Keep late-cycle playbooks handy as markets bet on ‘sweet spot’

There’s no sign of cracks in the bullish narrative, but investors should keep their late-cycle playbooks at hand as they navigate what’s often the worst time of year for stocks.

Nvidia’s shares surged 13 per cent on Wednesday after diving as much as 27 per cent from a record high of $US140.76 to a two-month low of $US102.54. Picture: Getty Images

As much as the risk appetite has turned positive after strong gains in stocks this week, the Australian market in particular has come a long way on a favourable monetary policy and economic outlook.

There are no cracks in the bullish narrative at this point, but investors should keep their late-cycle playbooks at hand as they navigate what’s often the worst time of year for stocks.

Morgan Stanley’s elevation of Nvidia to its top pick among US chip stocks for the first time in six month, together with strong results from Advanced Micro Devices and Meta, looks to have rung the bell on the correction in US mega-cap tech stocks that worried global markets at times last month.

Amazingly for a company with a $US2.88 trillion ($4.36 trillion) market capitalisation, Nvidia continues to behave more like a penny stock. Its shares surged 13 per cent on Wednesday after diving as much as 27 per cent from a record high of $US140.76 to a two-month low of $US102.54.

Nvidia shares rose another 3.7 per cent in after-hours Asia-Pacific trading. Meta soared 7.2 per cent on signs that its AI investments are paying off and that the massive AI capex cycle remains intact.

The recent pivot to small caps is fully justified, based on valuations and leverage to rate cuts.

But if the money flows back to AI mega caps before Nvida reports on August 28 it’s not hard to see that causing some short-term pain for small caps. After all, the Russell 2000 Small Caps index had diverged positively by 20 per cent relative to the Magnificent Seven after the US CPI undershot three weeks ago.

Australia’s S&P/ASX 200 hit a record high of 8148.7 points on Thursday after surging 4.2 per cent in July. That included a massive 1.8 per cent jump on Wednesday after CPI data came in lower.

But it’s now trading a 12-month forward PE multiple of about 17 times versus a 20-year average of 14.8. With an RBA cut priced as a 70 per cent chance by year’s end – even as inflation remains high and the jobs market is strong – rate cut speculation may be swinging too far in a dovish ­direction.

With two months of economic data ahead, a US rate cut in September isn’t a done deal either.

However, the FOMC statement shifted from “the Committee remains highly attentive to inflation risks” to “the Committee is attentive to the risks to both sides of the dual mandate”.

And while careful not to greenlight September, Jerome Powell left the door wide open.

He said: “The downside risks to the employment mandate are real now” and “the reduction of the policy rate could be on the meeting as soon as September” if justified based on the ‘‘totality’’ of data.

“The Fed is expected to begin its cutting cycle in September but this expectation is a little too optimistic,” T.Rowe Price capital markets strategist Tim Murray said. “We will get two CPI prints before the September meeting, and we should know by now that there’s some chance that the CPI prints won’t co-operate with the prevailing narrative.

Mr Powell described the softening labour market conditions as a “normalisation”.

“This is important because we shouldn’t expect the Fed to have a sudden urgency for accelerating the rate-cutting cycle unless they sense real weakness in the labour market, rather than the gradual normalisation we are currently experiencing,” Mr Murray added.

Pepperstone head of research Chris Weston.

Of course all rate cuts aren’t created equal – the S&P 500 fell more than 50 per cent in both the Tech Wreck and the Global Financial Crisis, even as the Fed slashed interest rates.

And there was a worrisome Bloomberg column from former Fed Vice-Chair Bill Dudley last week, saying that the Fed needed to cut rates “now”.

“Have we hit a sweet spot again for risk assets, with Fed cuts all but assured, US labour markets cooling but not collapsing, inflation glacially falling in line and solid company EPS growth?” Pepperstone head of research Chris Weston said.

“One could argue that is the case, but trends in the economic data hold the key, and we know that there is a stark difference between insurance rate cuts (the market’s current base case) and where the Fed and other central banks need to consider more front-loaded rate cuts.”

The latter path would be “a sign of greater concern, and a dynamic which would see much more liberal de-risking through equity and risk assets”.

A scenario where the Fed gradually lowers rates to a neutral setting to stop real interest rates from rising as inflation falls would have vastly different market implications to one where the Fed was forced to slash rates to possibly well below neutral levels to stop a recession that hits earnings.

“Rate cuts when you’re going into a recession aren’t a positive signal for risk assets because policy makers are fighting a fire that’s already ablaze,” Mr Weston said. “In recent times when you get some kind of existential crisis, it’s usually liquidity and aggressive use of the balance sheet that solves it.

“In the latter stages of the business cycle, fund managers typically weight their portfolio to stocks that do well typically in that stage of the business cycle, and that’s where we are.

“The Fed is now firmly emphasising its dual mandate, from solely looking at inflation to one where they’re equally looking at the labour market.”