Last week was one of high drama and left global equities down around 2.5%, government bonds up 0.5-1% and crude oil down as much as 15%. The reason of course was the shock mid-term election results in the US which saw the Democrats gain much larger than expected majorities in both the House and the Senate.
As of writing, the Democrats have 254 seats in the House of Representatives versus 162 for the Republicans with 19 seats still to call. And in the Senate, they have 54 seats versus 44 for the Republicans and are fractionally in the lead in the two remaining states Mississippi and Alaska.
The market flip-flopped in its reaction to the Democratic blue wave – rising initially on the news, only then to more than reverse its gains the following day. It has form on this front – notably in 2016 when Trump’s Presidential win triggered an immediate market fall which was reversed in short order.
The initial gain this time was fuelled in part by relief that the results were clear cut enough to prevent any attempt by Trump to contest them. Democratic control of Congress also now heralds a period of policy gridlock – the Democrats still lack the two-thirds majority needed to overcome a Presidential veto – and divided government in the past has been associated with a somewhat stronger market performance than otherwise.
Finally, with the war against Iran a major factor behind the Republican losses, the results were perceived to reduce sharply the risk of new attacks by the US and Israel – even if foreign policy remains very much under the control of Trump rather than Congress. Indeed, Trump has now said he has no immediate plans to attack.
The market’s opinion on all of these fronts did not really change that much over the course of the week and the oil price remains at $97 per barrel, down from $115 before the elections. Rather, these positives were overtaken by worries that the Democrats will rein back the construction of new data centres. These were on the ballot box across 45 jurisdictions in ten states and in almost all cases were rejected.
US tech stocks fell heavily on Thursday with the Nasdaq index down 5.5% and semiconductor chip companies falling as much as 12%. This continued the waves of fear over the AI boom which have sporadically gripped the market over the last few weeks.
Last week’s fall, however, was rather larger and begs the question of whether it marks the start of an unruly deflation of the AI boom or bubble. Forced deleveraging by investors means market declines can gain a momentum of their own and the bursting of a bubble usually only becomes obvious with hindsight. But, while it certainly cannot be ruled out that this turns into a much more sizeable decline, our central view remains that this is still just a tail risk.
It’s early days but the fact that markets recovered a bit of their losses on Friday and have generally opened higher this morning is reassuring. The latest fall also just continues the reversal of the surge in chip stocks which has been underway since June, with the sector now down 35% from its high.
This sizeable decline has occurred without doing too much damage to the market overall. More fundamentally, there are several factors arguing against a major slide in equities:
First, the construction of data centres and tech earnings growth will not just stop overnight. Rather, the pace of construction will just slow – which may not be a bad thing given mounting concerns over the growing need to raise money from the markets to finance all this construction.
Second, the continued resilience of the global economy, particularly the US, remains a major support. Indeed, Friday’s US payroll numbers for October were considerably stronger than expected and showed the labour market remaining in good shape. This, along with the strength of the core business models of the tech titans, means corporate earnings generally and of the tech sector specifically should continue to see health growth, even if down from the stellar pace seen of late.
Third, global equity valuations have fallen significantly. Their price-earnings ratio has dropped from a high last year of just under 20x to 15.2x, leaving them no longer looking so obviously overvalued. Moreover, for the first time in ten years, the tech sector does not now trade at a valuation premium to the rest of the market.
Finally, if oil holds onto its recent decline, this will ease the pressure on central banks to continue raising rates. The market still expects the US Fed to increase rates a further 0.25% in December but is now looking for only one more hike next year rather than two.
Here in the UK, the BOE raised rates from 3.75% to 4.0% on Thursday. While the move itself was as expected, the Bank was more hawkish than anticipated. Eight of the nine MPC members voted for a 0.25% rise with one voting for a 0.5% hike and the Bank now sees inflation reaching as high as 4.9% in the spring. Governor Bailey pointed to at least one more increase with February looking the most likely date, although December is possible.
All in all, we stick to our view that this is not the time to sell up and head for cash. But we believe it is all the more crucial in this uncertain environment to have a well-diversified portfolio which will allow one to benefit if the market in time resumes its uptrend while providing some protection on the downside.
In this respect, it is worth noting that diversification did help last week to mitigate any losses. As already mentioned, bonds saw modest gains. And on the equity side, the UK was down only 0.4% while Europe was up 0.7% whereas the tech-heavy US and emerging markets lost 2.4% and 3.8% respectively. Even within emerging markets, diversification paid off with the recent laggards China and India gaining as much as 5% and 10% respectively.
It was the same story at the sector level with the tech sector down 7% last week but the rest of the market basically flat with defensive sectors such as consumer staples, real estate and infrastructure all posting gains of 1-2%.
This coming week, the main focus will be on the US October inflation numbers on Tuesday although the affair of Jensen Huang, Nvidia’s CEO, with an alleged Chinese spy will also no doubt be centre stage. On a rather less scurrilous note, we also have UK GDP data for September out on Thursday.
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