EXECUTIVE SUMMARY
AI’s ‘mania’ by some measures already dwarfs that of the 2000’s TMT bubble;

• As the poster boy for the bull market, NVIDIA’s recent price action is parabolic and a trend ending signal;
• Economic data is beginning to disappoint, softer real retail sales often forebodes higher unemployment numbers;
• Yet other economic data paints a different more constructive picture, all leading to rangebound, choppy price action to continue for a while, (save for geopolitical tensions increasing further);
• With a slowing economy, and inflation ticking lower, our asset allocation regime has transitioned from ‘Reflation’ to ‘Goldilocks’, with attendant asset allocation changes;
• Increasing evidence of a medium term top as ‘market internals’ diverge from headline index performance;
• Regime shift in portfolios towards more defensive positioning – in anticipation of an intermediate term correction, rather than a market top.

INTRODUCTION
In one of humanity’s first visions of modernity, those who bore witness found it discomfiting. In 1830, the first passenger railway was constructed between Liverpool and Manchester – a feat of engineering which required an act of Parliament. So unprepared and unfamiliar society was with what the prospects of George Stephenson’s rocket train held in store for it, the inauguration ceremony itself served as a harrowing and gruesome episode. William Huskisson, a Member of Parliament for Liverpool and the Prime Minister himself, having misjudged the speed of approach, failed to alight the tracks quickly enough, and was killed underneath the wheels of the locomotive.

That however did not stop the rapid ascent of the railway. Forecast to carry 250 passengers per day, within a month, the number was 5 times that. The 1830’s witnessed a mini boom in railway construction. Thereafter the UK government sought to add fuel to the fire and put forwards the Railway Regulation Act of 1945. Within the confines of an otherwise flatlining stock market, railway stocks went on a tear, accounting for nearly two thirds of the stock market’s capitalisation*. Of course, within a year, railways stocks found the air a little too thin, and the market generally gave way to a significant collapse.

Much ink has been spilled on the AI boom, and the whilst the UK railway bubble certainly has some parallels, it would be a stretch to suggest that it provides a case study for the current environment. That said, AI stocks are in a rarified space and it would be too easy to misjudge the velocity of artificial intelligence’s approach and its likely profound implications.

For now though, as it oft the way, the move may have gotten ahead of itself. Just this past week, the Felder Report is on record, acutely, at drawing attention to the following: NVidia has added over 1trn USD of market capitalisation during the last 32 trading days, let’s round that off at 6 weeks, whilst it took the venerated Mr Warren Buffett, one of the most successful investors of all time, nearly 60 years to see Berkshire Hathaway to register the same market cap.

Of course, market structures and the prevalence of Exchange Traded Funds have a huge bearing on this. The ‘passive investing’ trends unthinkingly directs monies to shares to buy in proportion to the index and by definition, it becomes self-perpetuating. As Nvidia grows in market capitalisation, so does its size in the index, and hence more ETF flows are shovelled toward it. Telsa was the poster boy of a more recent time and since lost traction. To give credit where it is due, Nvidia has at least posted some spectacular earnings in recent quarters, which has justified much of the advance – that was not quite the case with Tesla, and the rose has come off its bloom a little in the absence of supporting financial performance.

To what degree are we witnessing a ‘mania’? By some historical benchmarks, such as valuation metrics, the AI bubble is bigger than its TMT brethren in 2000. AI companies have raised billions, and have spent billions on a capex cycle, creating the demand for Nvidia’s chips. As we stand, many are still awaiting a product to match the capital committed to date.

Chart 1: 2024’s AI mini boom now outshines the TMT boom of 2000

Source: Bloomberg, Apollo Chief Economist, ARIA

Habitually, bull markets aren’t assassinated – it is less often the case that demand fails away and bursts the bubble, rather the air more gently dissipates as supply of the goods or service of that particular section in question increases. Next year is slated to see some significant listings of private equity tech behemoths, such as Elon Musk SpaceX, Stripe and Databricks and inevitably of course, others will catch up to Nvidia increasingly the choice of chips.

CROSS CURRENTS IN THE MARKET’S MUDDY WATERS
Most investors of course, perhaps the average investor, will have exposure to technology and have benefitted year to date. That said, the average stock has fared less well. Whilst most large cap equities have posted returns, smaller companies, such as those of the Russell 2000 not so much – returning a meagre 0.15% in 2024 at the time of writing. Perhaps that is a better read on the economy than the mini AI Boom and extended semi-conductor prices.

We are seeing increasing weakness in labour markets, and retails sales in particular, which are often considered a leading indicator of economies’ performances. For example, the Bloomberg Business Cycle Surprise Index has given off very dovish reads lately. That’s to say that economic results have become consistently underwhelming relative to expectations.

Chart 2: Economic Surprises have been to the downside in the last quarter

Source: Bloomberg, ARIA

Jobs numbers in the US though seem to have held off the doomsayers, with headline numbers consistently fairing well, although that would not appear to tell the whole story.

