Q2 2024 - Market Review
ECONOMIC COMMENTARY
The equity markets’ rally which started in late October came to a screeching halt in April when inflation and wage growth data in the United States came in above consensus. This also caused bond yields to approach multiyear highs reached last fall. That being said, as the quarter progressed, losses reversed on the back of a strong earnings season and more economic headlines that showed that the economy was indeed slowing, reviving hopes for imminent rate cuts. In the end, equity markets posted mixed results. On the one hand, the MSCI All Country World Index[1] and the S&P 500 Index advanced 3.35% and 4.18% respectively, during the quarter. On the other hand, the S&P/TSX Composite declined by 0.53%. As it has been the case since early 2023, the performance of the broad US and Global equity indices masks the performance of the average underlying stock. To illustrate this, consider that the S&P 500 Equal weight posted a return of -2.77% during the quarter, nearly 7% less than its market capitalization weighted counterpart. The lack of market breadth continues to affect small capitalization and value equities which underperformed large cap indices by a significant margin.
Fixed income markets were also mixed. To be specific, the ICE Bank of America Global Government Bond Index, the ICE Bank of America Global Corporate, and the ICE Bank of America Global Corporate & High Yield Index returned -0.84%, 0.18%, and 1.37%, respectively. In Canada, the ICE Bank of America Canada Broad Market Index gained 0.98% due to less robust growth prospect than in the United States, which the Bank of Canada confirmed when it delivered a much anticipated rate cut in early June.
ONE THEME TO RULE THEM ALL…
In J.R.R. Tolkien’s medieval fantasy story[2], the inscription on the One Ring entrusted by Gandalf to Frodo read:
“One Ring to rule them all, One Ring to find them, One Ring to bring them all, and in the darkness bind them.”
This One Ring was the most powerful artefact ever crafted in Middle-earth and those black speech words symbolized the ascendency of this ring over everything. The reason to bring this up is that this is what Artificial Intelligence has become, in my mind. An idea that dominates all others. To this point, Artificial Intelligence, as an investment theme, seems to have supplanted all other pre- and post-pandemic popular investment ideas including blockchain and related fintech themes, meal kit, cybersecurity, plant-based meat, as well as everything related to electric vehicles. The dominance of the Artificial Intelligence theme is witnessed in many ways.
Most searched keywords analysis on Google Trends.
Diminishing breadth of the equity markets rally in the past few months. In effect, the percentage of S&P 500 constituents that are outperforming the index year to date through June 30th stood at a 50-year low[3].
Elevated multiples of forward earnings valuation ascribed to companies involved in the manufacturing of semiconductors, the industry which has by default become the most direct expression of the theme. For instance, the S&P 1500 Semiconductor Index[4], which did not trade at multiples of forward earnings exceeding 25x at any time from 2010 to 2019, traded at 40x on June 30th[5].
Low S&P 500 realized volatility in spite of ongoing uncertainty concerning trade relations with China (which may impact semiconductor supply chains) and high interest rates. To be more specific, after reaching levels of 65% in Q2 2020 and nearly 30% three years ago, the 60-day realized annualized volatility of the S&P 500 had collapsed to less than 11% on June 30th[6], just a few percentage points shy of the prior decade lows.
Attraction gained by recently launched single stocks leveraged ETFs[7] and Magnificent 7 ETF[8].
All the above suggests that the Artificial Intelligence theme has been gaining momentum at the expense of everything else. Still, it is all anecdotal and the same arguments existed a few months ago. In other words, there is not much new apart from the sense that excesses have gotten worse and that the trade has gotten even more crowded, as a recent Bank of America Global Fund Manager Survey suggested[9]. Nonetheless, David Cahn (a Partner at the VC firm Sequoia), in a recent study[10], attempted to put a dollar amount on the size of the Artificial Intelligence bubble that has been growing. Using basic math, which looks at the implied revenue expectation derived from Global Processing Units (“GPU”) sales (for which Nvidia’s H100 superchips are a good proxy) and actual revenue growth in the Artificial Intelligence ecosystem (for which OpenAI and ChatGPT™ are good proxies), Cahn estimates that the revenue shortfall has grown to approximately 600 billion per annum at today’s capital expenditure levels. In other words, revenues are nowhere near where they should be considering the upfront cost.
