Navigating Choppy Markets!

After a generally constructive first half of the year, the North American markets witnessed increased choppiness in price action during the month of June which was driven by a few dominant narratives. First, investors questioned whether the capital expenditures to build Artificial Intelligence infrastructure has peaked and if the sell-off in software stocks on fears of disintermediation is overdone. Second, the new Federal Reserve chair, Kevin Warsh, held his first press conference after the (Federal Open Market Committee) FOMC meeting on June 17 and delivered a hawkish message with repeated emphasis on bringing inflation under control. The new Fed chair also did not submit his projection for the dot plot given his view that Fed should move away from providing forward guidance. This led investors to question if going forward there will be less clarity on the Fed’s reaction function. Third, while the war in middle east appeared to be finally reaching a point where a narrow path to truce was visible, the sticking point of control over ‘Strait of Hormuz’ remained unresolved leaving the memorandum of understanding (MOU) on risk of being breached.

Year-to-date, semiconductor stocks have done the heavy lifting to help the performance of the broad indices. With exponential growth in capital expenditures for the build out of Artificial Intelligence infrastructure; semiconductor companies have seen their revenue and earnings growth expectations soar and so have their stock prices. Semiconductors is a highly cyclical industry and follows a boom-and-bust cycle, where bust typically starts at the peak of earnings. Broadcom and Micron both reported better-than-expected revenue and earnings growth in June, however, this did not stop investors from selling the shares as they speculated if a peak has been reached. Profit booking on the year-to-date winners benefitted the year-to-date laggards as investors rotated to the areas offering the relative safety of better valuations. We note that several of these highly cyclical companies have taken advantage of current supply-demand dynamics and signed long-term contracts that provide them with a better control over earnings through the cycle. Looking ahead, we think the debate on cyclicality vs durability of earnings will keep the industry price action choppy, however, earnings growth expectations continue to make a case for constructive outlook, in our opinion.

The newly elected Fed Chair, Kevin Warsh, delivered a hawkish message to the industry participants and committed to keeping a staunch focus on bringing inflation under control. He committed to bring about a regime change to the Fed by constituting five task forces that take a fresh look at the Fed’s communication strategy, balance sheet, data sources, artificial intelligence and its impact on productivity and jobs; and inflation targeting framework. The new Fed chair holds the view that central bank should not be in a business of providing forward guidance. By telegraphing a predetermined path, the Fed allows market participants to adjust their expectations in advance and influence markets. Instead, he prefers the market data should guide policy decisions. To this end, he abstained from participating the in the Fed’s dot plot exercise that signals potential path the policy rates might take. While the US president has well communicated his wishes to see the policy rates lowered, the sound bites from the new Fed chair and projections of other FOMC participants are signalling the lean towards a more hawkish stance (see Figure 1). Overall, we think the new positioning of the Fed alleviates concerns around the independence of the Central Bank but introduces a new uncertainty around the Fed’s reaction function to the incoming data.

Figure 1: Federal Open Market Committee (FOMC) Dots Median

Source: Bloomberg

The hopes of peace in the middle east and easing of pressure on oil prices did not last long. As of this writing, both sides have started full scale attacks on each other and the US President has stated the United States is at war. Nymex WTI Crude oil prices hovered around USD 90/barrel at start of June, dropped to about USD 70/barrel at the end of June, and has now jumped to ~USD 79/barrel as of this writing. We think the expectations of lower headline inflation going forward after the oil prices had softened during the past couple of months since the start of conflict will likely get revised in the coming weeks. Further, the probability of oil prices staying structurally higher driven by higher geopolitical risk has increased, in our opinion. The control of ‘Strait of Hormuz’ remains the sticking point in negotiations where Iran wants to firmly establish its control over right of passage and collect a toll; while United States had earlier stated its wish for it to remain free of any tolls.

Overall, we think North American equity markets could continue to experience choppy trading on the ebb and flow of developments around these narratives. That said, the outlook for earnings growth remains positive keeping the case strong for a net constructive price action through the end of the year, in our opinion.

Source: Bloomberg

Vipul Arora is a Portfolio Manager with CI Assante Wealth Management Ltd. The opinions

expressed are those of the author and not necessarily those of CI Assante Wealth

Management Ltd. Please contact him at 613-258-1997 or visit ofarrellwealth.com to discuss

your circumstances prior to acting on the information above. CI Assante Wealth Management Ltd. is a member of the Canadian Investor Protection Fund and the Canadian Investment Regulatory Organization. Insurance products and services are provided through Assante Estate and Insurance Services Inc