CPI test ahead

Global stocks sold off further last week, reflecting continued AI jitters and higher oil prices. Bond yields fell, however, reflecting safe-haven flows.

AI-related shares sold off again last week, as the market’s tempestuous on-again/off-again love affair with the theme continued. The ongoing heavy investment plans in the sector are increasingly under question, with not even the major hyperscalers spared. Meta shares fell more than 7% on Thursday after the company again lifted its expected AI spending, while also outlining plans to raise additional capital to help fund the build-out. It did not help that Meta reported free cash flows in the quarter turned negative for the first time since 2012.

Other factors were also behind the tech sell-off – namely concerns over inflation and interest rates. Oil prices moved higher, with ongoing Houthi attacks on Saudi Arabia’s oil facilities and press reports suggesting the US and Israel are planning a major new strike on Iran after the mid-term elections. A surprise 6k drop in US weekly jobless claims to 194k – a near 57-year low – also spooked markets, as it suggested the US labour market may be tightening and the Fed could have more work to do in raising rates.

Last but not least, S&P US PMIs for October on Friday revealed resilient economic activity and higher pricing pressure, with the latter reflecting both higher energy and raw material costs (such as for steel, aluminium and copper).

Offshore, attention will be focused on the Federal Reserve decision (Thursday morning, Australia time). Although the market expects the Fed to remain on hold (90% probability), Fed chair Warsh is on record not wanting to offer market guidance and so there’s some chance the Fed could surprise.

To my mind, the case to raise rates is already in place, given the recent higher-than-expected US CPI report and signs of a tightening labour market. A Fed rate hike just ahead of the mid-term elections would be further affirmation of the Fed’s political independence, which might be an attractive proposition for both Warsh and the still nervous bond market. But having just raised rates in September, markets feel the Fed will wait a little longer and hike in December.

A further inflation reality check comes later in the week, with the September core personal consumption deflator expected to gain 0.3% in the month, taking annual underlying inflation to 3.1% from 3.0%. This follows the recent 0.3% core CPI gain earlier this month.

Other central banks also meet this week: the ECB, BOC, RBNZ and BOJ. While the ECB and BOJ are expected to raise rates further, markets anticipate both will hold off this month – given they both raised rates in September – and await more information. This is similar to the market’s Fed outlook.

Canada has a stronger chance of a rate hike given the last increase was in July. A still low cash rate and heightened oil and currency related inflation pressure suggest the RBNZ will also hike rates this week despite having raised rates early last month.

The US earnings reporting season also rolls on this week, with more major technology announcements. Microsoft and Alphabet report on Wednesday (US time) and Amazon on Thursday. After Meta’s punishment last week for its escalating AI spending plans, investors will be watching closely not just for stronger AI revenues, but also for what happens to capital spending and free cash flow.

Microsoft’s Azure growth and spending plans, Alphabet’s cloud and Gemini economics, and Amazon’s AWS performance could therefore matter almost as much for the broader market as the Fed meeting itself.

Is the AI boom coming to an end? I still think it has further legs, given there’s still excess demand for AI computing capacity and the take-up of AI by end-users – business and consumers – remains in its early stages. That said, the investment theme will continue to suffer wobbles as the high cost of the AI rollout becomes evident, competition intensifies and ultimate AI adoption remains uncertain.

After a brief rebound in relative performance over recent months, popular AI trades underperformed again for the second week in a row. Broadly speaking the “AI trade” has been on the nose since mid-June, with underperformance by Japan, emerging markets and the Nasdaq 100 evident. While there have been concerns over AI capex and debt funding, the pullback has also broadly coincided with the leap higher in oil prices and bond yields over this period.

Local equities edged back only modestly last week, despite heavy declines in both technology and materials. Investors gravitated toward more defensive sectors, like health care, staples and even property.

Global tech jitters are rebounding back onto the local resources sector, with investors fearing weaker commodity demand if the AI investment boom tapers off. Fear of inevitable Fed tightening and a firmer $US also continue to undermine gold and gold miners.

In terms of economic events, RBA Deputy Governor Andrew Hauser sounded yet another warning on the inflation and interest rates outlook. He conceded this week’s underlying inflation report is likely to be “materially worse” than what the RBA expected back in August, adding that the Bank faced “difficult choices” in balancing upside risk to inflation expectations and downside risk to economic growth. RBA Chief Economist Sarah Hunter said as much again in a 60 Minutes interview that aired last night.

As noted above, the deterioration in risk sentiment in recent weeks has undermined the performance of resources, leaving investors to favour financials as a “safe haven” trade. Of course, that’s despite the fact the local economy and credit growth is slowing, and house prices continue to slump.

Along with financials, sectors considered defensive and in favour include health care, utilities, consumer staples and property. In terms of factors, local quality continues to steadily outperform.

The key local event this week is of course the September CPI report on Wednesday. The market expects the quarterly gain in trimmed mean inflation to be 1.0%, which would meet Hauser’s definition of a “materially worse” outcome than the Bank’s 0.8% forecast in August. To my mind, that should be enough to cement the case for a rate hike next week, even though the Bank arguably already delivered a pre-emptive rate hike in September in response to “materialising” upside inflation risks.

Have a great week!