Tom Stevenson, Investment Director at Fidelity International, notes a sharp improvement in investor sentiment at the start of the week as movement in Washington towards ending the Federal shutdown helps markets claw back last week’s heavy tech-led losses.
Tom Stevenson, Investment Director at Fidelity International comments on what’s driving markets this week:
“Investors have come out of the weekend in a much better mood than they entered it.
“Last week ended very much on the back foot, as AI-focused US tech stocks lost close to $1trn in value in the worst week for the sector since Donald Trump’s tariff announcements in April.
“But markets rallied on Monday after the US Senate began moves to end a month-long shutdown of the Federal government. Germany’s Dax was up 1.5%, building on a strong recovery in Asia, where South Korea’s Kospi index was 3% higher and shares in both Hong Kong and Japan rose more than 1%.
“Eight Democrats crossed party lines to endorse a compromise plan that keeps the government funded until the end of January, reversing lay-offs initiated by the White House last month.
“Resolution of the US government funding stand-off should help stabilise Wall Street after a wobble last week. The tech-heavy Nasdaq index fell 3% over the week, while eight of the biggest AI-related stocks – including Nvidia, Meta, Palantir and Oracle – shed $800bn as investors worried about high valuations, heavy expenditure that may or may not earn a decent return and the growth of debt-funding with echoes of both the dot.com bubble and financial crisis.
“Worries about tech are not linked to the government shut down but they were accentuated by an unclear economic backdrop as the longest-ever federal government shutdown has limited the flow of data, making investors nervous that the labour market may be weakening faster than the markets expect.
“Consumer sentiment, as measured by the University of Michigan’s index, fell to a three-year low in November, adding weight to concerns that the US economy is fracturing along wealth lines. The richest are benefiting from a buoyant stock market while the poorest are suffering from a persistent cost-of-living crisis.
“The uncertain economic environment makes it harder to justify the surge in stock markets since April, which has taken benchmarks all around the world to new highs.
Earnings strength offsets valuation fears
“One of the reasons why markets have performed so well this year is that corporate earnings have continued to defy fears that tariffs would hit companies’ profits. As we approach the end of the third quarter earnings season, it is clear that businesses are handling the new trading environment much better than anyone could have hoped.
“Having entered the July to September results round with forecast earnings growth of 7%, it is now clear that the quarter will instead deliver growth of around twice as much. Earnings often emerge higher than expected at the start of a results season but the scale of the outperformance this time is unusual.
“The strong third quarter means that calendar year estimates have now risen to around 11.5%. And the good news on company profits is not limited to the US either. Estimates for the rest of the world are also rising and closing in on the US. That’s led to outperformance by non-US stock markets too. The gap between the two is wider than at any point since 2017.
“Strong earnings go some way to answering investors’ concerns about valuations which on the smoothed, cyclically-adjusted CAPE measure stand higher than at any point in the past 100 years except the peak of the dot.com bubble.
“Knowing what the right valuation should be is an inexact science, but back of the envelope calculations provide some pause for thought. Earnings need to grow very strongly indeed (and faster even than the current rate) to justify the current level of the market. Or looking at the question another way, the market needs to fall back considerably to fit in with the reality of today’s earnings trajectory.
Bubble talk remains muted – for now
“However you look at it, the market is priced for perfection. A lot is riding on hopes for the productivity enhancements that AI can bring. Perhaps artificial intelligence will be the game-changer that the optimists believe, but the numbers suggest that it needs to be if investors are not to be disappointed.
“The more encouraging news is that talk of another bubble still looks wide of the mark. Between 1998 and 2000 the valuation of the 50 biggest stocks in the S&P 500 doubled from 20 to 40 while those of the other 450 stocks remained below 20. This time around the gap between the two is much narrower – 29 versus 24.
“Other measures suggest an absence of the froth that pervaded markets 25 years ago. The market is less far above its long-term trend than it was then. Sentiment, too, is less stretched than it was then even if there are pockets of excess today.
“So, the current level of the market and where we stand in the market cycle are hard to read. It is entirely possible that the market could power ahead as a real bubble starts to inflate. Equally, markets could start to price in a slowing consumer economy and decide current valuations are just too high in that more sluggish context. A third alternative is that things just muddle along, with decent earnings growth offsetting valuation fears.
UK data in focus ahead of Bank decision
“The UK is in focus this week from an economic perspective. Investors will be looking to labour market data on Tuesday and GDP figures on Thursday for clues about the state of the UK economy and where the Bank of England might head next when it sets interest rates for the last time this year next month.
“The central bank held rates steady at 4% in a knife-edge decision last week but governor Andrew Bailey hinted that a December cut could be on the cards if a disinflationary trend is confirmed by upcoming data releases.
“Unemployment is forecast to have risen slightly from 4.8% to 4.9% in the three months to September and wage growth is expected to have edged down from 4.7% to 4.6%. Meanwhile GDP growth is expected to slow slightly from 0.3% to 0.2% in the three months to September.
“Much could depend on what Rachel Reeves has to say in the Budget in two weeks’ time. A rumoured hike in income tax would clearly be a disinflationary measure that might convince the Bank that the time has come to ease policy again.”