Again, Bloomberg in drawing on data from Homebase, a small US business payroll company, showed that the non-farm payroll numbers have perhaps over inflated numbers, given the assumptions made in their business birth/death rates. If these were adjusted for, headline jobs numbers would be of a much paler complexion.

We shouldn’t be surprised though, if having worked through the pandemic’s supply chain disruptions, we see a cyclical slowdown in housing. Moreover, real retail sales continue to slow – May came in at 0.1% in real terms, April was revised down by 0.2% and hence four of the last five counts have seen negative year-on-year growth. Historically, consumption leads employment, and the real retail sales numbers portend slowing employment data over the coming months. That in itself is not necessarily a concern for investors – a softening of jobs may simply continue to soften further inflation’s tailwinds, which could embolden the US Federal Reserve to cut rates. The UK’s Bank of England are currently on hold, and the European Central Bank made a pre-emptive cut. Should the pace of lay offs increase markets will take heed, but we are not there as yet.

In fact, there’s some economic evidence to fit every narrative. For those in the ‘higher for longer camp’, (higher interest rates will prevail and anticipated interest rate cuts do not materialise this year), recent Purchasing Manager’s Index (PMI) data is grist to their mill.

The most recent PMI report, (which takes the temperature of the purchasing/capex plans of corporates procurement departments) and the leading index of the US Conference Board’s LEI Index could be said to paint a different picture.

In respect of PMI’s, a reading above 50 indicates expansion and below that threshold economic contraction. In the most recent report, the composite PMI that combines both hit 54.6, which is a 26-month high. The chart below plots the composite PMI along with GDP growth and perhaps it has turned again for the better.

Chart 3: S&P Global Flash US PMI vs gross domestic product (GDP)

Source: S&P Global PMI, Bureau of Economic Analysis via S&P Global Market Intelligence, ARIA

Moreover, the US Conference Board’s index also seems to corroborate PMI’s ‘green shoots’. In markets, it is often not the ‘number’ that matters, rather than rate of change of that number, and as we see below, the year-over-year change is still accelerating off a negative level, which historically is the strongest regime for forward stock returns.

Chart 4: Has LEI turned a corner, setting the scene for further late cycle growth or flattering to deceive?

Source: The Conference Board, ARIA

QUAD POSITIONING
Both of these data points inform our forwards looking macro regime investing approach – whereby we determine which of the four quads or market regimes – goldilocks, reflation, deflation or decline, best describe the current market conditions. In doing so, we pay particular attention to liquidity (the availability of money or credit as fuel for both markets and the real economy), economic growth – specifically the direction of travel going forwards and finally, inflation.

We then reflect in our portfolio’s, asset allocations sympathetic to which quad we sit in. Each quad as you can see below has historically favoured certain assets. That’s to say in a reflationary regime, with higher growth and higher inflation, portfolios will lean into assets such as miners, infrastructure or real economy investments that benefit from an upturn in growth.

In a ‘goldilocks’ environment, where growth maybe slowing, yet inflation is under control, companies that can generate earnings irrespective of a flatlining environment outperform – that would be technology or even utility companies frequently. Year to date, as we have seen falling inflationary pressures, our regime based views have meandered between ‘goldilocks’ and ‘reflation’.

LIQUIDITY
Whilst central banks have been reducing their post pandemic bloated balance sheets, it has been for governments and fiscal policy to do the heavy lifting. In fact, as a percentage of GDP, we’re now back to pre-COVID levels, although massive infrastructure spend has offset the removal of central bank’s monetary support, and kept nominal growth upbeat.

Chart 6: US Federal Reserve Balance Sheet as Percentage of GDP

Source: Bloomberg, ARIA

GROWTH
Perhaps something that has eluded many, this economic expansion is underpinned by growth in personal income. We have become so anaesthetised with credit led expansions (that is to say economic growth which is fuelled by easy money provided by quantitative easing measures), many aren’t familiar with 5% nominal GDP growth, which is fiscally led – i.e. driven by the public purse. Quantitative easing often shows up in share prices, but not main street. So to see growth which is not driven by credit expansion, but an increase in personal spending is a (welcome) change from the post GFC period.

INFLATION
Throughout 2024, inflation has generally trended down, and whilst any fall will always be more vertiginous from 7% to 4%, the move from 4% to 2.5% should be tougher sledding. We believe that the central banks globally have already accepted that ‘3% is the new 2%’, whilst will be to slow to acknowledge that) and the baseline level of inflation is generally higher going forwards. But whilst the major components of inflation, housing and energy prices remain anchored, we would suggest markets have already priced in the implications of 3% inflation levels as the new ‘given’. As we stand at least, the global economy hasn’t yet been bowed by higher rates.

ASSET ALLOCATION VIEWS

SECTORNOMICS: GETTING THE BAND BACK TOGETHER
In June, we witnessed a significant stock market correction in European banks – falling over 9% in a week. French bonds have underperformed both Spanish and Italian bonds over the past year. Concerns that a populist agenda may mean France abandons any fiscal restraint promptly pushed yields to rise. In fact, the extent of the reaction in financial markets is consistent with one where participants are once more beginning to question the prudence of the European project. We could point to previous commentaries in 2012, (memorably The Eurogroan’), where we underlined that one interest rate, perhaps still largely set by or for the Germans, did not necessarily sit comfortably for all 27 separate, differentiated economies. The EU’s objectives are noble, but it is difficult to centralise a monetary policy unless substantiated by a centralised tax collecting authority, which is still not the case.

