Ketu Desai
By Ketu Desai
There was an important shift in the market narrative this month. We shifted from an expectation of recession and disinflation to the economy regaining its footing with a higher steady state level of inflation. Atlanta Fed GDPNow shows a whopping 5.6 percent growth rate for the third quarter. 10-year break-evens (a proxy for average expected inflation) have steadily climbed since July. The yield on the 10-year and the 10-year TIPS hit the highest level in more than 10-years.
Rising energy prices, new union contracts, infrastructure spending, the government deficit, and significant government debt issuance are some of the factors driving yields and inflation expectations upwards. Union contracts are illustrative of the bigger picture of an economy transitioning power from the few to the many. We have seen strikes or workers threaten industry action from the pilot associations at major airlines, the Teamsters Union at UPS, Workers United at Starbucks, the International Association of Machinists and Aerospace Workers, both writers and actors strike, and the UAW at major automakers.
We are seeing the lowest income households with the highest wage growth. Growth in unemployment payments is growing fastest at the high end and slowest at the low end. Similarly, the highest savings growth is at the low end. Longer-term, AI will help accelerate this transition as knowledge work faces disruption. The bottom line for the economy is that with the many experiencing wage growth with low debt levels and high savings combined with nearly $2 trillion in infrastructure spending coming, the economy remains well supported and we are in a higher for longer regime.
The market rally so far this year has been led by a few large cap technology companies. The rally for large cap tech this year has come in three phases. The first phase was driven by positioning. The second was a flight to balance sheet safety driven by the regional banking crisis. The most recent phase was driven by AI.
I suspect in the fourth quarter we will see a FOMO rally in large cap tech. The rally in large cap tech has led to a historic more than 10 percent gap between the equal-weighted S&P versus the market-cap weighted S&P. While positioning is very high, their weighting in the S&P is reaching the peak level, and valuation is high, it remains unlikely that there is a broad reallocation out of large cap tech. There is a large cap tech put due to their balance sheets and upside from AI.
The change in narrative has been in secondary and tertiary tech names. We have seen many of these names go down double digits with certain names down more than 20 percent over the last month. The negative earnings reaction to names such as Fortinet, Marvell, AMD, Qualcomm, Datadog, Palantir, PagerDuty, Snowflake, Ambarella, Box, HP, and The Trade Desk has been telling. These types of moves suggest that a lot of good news might already be priced in technology and that it might make sense to be more selective.
The current pricing in markets is for structurally higher rates. The environment since 2010 can broadly be characterized as low inflation, low rates, and low growth, which makes companies with high growth worth a premium, thus driving valuation for tech. Tech was in a rising tide lifts all boats environment. As the environment changes to higher for longer, tech investing will require more selectivity. Tech moves from a beta sector to an alpha sector. Valuation becomes more critical when rates are higher. The dominant theme in technology is AI, which appears to be the next major super cycle in investing. However, unlike previous super cycles, the capital expense and the necessary data and cloud infrastructure will mean a narrow number of winners within technology. From a portfolio perspective, a barbell of the narrow potential tech AI winners with cyclicals provides protection against many scenarios.
The AI winners provide you with a winner across nearly all economic scenarios, while the cyclicals provide significant upside, cheap valuation, and are a hedge to technology. As rates continue to stay high, we will have fewer winners in technology and many winners in the rest of the market.
Looking forward, the market will focus on the economic data, the Fed meeting, and conference season.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. [email protected]