I don’t know when this bubble will start to deflate, but given how it formed in the first place, I increasingly think it might look like a replay of the network and telecom equipment manufacturers in early 2000. To be precise, it could start with an earnings miss and lowered guidance by one of the Artificial Intelligence poster children, which could trigger a wave of downward revisions from the sell side.
When I translate these views into our risk factor framework, it means that on a 3- to 5-year view, our excess return projection for US equity exposure relative to the rest of the world equity exposure, and our return projection for growth-oriented exposure relative to other style factor exposure, are turning lower.
What that means is that in discretionary portfolio mandates where we have that flexibility, we have started reducing exposure to fund managers that have become too enthusiastic about Artificial Intelligence in favor of other public equity strategies.
It is risky to go against the most successful theme in recent years because, in this line of work, we get rewarded for delivering above-benchmark returns, not for delivering superior risk-adjusted returns or for having planned for various adverse scenarios that never materialize. Investors look at the performance of their portfolios relative to that of a reference portfolio. If the portfolio returns fall too far behind for too long, the investor is more likely to conclude that the actions (or inactions) of his or her advisor resulted in missed opportunities more than superior risk control efforts. This introduces a perverse reaction function because when an advisor senses that he or she is at risk of losing a client’s business due to prolonged underperformance, he or she may attempt to play catch-up with the benchmark when he or she should do the exact opposite.
While I neither have the bravery or motivation of a certain Frodo Baggins who carried the OneRing across an entire continent to the furnace of Mount Doom, I have a greater aversion to the risk of ending up like poor Sauron who waged everything on the One Ring.
MEDIAN VOTER THEOREM AND FISCAL STEWARDSHIP
CNN hosted the first 2024 US general election Presidential debate on June 27th. The unanimous view is that during that debate, President Joe Biden appeared weak and confused on too many occasions in contrast to former President Trump who was more convincing and surprisingly restrained. As such, in the hours following the debate, PredictIt[11] indicated that Former President Trump’s odds of winning the November Presidential election went from 55% to 58%[12], while President Biden’s odds went from 45% to 33%. PredictIt noted that no other political debate had such a significant impact since they started tracking that 9 years ago.
The next morning, Biden’s campaign went into full damage control mode while senior democratic party leaders were openly calling for Biden to be replaced on the ballot. The reaction of the equity markets was rather muted, but the US Treasury market appeared to temporarily seize with the yield on the US Ten Year Treasury Note, jumping from 4.28% to 4.48% over the following two trading days on speculation that a second Trump term would cause the fiscal deficit to balloon. This would become highly likely if some of the tax cuts implemented during his first mandate[13] and which are set to expire next year, were extended. We touched on this in the first quarter letter[14].
Could this be a market overreaction? Perhaps. After all, it is unclear to me that Biden would show more fiscal restraint. He certainly hasn’t so far. The US federal government deficit is projected to be 6.3% of GDP this year[15], higher than all other G7 countries except for Italy[16]. In reality, no US President or party has shown effective fiscal restraint in a while, in peacetime or not. The last time it happened was for a brief period during Bill Clinton’s late presidency and the last time before that was in the 1960s[17].
Americans do not like government debt. It is visceral. The question about the long-term sustainability of the government debt has always been a hot topic, yet nothing ever gets done about it. That is because there is one thing that Americans dislike more than government debt: taxes. Keep in mind that the War of Independence was fought largely by a desire to stop financing the British Crown. Also remember that when George Washington proposed a seemingly innocuous excise tax upon spirits distilled within the United States, it led to the Whiskey Rebellion of 1794. Maybe Americans have a higher aversion to taxes than others, but since government debt has been growing elsewhere as well, maybe there’s another explanation to this.
Political decision-making was a popular research field in the early twentieth century, but a major development came when Scottish economist Duncan Black proposed the Median Voter Theorem[18]. According to the Median Voter Theorem, in a two-party parliamentary system, the primary objective of the two political parties is to win the elections by maximising their popularity. The parties do so by adopting the preferences of the median voter. In other words, parties will tend to propose ideas that appeal to the greatest number of voters while at the same time antagonizing the fewest. The Median Voter Theorem cynically explains why there is a tendency, from government to government, to create new programs and improve existing ones by targeting new favorable audiences while postponing the discussion about their funding to not displease tax-sensitive voters. In a sense, elected officials simply want to spare voters real pain, and they will pursue that goal for as long as they are permitted to do so. But to the extent that voters remain unmoved by the fiscal profligacy of elected officials, financial markets participants will not always be. We just do not know when. For the moment though, the governments in western democracies continue to follow the guidance of the Median Voter Theorem.