In fact, recent headlines have almost been reminiscent of the origins of the EU. Founded in 1951, the European Coal and Steel Community, was a tentative step forwards in establishing a collective interest across Europe and to secure peace and harmony after the Second World War.

The newsflow bears more than a passing resemblance, with 10.5bn EUR of grants given to European steelmakers to aid their decarbonisation plans. Whilst the decarbonisation efforts can be cloaked in the voter friendly trappings of energy transition spend, it can also double as a very convenient means of using industrial policy to prop up economies.

PINNING OUR COLOURS TO THE MAST
Whilst we have seen some cyclical data that suggests there is still life in this late cycle period, generally we do expect a soggier period for global economies and the markets at this point.

When we look under the bonnet, (we refer to these as ‘market internals’), a number of divergences foretell of softer economic conditions, and perhaps corrections in markets to come throughout the summer and in the run up to the US General Election.

Credit is not keeping pace with equity markets, smaller companies are underperforming large caps, defensive sectors (such as utilities, consumer staples) are beginning to catch a bid. In fact, in line with our Quad Regime’s latest read, portfolios have transitioned towards a ‘Goldilocks’ environment, from a ‘Reflationary’ one, which has a distinctly more defensive posture.

Such asset allocation changes include utilities and consumer staples sectors, which have been out of favour for some time. The below chart shows perhaps that that tide has turned, and specifically markets may for a period of time take on a more defensive leadership. A housing and retail led slowdown is long overdue.

Chart 8: Performance and valuation discrepancies between defensive and growth sectors is at an extreme

Source: ARIA, Bloomberg

CONCLUSION
The May Consumer Price Index (CPI) and PPI (Producer’s Price Index), were welcomed by equity markets showing further improvement (softening) in inflationary pressures. That on its own does not appear to be sufficient for the Federal Reserve to cut interest rates – it will need a notable weakening in the labour market as a necessary precursor. However, real retail sales perhaps suggest we should expect just that contingency. Jerome Powell, US Fed Chair is of the view that higher employment numbers will be needed to break wage inflation, and hence weigh on inflation towards the 2% inflation trend growth target.

Markets are exhibiting a note of caution. There had been notable underperformance in small caps, regional banks and consumer discretionary stocks during H1 of 2024. However, more recently, this has broadened out to larger banks, industrials, energy and materials. Unsurprisingly then, our asset allocation models have determined a regime shift to ‘Goldilocks’ rather than ‘Reflation’. Across the board, that would suggest lower tech exposure, and greater exposure to more defensive sectors would be appropriate as well as taking on greater exposure to long dated government bonds once more.

We also think it prudent to put readers on notice of a potential escalation in geopolitical tensions, which is underpriced by our lights. There is a non-material chance that Israel is planning a full scale invasion into Lebanon to eradicate Hezbollah. The jungle drums have been sounding for a while, but we do not think (oil) markets are paying sufficient heed. Moreover, perhaps there is a more subtle collaborator too. Vladimir Putin needs to draw a line under the current conflict in Ukraine – the special military complex is currently draining Mother Russia of financial resources. Perhaps a means of expediting matters, would be a Trump Presidency. Therefore, by whatever means that Mr Putin can cause higher oil prices, driving inflation higher, would seriously undermine his re-election efforts. Any flare up in Middle East tensions would do just that.

ALL CONSUMING CONTENT
Carlota Perez** has referenced a recurring ‘frenzy phase’ in every major technology rollout from the last 200 years, from the original telephone cables to contemporary high bandwidth internet. The boom never lasts, but the residues of speculative forces do crystallise into lasting change, a new technology substrate. The coming wave of technology, artificially intelligent machines and genetic engineering will build upon that which has gone before – perhaps only faster. It took Warren Buffet nearly a lifetime to build a trillion dollar company, and Jensen Huang the CEO of Nvidia 32 trading days to add the same market cap. Technological innovations are gathering at a quickening pace. In the space of 100 years, successive waves took humanity from an era of candles and horse cart, to one of power and space stations. The next 30 years will pose foundational questions for humanity; how comfortable we are with editing the genome, customising our children or whether we are prepared to cede our hegemonic position as the apex predator, at the top of the evolutionary pyramid, to emergent AI systems. In the short term, Nvidia’s price may have gotten ahead of itself, but in a broader sense it heralds a much more profound era of technological proliferation as society moves from the manipulation of the atom, or physical elements of the foundations of human development to bits, bytes and base pairs. Strings of 1’s and 0’s and DNA are anything but passing stock market fad.

*The railway boom of the 1840s, The Beaty of Bubbles, Economist, Dec. 18, 2008.
** Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages, 2022.