It may be drawing a long bow but it now seems plausible that, just below the surface, AI inspired optimism has helped markets remain surprising resilient throughout this year, particularly when facing the US regional banking crisis that started in mid-March and more recently the polemic surrounding the US Debt Ceiling. In both cases most commentators have been surprised by the lack of volatility in equity markets. Of course the general strength of the US economy, listed corporates and consumers will have helped but these all mitigate for higher rates which can cause as much or more volatility than changes in the fundamentals of GDP, earnings and consumer spending. Productivity gains on the other hand are much more of a win/win and large language models like ChatGPT have continued to surprise even their creators all year and software engineers and business leaders alike are starting to see the real-world applications. In markets, May 2023 was the month that the AI theme really broke cover in markets. Nvidia’s blow-out result at the end of the month seemed to cement the notion that this theme represents more than just hope about the future - people are using the technology and others are making vast sums of money.  However, it still remains early days and opportunistic capital has gravitated to an arrow subset of large US tech titans and smaller, mainly US domiciled, software/hardware stocks that are seen to have a network and first-mover advantage respectively. As a result, overall market gains excluding these stocks were actually fairly muted for the month, and indeed for the year to date, while the technology-based Nasdaq was up 10% (and some 30% for the year). Most other markets, with one exception, were actually in negative territory in May. The exception was Japan, which has been quietly growing earnings momentum for the last few years but really took off in early May as Warren Buffet’s interest seemed to spark investor enthusiasm. As the debt ceiling negotiations progressed and a resolution seemed imminent a much broader rally in markets gathered pace in the last few days of last week, after the month end.

The narrowness of markets has also led to wide dispersion within styles as exposure to a handful of these very large tech stocks has had an outsized impact on relative performance even within similar styles. For example, if you were a growth manager with the trifecta of Nvidia, Tesla and Broadcom at say, a 5% weighting, you would have outperformed by 4%just due to these positions alone. This is the culmination off a trend that has been becoming ever more dominant in the first half of the year and if your trifecta had been Nvidia, Meta and Advanced Microsystems since the start of the year then the relative gains for the year would have been almost 20%. Holding overweight positions in 3 or 4 stocks from a list of around 10 very large stocks that are up 50% or more year to date (like Microsoft and Google/Alphabet) would have yielded pretty similar results, but not owning any of just those 10 stocks would have left you well below the benchmark. That means that most growth managers have outperformed but the outcomes range from modest out performance over a 3% return from world markets to outperformance of15% or more. Most value managers underperformed but formed a tighter group underperforming by a few percent and ending flat for the month. The question for growth focused managers is now whether the market has got ahead of itself with all the flows being directed at the most obvious AI beneficiaries or whether AI really is going to be a winner takes all situation. Value managers on the other hand may be wondering whether and when all this hype will flow through to the bottom line of the corporate users of AI. Either way there is mounting evidence that this will have a beneficial impact on productivity which has been languishing, not least in Australia.

The worst performing market was the UK where the FTSE 100 was down more than 5%. While the headlines about inflation and the onset of a wage price spiral won’t have helped sentiment it was really the negative performance of the large global energy, banking and consumer staples stocks in this index that drove the lackluster returns. While Australia was down over 2% last month this was pretty much in line with most other markets (including the US ex-IT stocks), which all traded more or less in-line without moving very much either way. However, the trends were similar to the UK with the large banks and materials stocks weighing on returns as, outside of some large US tech stocks, the world weighs up the impact of a likely recession later this year or in 2024 (most survey’s and quantitative frameworks put the probability of recession in the next 12 months at around 75%). As these expectations firmed, energy prices and most other commodities were also on the back foot during the month with modest declines across the board.

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The other main talking point in markets is the fact that bond yields have started to drift up again. The US market sets the tone and there is growing recognition that there are pockets of stubborn, mainly services based, inflation that may force central banks to maintain current levels of interest rates and even lead to more rises. Even the debt ceiling deadline has passed without too much bond or equity market drama but it has forced the US government to run down its cash account (the Treasury General Account). The US Government will now have to issue more debt to rebuild these reserves and that is also putting upwards pressure on yields. Over the past month or so this has led to increases in short-term rate expectations in the US with one or two more 0.25% rises expected in the US by year end. In Australia similar conditions have led to an expectation of one more 0.25% hike as opposed to hopes for a reduction of rates by 0.25% in 2023 just a few weeks ago. This means rates are now expected to peak in the US and Australia at about 5.25% and 4.25% respectively by year end. After that time, they are expected to decline suddenly as that recession kicks in. Anything either side of this prognosis could surprise quite a lot but for now corporate bond spreads (often the canary in the recessionary coal mine) have remained sanguine, even tightening slightly in May.    

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