities and uses of AI have been massively overstated. So far, Elliott analysts said, there have been few real uses of AI other than “summarizing notes of meetings, generating reports and helping with computer coding”. Either way, the bull market may have stumbled this summer, but looks set to continue to run.
