Opinion
Wall Street is disconnected from reality
Stephen Bartholomeusz
Senior business columnistOn Friday, the latest US unemployment and wage numbers pointed to a slowdown in the US economy. The sharemarket, however, hit another record.
Can the two developments be reconciled?
The performance of the tech giants has driven Wall Street to record levels.Credit: AP
Yes, higher unemployment and slower growth make the case for the Federal Reserve Board to start cutting interest rates later this year and, for a market that has maintained a conviction that rates will be cut, what others might consider bad news is good news.
Investors have maintained that faith, pushing the sharemarket higher even when first-quarter inflation numbers surprised on the upside and expectations of the number of rate reductions shrunk from six or even seven at the start of the year to just two. Now derivative markets are pricing in a more than 75 per cent probability of a cut in September.
The market’s obsession with rates has overwhelmed the momentary focus on US politics, with the sharp increase in bond yields last week after Joe Biden’s disastrous debate performance subsiding after Friday’s data.
The spike in yields last week relates to Donald Trump’s economic agenda.
His plan to impose a baseline universal tariff of 10 per cent on all imports and a 60 per cent duty on imports from China and his immigration policies would be good for stocks but would be highly inflationary.
Loose fiscal policy – and it will remain loose regardless of which party prevails in November – is generally good for economic growth, although there is a risk that the Fed (assuming it retains its independence in the event of a Trump win) would be forced to resume raising rates if there was a new inflation breakout.
The momentary period of bond market anxiety about a return of Trump, however, seems to have passed even though the Democrats are turning themselves inside out over whether Biden should remain their candidate. Politics has, at least for the moment, been overshadowed by economic data.
The jobs report showed the unemployment rate ticking up to 4.1 per cent – the first time it has been above 4 per cent since November 2021. A year ago, it was 3.6 per cent after coming off a low of 3.4 per cent earlier in the year. Wages growth is also slowing.
With the Fed’s chair, Jerome Powell, due to give his biannual report to Congress on Tuesday and Wednesday and the June inflation data scheduled to be released on Thursday, the outlook for interest rates might become a lot clearer by the end of the week.
Powell has said in the past that if labour markets were to weaken unexpectedly, the Fed is prepared to respond by cutting rates.
Last week’s data and recent signs that America’s manufacturing and service sectors are contracting strengthen the case for a rate cut by showing an economy that is losing steam, which wouldn’t conventionally be a positive for the sharemarket. This isn’t, however, a conventional sharemarket.
The US market is highly concentrated and dominated by the big technology stocks – and those providing the semiconductors for artificial intelligence in particular. The 10 big technology stocks account for almost 35 per cent of the S&P 500.
The “Magnificent Seven” is something of a misnomer, given that two of the seven – Tesla and Apple – have lagged the other five, but the contrast between their performance and the rest of the market is stark.
The New York “FANG” index that contains companies such as Nvidia, Microsoft, Google’s parent Alphabet, Facebook’s Meta, Tesla, Amazon and Apple, is up 39 per cent this year and more than 57 per cent from a year ago.
The S&P 500 is up just under 17 per cent this year and 28.4 per cent from a year ago, underscoring how much the mega techs have distorted views of the broader market’s performance. As a reference point, the ASX 200 is up only about 3 per cent this year.
The S&P 500 trades on an earnings multiple of 26 times the index members’ earnings – the highest in an election year for more than three decades. The ASX 200 trades on 19 times earnings.
Big tech companies and their investors are unlikely to be fazed by any of Trump’s quite radical policies.
Even more telling is the Russell 2000 small cap index, which has risen less than 1 per cent this year and only 10 per cent over the past 12 months and which is more consistent with a US economy that is slowing and where conditions are quite tough for America’s smaller companies.
With the effective Federal Funds rate – the Fed’s equivalent of the Reserve Bank’s cash rate – more than twice the latest US core inflation rate of 2.6 per cent, borrowing costs are quite high and financial conditions are tight and will tighten further if the inflation rate continues to subside while the Fed leaves rates on hold.
That’s of no concern to the mega-techs, which generate massive cash flows and hold massive cash balances. They benefit from the higher yields on their cash reserves, which has more than offset the conventional wisdom that high real interest rates are poison for high-earnings-multiple companies.
(It should be noted that not all mega-techs are equal. Tesla’s share price, despite its recent sharp rebound after a better-than-expected June quarter sales report is down 1 per cent so far this year. Apple, which hasn’t benefited from the excitement around AI, is up “only” 15 per cent).
US election years (other than the bursting of the dotcom bubble in 2000 and the global financial crisis in 2008) have generally been good years for the US sharemarket, regardless of which party or presidential nominee is leading in polls.
This has been, so far, a very, very good year for the sharemarket, or at least for that relatively small number of big tech companies that dominate its performance.
Whether that will continue to be the case as the election draws closer is an open question, although big tech companies and their investors are unlikely to be fazed by any of Trump’s quite radical policies, which favour the interests of big companies and wealthy individuals.
That means the future of a market that sits on the very narrow base of those big tech companies probably still rests on their performance and whether the Fed delivers the rate cuts this year that the market still has priced in.
Powell’s testimony and the US CPI data ought to provide a better sense of where the Fed’s thinking lies while the fate of the mega-tech valuations will continue to hinge on whether the extraordinary optimism built into valuations is validated by their ability to turn potentially revolutionary technologies into outsized profits.
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