Three questions for asset allocators: Politics, Nvidia and Bonds

This very powerful behavioural bias, choosing the best from what is available rather than judging an item on its own merits, is called the ‘contrast effect’. 

More about that after a short break. 

In the last two weeks, a few interesting things happened. 

Is France in trouble?

For one, in France, Mr Macron joined a long list of Western leaders who got significant market backlash as a result of a political gamble. Spreads with Germany are wider, French large caps are down 7% and billionaires are threatening to leave the country if a hard-left coalition gains power. It was not but a few years ago when Francois Hollande, Mr Macron’s former political boss caused another exodus of the ultra-high net worth. In a world laden with debt, political wiggle room disappears as quickly as fiscal space. The more the potential for government giveaways is reduced, the more world leaders are incentivised to make riskier decisions, and the more uncertain the outcomes. Is higher political risk priced in markets? Or better yet, are markets any good at understanding political risk, especially in historically stable countries, let alone properly price it? Investment experience shows that markets have a difficult time appreciating non-financial and non-linear risks, which means we need to assume that there are pockets of risk in global geopolitics, that may have gone under the radar. 

What can stop Nvidia?

The second thing that happened was Nvidia crossing the threshold to become the world’s most valuable company. Is the former graphics card maker and Warcraft-lovers icon poised to take over the world? What can possibly break its ascendance and, subsequently, the ever-larger weight of tech in global and US equity indices?

 For one, the government. Unlike Apple and Microsoft, the company is a virtual monopoly in the high-end microchip space, the equivalent of Standard Oil and JP Morgan one hundred and twenty years ago. As such, one can’t help but wonder whether it will face the same fate, that of a government-mandated breakup. Mitigating that risk is Nvidia’s importance in the global race for AI. If a company is considered a strategic asset, a national champion of sorts, then breaking it up is risky.

Another possible obstacle could be a bottleneck energy supply. Demand for AI is already wreaking havoc in domestic power grids (click here). Those grids are already heavily taxed by demand from electric vehicles and are now even more pressured by demand from data centres. Quotas in computing power could significantly ease demand for Nvidia’s product.

It took roughly one hundred years from the first to the second industrial revolution (1760 to 1860), from textile mills to the beginnings of mass production. It took nearly one hundred more to get from there to the information revolution, which really didn’t take off until the turn of the century. The fourth industrial revolution is happening fast. An infrastructure revolution is quite sure to follow, but will it happen fast enough to cover the voracious energy needs of the next step in human development?

Is 4.5% yield an opportunity?

While the limits of politics in a world full of debt and the “what can stop Nvidia” scenario are definitely questions to ponder, the one most prevalent in my mind is bond valuations. The market seems ravenous for bonds north of a 4% yield and traders are determined to gobble up debt, against heavy issuance this year despite central banks running off their balance sheets. 

Are they right? 

Is this a case of “the contrast effect” mentioned above? Are we simply liking a yield because it’s relatively high compared to the last 15 years, even if we know that it’s difficult to return to a low-yield world? 

Or are investors simply loading up on bonds in anticipation of rate cuts (which should reduce yields and improve prices, all other things being equal)? 

In a world with so much debt, where governments might even welcome a spot of inflation, is a 4.5% yield for a mid-range bond still attractive, or is it the new norm?

Beyond geopolitics and Nvidia, I suspect this is the question that will define portfolio returns in the next few years. 

George Lagarias, Chief Economist

Market update

Global equity markets rose by +0.8% last week in a broader based rally. Most sectors of the major equity indices saw positive returns, while the information technology pulled back slightly following two very strong weeks. UK and EU stocks rose by +1.2% and +1.0%, as concerns over political uncertainty appeared to wane. Meanwhile, US stocks rose by a smaller +0.9% during a shortened week of trading due the Juneteenth holiday. Japan was the main point of weakness this week, as both its stock market and currency declined, resulting in a -1.8% return in GBP terms.

Yields increased modestly over the week. The US 10-year treasury yield advanced by +4 basis points, while the yields on 10-year UK gilts and German bunds increased by +2 and +5 basis points respectively.

Crude oil rose by +3.2% over the week, while gold fell by -0.2% in GBP terms.

Macro news

Flash PMI results for June, compiled by S&P Global, highlighted a juxtaposition between the strength and resilience of US economic activity and the slowdown in activity of its transatlantic neighbours. In Europe and the UK activity growth cooled, driven primarily by a slowdown in the services sector, while in the US, output and demand accelerated strongly, with new order inflows reaching a three-month high. US business optimism also edger higher as the pressures associated with the ‘cost-of-living crisis’ were reported to have eased. However, this rosy picture obscures the pressures faced by US manufacturing businesses, which, despite greater manufacturing output in June, continue to struggle with a pessimistic outlook over demand, primarily associated with the upcoming US election and the resulting policy impacts.

As anticipated, the Bank of England shared the Federal Reserve’s concerns surrounding uncertain inflation data, opting to hold interest rates steady at 5.25%. This was in spite of both headline inflation falling back to 2% in May and core inflation easing to 3.5%, as price pressures in the services sector continue to weigh on the thoughts of rate setters, coming above expectations at 5.7%.

S&

The week ahead

Investors will be watching May’s core PCE figures, which will be reported on Friday this week. Often touted as the Federal Reserve’s preferred inflation gauge, investors are anticipating a slight easing of price pressures to 2.6%, down from 2.8% in April.