Technology Leads Again

Despite fears that inflation will reassert itself and weigh on assets prices, stocks rallied further in May. Again, technology companies were the standout performers amidst high AI demand and the announcement of several large upcoming initial public offerings (IPOs) in the sector. Whilst oil prices remain elevated in comparison to a few months ago, they have eased significantly over recent weeks as geopolitical fears have faded, helping alleviate some inflation concerns and bond yields to fall from intramonth highs.

For some, there are fears that inflation, which is expected to rise over the coming months as higher oil prices feed into the cost of goods and services, will trigger bad memories of the inflation spike in 2022. However, we believe the current situation is somewhat different. In 2022, inflation fears were driven by both the scale and persistence of price pressures: US inflation peaked at 9%, while wage growth also accelerated sharply. In contrast, this year it is expected that inflation will rise only moderately, peaking around 4-5% in the US and UK. It is also expected for this increase to be short-lived as wage growth has softened, reducing the likelihood of stubborn demand pushing up prices. This is a level that is far less dramatic for interest rates and at which corporate revenues are expected to be able to expand as higher prices are passed on to customers. Inflation concerns were also dampened in May as oil prices eased in response to further ceasefire discussions between the US and Iran. This backdrop was constructive for stocks and helped bond yields fall from intramonth highs, particularly in the UK where Gilt investors welcomed softer April inflation data which came in at a lower than expected 2.8%.

Strong corporate earnings reports provided further positive news for stocks alongside signals that AI capex trends will persist. South Korean trade data is a bellwether for global activity because its economy is very exposed to global manufacturing, especially for AI. Two of the largest companies in Korea, Samsung Electronics and SK Hynix, dominate high-bandwidth chips used in AI systems linked to Nvidia GPUs, making them a useful way to track AI-related spending. The latest data shows South Korean exports rising sharply with strong demand from the US and China. This helped technology stocks outperform in May, lifting indices in the US and emerging markets considerably.

Staying with technology – after much speculation, SpaceX has officially filed for an IPO and will list its shares on the Nasdaq, appropriately with the ticker symbol SPCX. SpaceX designs, manufactures and launches advanced rockets and offers a satellite internet service, Starlink. The IPO is expected to come in June and is likely to be the largest in history with a valuation of around 1.75tn USD. The valuation reflects a huge expansion over time of the commercial use cases for space. Satellites support communication, navigation, weather forecasting, and global internet services, while reusable rockets have made launches more affordable. As the IPO is so big, SpaceX is likely to be one of the largest components of the Nasdaq and will, as a result, attract a wide range of buyers. There are risks, however, as funds may need to be pulled from elsewhere to facilitate the buying and we could see volatility in asset prices as a result.

Although AI developments have had the most direct impact on equity markets, their effects could increasingly be felt in bond markets as well. Minutes of the last Federal Reserve (Fed) meeting revealed that several committee members wanted to drop the interest rate easing bias – thus signalling that the next interest rate move may not be down, as was expected earlier in the year. This comes at an interesting time for new Fed Chair Warsh who took up his post last month. He has openly stated that he believes AI developments mean we are in the early innings of a structural decline in prices. As such, he does not think the existing models used within the Fed to guide the path of interest rates are fit for purpose. While many agree that AI will eventually be deflationary if it delivers on productivity, there is much debate over how quickly this can happen. As Warsh is, arguably, the most powerful monetary policymaker in the world, his stance is hugely significant and, all else equal, suggests an environment where economic growth will not necessarily lead to higher interest rates because it will not be assumed that this growth is inflationary. There are twelve voters on the committee so whether Warsh will be persuasive enough to enact his views is unknown but, historically, it has been rare for the vote to go against the chair. If he can change the committee’s approach to setting interest rates, we should expect to see lower short-dated bond yields and further gains in stocks.

Bottom Line

Inflation is likely to follow a bumpy path over the coming months as the impact of higher oil prices feeds through, raising the probability of some volatility in markets. However, AI investment and global trade are likely to continue providing a positive impulse for growth and asset prices over time.

Noteworthy

Is EM the new AI trade?

Emerging market equity indices have undergone a quiet but profound transformation over the past decade. What was once seen as a commodity heavy, cyclical asset class, dominated by energy companies, raw material exporters and state-owned banks, has become far more technology driven. Semiconductor and chip equipment companies Taiwan Semiconductor Manufacturing Company, Samsung Electronics, and SK Hynix are currently the largest constituents of the index, leaving the asset class more exposed to the AI theme than many investors may realise. In fact, emerging markets has a higher explicit weighting to technology than the US, an index many investors already worry is too heavily influenced by the sector. There are caveats, of course: several major US tech related companies sit outside the official technology sector, including Tesla, Meta and Alphabet. Even so, the broader point remains, technology has become a dominant force in emerging market equities in a way that would have been unrecognisable a decade ago.

The extent of that reliance is striking. Strip out the three biggest AI related constituents from emerging markets and the rest of the index has barely moved above last year’s lows relative to the US market. For investors already exposed to US mega cap technology, this suggests emerging market equities may offer less diversification than headline allocations imply. Rather than providing a clean break from the AI trade, emerging markets may increasingly represent just another expression of it.

Starmer under pressure

The recent turmoil around Keir Starmer’s leadership has mattered for markets because it has collided with an already fragile fiscal backdrop. Labour’s heavy losses in the May elections have raised questions about Starmer’s grip on power and fuelled speculation over a potential leadership contest, with Manchester mayor Andy Burnham widely viewed as a possible successor. Markets have focused less on the politics itself and more on what a change in leadership could mean for fiscal discipline. Burnham’s past suggestion that the UK should not be “in hock” to the bond market only added to concerns that a future government could take a less disciplined approach to the public finances, either by loosening spending plans or pushing back against the constraints imposed by gilt investors.

The deeper issue is that the UK has very little room for error. Public sector debt has risen dramatically over the past two decades, borrowing remains elevated, and debt interest costs are now absorbing a large share of government revenues. With the UK expected to spend around £92 billion on debt interest this year alone, higher gilt yields quickly make an already difficult fiscal position even harder to manage. That is why political uncertainty is proving so market sensitive: investors are not simply reacting to Westminster noise, but to the possibility that leadership instability could undermine confidence in the UK’s ability to control borrowing. In that sense, the pressure on gilts and the pound reflects a broader concern that, with fiscal buffers so thin, any hint of looser policy or weaker discipline risks reigniting fears of a more persistent debt problem.