Tom Stevenson, Investment Director, Fidelity International comments on what’s driving markets this week: “With October closing out at the end of last week, US stocks have now hit their longest monthly winning streak in four years. The S&P 500 added 2.4% in October, enough to register a sixth consecutive month of gains. It has hit an all-time high on 36 occasions so far this year.
“The tech-heavy Nasdaq did even better. It rose 4.8% in October to notch up a seventh straight monthly improvement. That is its longest run since 2018.
“It has been a remarkable year for equity investors because outside the US, returns have been even higher, between 20% and the mid 30% range for Europe, Japan, and emerging markets. Only gold has done better.
Tech and AI power the rally
“Stock markets are caught between two competing narratives. On the one hand there are growing fears of an AI-fuelled bubble, similar to the one that inflated at the end of the 1990s, also coincidentally after the Fed cut interest rates in the face of a strong economy.
“At the same time, bullish spending announcements and strong earnings from the tech groups that dominate the US market, together with an apparent trade agreement on rare earths between the US and China, have kept the market bubbling. A continuing large fiscal boost from the one big, beautiful bill is the icing on the cake.
“Other signs of optimism include a rapid growth in mergers and acquisitions in America, again reminiscent of the late 1990s bubble.
“The consensus is firming that AI really is going to be transformational for the global economy. That view is bolstered by spending of more than $100bn in the last quarter alone by the big tech stocks like Alphabet, Amazon, and Meta as they invest heavily in chips and data centres.
“In fact, a capex boom is a major feature of the latest rally. Capex as a percentage of revenues has grown from 5.5% to 6.9% in three years. That might not sound much until you realise that revenues have grown by about 50% over that period. So, capex per share has basically doubled.
“Amazon’s shares rose as much as 12% on Friday, adding almost $300bn to its market value after announcing strong growth in its cloud business. Meanwhile, Nvidia became the first company to reach a $5trn market value and Apple topped $4trn for the first time.
Bonds rally as rate expectations shift
“October was not only a good month for shares. Bonds also had a good month, with UK gilts posting their best performance in almost two years.
“Expectations for lower UK interest rates are driving the move. Top of the agenda among this week’s data releases is the Bank of England’s rate-setting meeting. After the Fed cut interest rates by another quarter point but the ECB left rates on hold, attention shifts to London this week and an increasingly hard to call meeting of the monetary policy committee.
“The consensus view is that the Bank will hold fire, but bets on a surprise cut have increased recently. From just a 5% chance in late September, the odds have risen to 30% a month later.
Inflation slows but policy uncertainty remains
“At the Bank’s last meeting, the focus was on concerns about inflation over the summer being firmer than expected. Since then, there are signs that things may be slowing. Inflation in September was 3.8%, above the Bank’s 2% target but lower than the 4% that had been pencilled in. At the same time, wage growth is running at its lowest rate since 2021.
“Money markets are now pricing in 60 basis points of rate reductions in the UK over the next year. At the start of October, they were expecting just 40 basis points.
“Analysts say it’s always been a question of when not if UK inflation would start to come back down towards target and there are now signs that this is starting to happen. That’s encouraged investors to be overweight gilts, and they have been rewarded with a sharp fall in the yield on 10 year bonds from 4.8% in the summer to about 4.4% today.
“Falling bond yields equate to rising bond prices.
Markets wait for signals from missing US data
“Meanwhile, over the pond, markets are continuing to fly blind in the absence of jobs data from the Bureau of Labor Statistics. If the US government doesn’t resume operations this week, investors will be left guessing about the health of the US labour market. And without clear signs of a weakening jobs market, the Fed may well be reluctant to follow the last two months’ rate cuts with another in December.
“Investors will have to watch company results to get some kind of hint as to how the economy is faring. This week, the key indicator may well be McDonald’s, a good indicator of how the lower-income US consumer is faring. Last week, Kraft Heinz set the tone by warning that it saw sentiment going into the holiday season as the one of the worst in decades.
Earnings season keeps the bull running
“The third quarter results season is still in full flood, although there’s probably less interest in the companies reporting this week than last week’s high-profile tech numbers. All in all, results are coming through in line or slightly better than expected. That means another low double digit growth quarter looks to be on the cards for the year after perhaps 13% in the third quarter.
“That’s becoming increasingly important as the summer bull market continues apace. With valuations in the US rising back towards historically high levels, and bubble talk everywhere, earnings growth is more than a nice to have. It’s become essential if the bull is to keep running.
Earnings and valuations interplay
“The interplay between earnings and valuations is important. In 2023, it was all about higher valuations as earnings fell marginally. Last year, both rose, amplifying each other. This year, earnings have picked up the baton while valuations have not moved much. That is normal, although valuations probably rose more than is usual in an upcycle.
“And that has been largely driven by the Magnificent Seven. If the valuation of the big stocks that are driving the US market fall back, then it will drag the whole index lower. That is what happened between 2000 and 2003, and back in the 1970s. It is the biggest risk for holders of passive funds. And makes a good argument for diversification to less highly valued markets.
China’s manufacturing under pressure
“Over in Asia, it will be China’s manufacturing sector that grabs the headlines. Signs are growing that China’s economy is starting to slow due to weak domestic demand and a contraction in property related activity. Today, we get the former Caixin purchasing managers’ index (it’s now known as the RatingDog index). It’s expected to fall a bit to just above 50 – the dividing line between growth and contraction. Last week, the official PMI for manufacturing and services also fell short of expectations at just below the 50 watershed.”
