Dear Investor
General Market Overview
Last quarter, we wrote about the dominance of the “Magnificent Seven”, which continues to constitute an increasing portion of the Standard & Poor’s (S&P) 500 index performance. There are now some interesting comparisons to give a “sense of scale” to the market capitalisation (market cap) and performance of the Magnificent Seven. According to Deutsche Bank, the Magnificent Seven, if listed by themselves, would make the second-largest stock market in the world. Their market cap is more than double Japan’s market cap and four times bigger than France’s market. Apple’s market cap is the same size as the entire United Kingdom (UK) stock market, and Microsoft’s market cap is almost five times the size of Italy’s entire stock market. There is, of course, a concern given the market concentration of the index. The top ten stocks now account for 75% of the index’s market capitalisation - the highest concentration level since the Great Depression.
In terms of performance, Nvidia (and Meta to a slightly lesser degree) have risen so markedly since 2023 that they make the performance of the others look a little lacklustre. Before the launch of ChatGPT, Nvidia was the laggard in terms of the market cap of the Magnificent Seven but given the stock market performance over the last 12 months, it is now the third largest among them with a market cap of just above $2 trillion.
Nvidia’s performance has become a proxy for Artificial Intelligence (AI) demand, which is dependent on Nvidia’s leading chip, the H100. Meta, just one of Nvidia’s “big tech” customers, intends to bring its total stock of H100 chips to 350,000 in 2024. Currently, Nvidia’s primary constraint is the ability to meet the demand from Meta and others. Founder and CEO of Nvidia, Jensen Huang, said, “Nvidia has enabled a whole new computing paradigm called generative AI…our highly-prized chips are “essentially AI-generation factories” of a new industrial revolution.”
The other noteworthy index performance over the quarter was a new high for the Japanese index, the Nikkei 225. Given the recent new highs of United States (US) indices, the Nikkei’s achievement is interesting because it’s taken 34 years. The Nikkei reached a high in December 1989 (just after the fall of the Berlin wall!) that has only just been surpassed. In a clear example of bear-market-arithmetic, the 82% fall from the December ’89 peak needed an almost 460% increase to achieve a new high.
Despite the continued equity market performance of the US headline indices, many market participants remain fixated on the actions of the US Federal Reserve (the Fed). Recently, the expectations that monetary policy easing (rate cuts) were highly likely, changed.
There was a degree of euphoria in December following the Federal Open Market Committee (FOMC) meeting as the market started pricing in a pivot in the increasing interest rate cycle, but following the end-of-January meeting, Fed officials commented that there would be no rate cuts until they “have greater confidence that inflation is moving sustainably towards the goal of 2%”.
The US inflation rate was 3.1% in January, significantly lower than the 9.2% peak in July 2022 but still ahead of the Fed inflation target of 2%.
In a recent Bank of America Fund Manager Survey, the percentage of fund managers expecting higher global inflation and higher short-term rates is now very low. This survey indicates market expectations that inflation has peaked; however, it may still take time for central banks to have the assurance that inflation targets will be met and feel comfortable to cut rates.
The Fed’s probability of cutting rates by 25 basis points (bps) is extremely low following the March meeting, with around a 30% chance of a cut in May and a two-thirds, or 68% chance of a rate decrease by June. These odds are calculated by the Chicago Mercantile Exchange Fed watch tool using the pricing of Fed Funds Futures contracts.
Within the global economy, given the interdependence of trade, monitoring shipping freight costs and transit times gives some sense of the friction in international trade. There are currently two simultaneous chokepoints for global shipping logistics companies: the Panama Canal and the Suez Canal.
Since mid-December, the regional conflict has steadily reduced shipping traffic through the Gulf of Aden and the Red Sea. Around 12% of global trade passes through the Suez Canal, but the Iran-aligned Houthi movement, which controls most of the populated parts of Yemen, began attacking vessels in what it says is support of Palestinians in Gaza. These attacks have prompted shipowners and operators to divert ships, primarily by going around the Cape of Good Hope.
At the same time, warm, dry weather and low water levels resulted in the Panama Canal Authority reducing the number of daily transits through the Canal, significantly increasing waiting times. A container ship voyage from China through the Panama Canal takes 34 days without delays versus 40 days through the Suez Canal and 47 days to bypass Africa. There are as many as 30-day delays to pass through the Panama Canal, translating to a 60+ day journey from China.
Ship operators try to pre-book slots through the Canal, but no slots are available until mid-April. Those pre-booked slots are currently being auctioned off, up to $4 million for the slot. Shipping costs eventually pass onto the product, meaning all products that move on a ship, which is 80% of all goods, will feel the effects of tightening bottlenecks.
Within commodity markets, those with a sweet tooth are likely to experience some price pain. Wholesale cocoa prices are above $6,000 per tonne, an increase of 120% within the last 12 months. Interestingly, 75% of the world’s production comes from Côte d’Ivoire, which accounts for 2 million tonnes of cocoa beans against global demand of 5 million tonnes. The beans are grown mainly by small subsistence farmers who lack the financial means to invest in fertilisers and replanting trees. As a result, many of the Ivory Coast cocoa trees are old and old trees mean low yields and greater vulnerability to weather and pests.
What is being experienced in the cocoa market is a classic example of a mismatch between demand and supply, resulting in a price explosion. 2024 will likely be the third consecutive year of a supply deficit, leading to a further fall in inventories. Customers should expect price increases and chocolate bar size shrinkage in supermarkets; sorry chocolate lovers.
General Conclusion
Over the longer term, broad macroeconomic factors influence the prices of all asset classes. The macro-interplay between supply and demand in commodity markets gives rise to cyclic price action while in other financial assets, interest rates are a crucial price driver. Expectations about future earnings or cash flows are discounted at the prevailing interest rate; the availability and ease with which consumers and businesses can obtain credit depends on interest rates, and monetary policy remains a primary tool for global central banks to manage and achieve their inflation targets.
Therefore, despite the impressive global equity market performance, attention remains on the Fed’s actions. The expectation of imminent monetary policy easing has recently shifted, with the Fed indicating no rate cuts until inflation aligns with the 2% target. With US inflation at 3.1% in January, while far lower than the peak, while it remains above the Fed target, the market is pricing a more conservative approach to rate cuts.
An environment where interest rates are higher for longer means that the discounted earnings and cash flows of equity markets give rise to lower current valuations. The outsized performance of a highly concentrated group of stocks that incorporate a large component of “future expectation” is certainly worth some caution.
08 March 2024