US Strategy Weekly: AI Under Pressure

This is an interesting point in time since we are only one week away from the potentially pivotal presidential debate between Vice President Kamala Harris and former President Donald J. Trump. It is only two weeks away from the Federal Reserve’s September FOMC meeting which is widely expected to produce at least a 25 basis point cut in the fed funds rate. And it is merely two months away from the presidential election which, despite the conclusions of several political polls, seems impossible to predict. Nevertheless, the outcome of the presidential and Congressional elections could produce quite different consequences in terms of America’s role in the global political and economic arenas and its domestic economic and fiscal health. Therefore, we are not surprised that equities sold off this week. Markets can handle good news or bad news, but it has never dealt well with uncertainty.

Seasonality also shows that September tends to be the worst-performing month of the year, and we think this may have something to do with the fact that analysts shift their focus from this year’s earnings to next year’s earnings during this time frame. Although this may not be an issue in 2024 since analysts have already shifted their sights from 2024, to 2025 and 2026 earnings! One study shows that equity performance in September and October has often been a forecaster of presidential elections. See page 10. Still, early September news items have not been helpful to the market’s seasonality funk.

Technology stocks have been under pressure due to legal problems that have been compounding all year. The Department of Justice recently sent a subpoena to NVIDIA Corp. (NVDA – $108.00), along with other companies, as it deepens its enquiry into antitrust practices in the chip industry. The DOJ began this investigation after receiving complaints from competitors that NVDA abused its market dominance. Moreover, last week the company indicated it received requests for information from regulators in the US, EU, UK, China, and South Korea, regarding its investments, partnerships, and agreements with other companies.

And NVDA is not the only AI company under a microscope. An early August court ruling concluded that Google violated antitrust law by creating an illegal monopoly and spending billions of dollars to become the world’s default search engine. This federal ruling now paves the way for a possible breakup of Google’s parent Alphabet Inc. C (GOOG.O – $158.61) which could change the landscape for online advertising, an area Google has dominated for many years. The Department of Justice also sued Apple Inc. (AAPL – $222.77) back in March, accusing the company of using a monopoly in the smartphone market to block competition, inflate prices for consumers and stifle competition. Last year the Federal Trade Commission (FTC) and 17 states sued Amazon.com, Inc. (AMZN – $176.25), accusing it of protecting a monopoly by squeezing sellers on its marketplace and favoring its own services. The FTC. argued that these practices also harmed consumers and resulted in “artificially higher prices.” A judge in the US District Court for the Western District of Washington has set the trial for October 2026. In short, a rally based upon the belief that artificial intelligence will produce a boom in earnings for a variety of companies, is now finding itself mired in legal red tape.

It should also be noted that two of the biggest benefactors of the AI movement, Nvidia and Salesforce Inc. (CRM – $248.06), reported excellent earnings for the second quarter, but in both cases, it also became clear that the pace of earnings growth is slowing. For all these reasons, it is no surprise that a shift in leadership materialized in recent days — away from technology and toward defensive stocks. This shift is what drove the Dow Jones Industrial Average and the NYSE advance/decline line to new highs at the end of August. See pages 11 and 13.

The main event this week will be the Friday jobs report, and it will be the last read on employment before the Fed meeting. But recent economic releases have been mixed, at best. The National Association of Realtors’ pending home sales index for July was 70.2, the lowest reading since the pandemic low of 70.0 in April 2020. And since this indicator only began in 2018, it was the second lowest reading in history. The housing sector typically represents 15-17% of total US GDP and is an important segment of the US economy. A recent string of housing data suggests this segment of the economy is slowing significantly. The big question is whether or not lower interest rates will revive the housing market. See page 3.

The ISM manufacturing index rose to 47.2 in August from 46.8 in July but has been stuck in “contraction” territory below 50 for 21 of the last 22 months. Note that readings below 50 are typically associated with recessionary periods. The details of the report were mixed with 8 of 11 components below 50 and 4 of 11 components falling in August. New orders and production indexes fell while the employment index improved to 46.0, albeit from a very low 43.4. The ISM service index will be reported later this week, and it dropped below the pivotal 50 benchmark in two of the last four months. See page 4.

The PCE deflator was the focal point of last week’s economic releases. In July, the headline and core PCE price indices were in line with consensus expectations and remained unchanged at 2.5% YOY and 2.6% YOY, respectively. However, both indices were fractionally higher in July on a year-over-year basis but after rounding to one decimal, remained equal to June’s readings. The PCE price index that excludes food, energy, and housing rose to 2.1% YOY versus 2.0% YOY in June. The housing index was 5.3% YOY versus 5.4% in June. The services index was 3.7% YOY versus 3.8% YOY in June. The healthcare index fell from 2.8% YOY to 2.4% YOY. The PCE price indices for durable goods were negative on a year-over-year basis for the 14^th consecutive month. See page 5.

Second quarter GDP was upwardly revised from 2.8% (SAAR) to 3.0%, which was more than double the 1.4% recorded in the first quarter. The second quarter’s pace was not far from the long-term average of 3.2%. Some of this strength was due to inventories, which had been a drag on growth in the first quarter but were additive to the second quarter. Consumption was the main source of strength in the second quarter, but government spending also increased. Fixed residential investment was slightly negative in the second quarter. This makes the low reading in pending home sales more worrisome, since it suggests that the third quarter began on an even weaker note. See page 6. The second revision of GDP also includes corporate profits. GDP corporate profits, before taxes and adjustments, rose a healthy 11.7% YOY after being up 10.2% in the first quarter. After taxes and with inventory valuation and capital consumption adjustments, profits rose 6.6% YOY, which followed a 5.3% gain in the first quarter. However, second quarter profits were negative in 2023 making this year’s comparisons relatively easy. Nonetheless, these results are in line with S&P 500 operating earnings which rose 5.4% YOY in the same quarter. It is reassuring that GDP and S&P corporate profits are moving in unison since disparities between the two series are often a warning sign for the S&P 500. See page 7. Nevertheless, despite the market’s selloff, the S&P trailing 4-quarter operating multiple is 24.2 times, and well above all long- and short-term averages. The 12-month forward PE multiple is 20.7 times and when added to inflation of 2.9%, sums to 23.6, which is at the top of the normal range of 23.8, this week. By all measures, the equity market remains richly valued. See page 8.

Gail Dudack

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