In the early 1800s, however, nobody paid attention to the Median Voter Theorem, and when Thomas Jefferson took office, the United States had a debt of roughly 75 million, which approximated a debt-to-GDP ratio of 30%[19]. Yet, twelve years later, the United States’ debt had been cut in half. How did this happen?
What happened is that Thomas Jefferson appointed Albert Gallatin as Treasury Secretary in 1801. Gallatin was a Swiss-born diplomat who emigrated to the United States in 1780. His childhood experiences convinced him that public debt was:
…”a nursery of multiple public evils—corruption, legislative impotence, executive tyranny, social inequality, financial speculation, and personal indolence[20].”
Gallatin obsessed on the necessity to extinguish federal debt as fast as possible and implement a governance process that would ensure the Treasury Department’s accountability to Congress by diligently scrutinizing federal expenditures. That process became the House Ways and Means Committee, which Gallatin implemented during his tenure and which still exists today.
So how did Gallatin do it? First and foremost, by cutting government spending, notably the military budget. Second, by reducing grants and subsidies for projects which he did not deem useful for the advancement of the nation. Third, through the expansion of public land sales directly to settlers in order to generate revenues for the state. Fourth, by the improvement of the nascent tax collection system. Gallatin did not have the flamboyance of some of the founding fathers, but he nevertheless acquired the reputation of an extremely competent statesman. In fact, he was also retained by President James Madison as Treasury Secretary and served until 1814. Gallatin occupied the position longer than any other Secretary in the department’s history[21]. It was also Gallatin who organized the financing package for the 15 million purchase of Louisiana from Napoleon Bonaparte in 1803, which became absolutely critical for the United States expansion to the West.
In summary, what Albert Gallatin showed is that the uncontrollable growth of public debt is not a fatality. Fiscal stewardship is a thing. At the moment, the Median Voter Theorem rides high, partly because we won’t know, until after the fact, how high structural deficits have to be to trigger an interest rate or a currency crisis. Still, it would be better if we didn’t wait for a crisis to occur.
Dimitri Douaire, M. Sc., CFA
Chief Investment Officer
[1] Local currency returns unless specified otherwise
[2] Tolkien, J. R. R. (2004). The Lord of the Rings 50th Anniversary Edition. HarperCollins
[3] Source: S&P Dow Jones Indices
[4] An index that regroups 22 companies including Nvidia, Advanced Micro Devices, and Intel
[5] Source: Bloomberg
[6] Idem
[7] T-Rex 2X Long NVidia ETF (ticker: NVDX) which was launched in October 2023 and reached 700M US$ in assets on June 30th
[8] Roundhill Magnificent Seven ETF (ticker: MAGS) which launched in April 2023 and reached 550M US$ in assets on June 30th.
[9] BofA Global Fund Manager Survey, June 2024
[10] https://www.sequoiacap.com/article/ais-600b-question/
[11] Victoria University of Wellington (New Zealand) on-line political and financial prediction firm
[12] We note that former President Trump’s odds of winning the US Presidential election were boosted further in the high 60s after he survived an assassination attempt at a rally in Pennsylvania on July 13th.
[13] Tax Cuts & Jobs Act of 2017
[14] https://www.patrimonica.com/all-news/q4-2023-market-review-1
[15] Source: Congressional Budget Office, June 2024 update
[16] Source: OECD
[17] Source: US Treasury
[18] Black, Duncan, On the Rationale of Group Decision Making, Journal of Political Economy, Vol. 56, No. 1 (Feb. 1948), pp. 23-34
[19] The Atlantic, The Long Story of US Debt from 1790 to 2011, 2012
[20] Burrows, Edwin G. (2000). "Gallatin, Albert". American National Biography. Oxford University Press
[21] US Department of the Treasury archive