Markets weigh AI bubble risk as Fed outlook turns hawkish

JACK JANASIEWICZ: Thanks. I'm Jack Janasiewicz.

BRIAN HESS: I'm Brian Hess.

JACK JANASIEWICZ: And this is Tactical Take.

BRIAN HESS: Hi, Jack. We're back for another episode we recorded late in the month of May, and we're a bit early here in the month of June, so it hasn't been too long since we sat down, but hopefully, we can find some fresh ground to cover. Speaking of that, you've been out of the office. Last week, you're out of the office and traveling outside the US, and I feel like, oftentimes when we get a change of scenery like that, it can clear the head, clarify one's thinking.

So I'm wondering, now that you're back, are you seeing any of the things we usually talk about on this podcast any differently?

JACK JANASIEWICZ: Yeah. No, that's interesting, because we spend a lot of our time buried in screens, data, numbers, all that sort of stuff. So when you get a little bit of time away from the office, you get, I think, a bigger picture view, like the 60,000-foot view.

BRIAN HESS: Exactly. You're not tied up in all the minutia and the day to day.

JACK JANASIEWICZ: And I think if you do step back and think about the bigger picture backdrop, I don't think it's changed. We certainly have had some narratives that maybe have popped in and out. But I think, again, the bigger picture backdrop still remains intact.

And that's the labor market seems to be cooling. I'm sure we'll get into that in a little bit in more detail here coming up, but certainly, not falling off of a cliff. Consumers, still spending away. Earnings, up and to the right. Margins still strong. You put all these things together, and it certainly makes the case that worst case scenario, we're probably at trend growth, maybe with some upside now going forward.

And again, all the noise and things that we hear on the day-to-day backdrop, let's zoom out a little bit. It's still pretty constructive.

BRIAN HESS: So you're coming back less worried. Not that you went away very concerned. I don't remember that, anyway, from two weeks ago, but you seem like, OK, so maybe things have things are a bit better, now that you've had a chance to reflect.

JACK JANASIEWICZ: Yeah, and I think maybe the argument we could make was at the margin, things have maybe improved. And we like to think about things in tail risks when we talk about it. And we could always say, I think prior to this, that the backdrop was stable, but with downside risks, maybe that's flipped a little bit, where the backdrop is stable with maybe upside risks now, certainly, with some of the data points that we've had more recently.

BRIAN HESS: All right. Now, with respect to upside risk, with respect to improvement, we got the May employment report last Friday. And that was, actually, kind of a shocker, I guess we could say. The economy created 172,000 jobs in May, and there were big upward revisions, at least to April. And so the prior two months, now we're looking at close to 200,000, on average, job creation. Those are booming numbers relative to the labor market or the labor force right now.

So there does seem to be some evidence the labor market might be re-accelerating. The JOLTS report, which we also got for April, that showed a nice uptick in job openings, which is usually suggestive of an improving labor market. So I'm curious if you mentioned right at your intro there, in response to my first question, you mentioned that it seems like the labor market is cooling. Is that still the case, or maybe are we starting to get a re-acceleration?

JACK JANASIEWICZ: Yeah, this goes back to that framing. It's certainly no longer downside risks. We probably flip that to maybe upside risk. So labor market is, we'll call it stabilizing, with now, I would say upside risks in here when you start to look at those numbers. And so that creates some conundrums going forward.

But when you start to look at the details of that report, there were some optimistic things to think of. You can take some of that with a grain of salt. We had some improvements with, for example, non-residential construction employment. Is that related to AI data center build outs?

You'd like to see some broader contributions.

BRIAN HESS: We don't want everything tied into the AI data center build out or the AI CapEx cycle.

JACK JANASIEWICZ: Yeah, but having said that, we've seen some improvement in manufacturing. Now, could you make the case that this is simply inventory restocking? Maybe. But again, at the margin, better. Again, health care and social assistance continues to be a big contributor there. And we also had a pickup in leisure and hospitality. Could you make the case that we're front running maybe some of the World Cup there as well?

Point being, these are all still better numbers, plain and simple. And that, I think, gives us a different view in terms of upside risks versus downside concerns.

BRIAN HESS: It's an important question because we just had this oil price shock, and there's been a big increase in inflation. We've been hanging our hats, in large part, on the idea that with wage growth fairly tame, we're only going to get so much pass through from the oil price shock into core inflation.

But if we start getting more and more job creation, if wages follow, like they typically do, that could create more persistent upside risk to core inflation, not just headline.

JACK JANASIEWICZ: And I think you're getting at something really important here. First of all though, the one maybe conundrum in that labor report was that wage growth really didn't tick higher.

BRIAN HESS: I would expect that to operate with a bit of a lag.

JACK JANASIEWICZ: Exactly. 100% And so I think that puts the Fed in somewhat of a potential defensive bias here, where they're maybe having to lean a little bit more hawkish. Because when you start to see the job ads increasing, the unemployment rates really not moving, that's going to probably make you a little bit more uncomfortable that the risk is for the potential for inflation to start to accelerate.

So I think that changes the narrative in here, and that changes the risk profile where the Fed now, is no longer potentially going to be leaning dovish. You're probably going to have to start thinking more hawkish going forward, and that's the risk markets going forward here.

BRIAN HESS: And that's something I wanted to talk about. So the bond market, or interest rate market, has reacted to this. And we now have one full hike priced before year end. And we've been saying that the bar is pretty high for an actual rate hike.

We were like, OK, sure. They could shift from being dovish to being more hawkish, but they're not actually going to hike rates. Do you still think that's the most likely outcome, and if so, what would have to change? We need another 150 plus thousand print. What would have to change?

JACK JANASIEWICZ: And we've talked about this in past episodes where we talk about sequencing. And the way the sequencing probably works with the Fed is going to be, well, you remove the easing bias, then the next one is to include a hawkish bias, and then you actually hike rates. That's still probably three or four meetings in tandem when you think about that sequencing.

And in the meantime, you're going to get more data prints. And that certainly will influence that sequencing going forward. So I think right now, it's still sitting on their hands, maybe more of a hawkish pause, if you will. That's just going to buy time for more data to come out, and we'll get a better look at inflation.

Are we seeing, to your point, the energy shock starting to bleed through to the broader economy? Are we starting to see wage growth accelerating? And that's obviously where we're going to start to focus going forward here. So maybe the focus on the market shifts from earnings, which have been very good to now, we're all going to be Fed watching again.

BRIAN HESS: Yeah, that makes sense, especially as we move away from earnings season and we're into a more quiet period from the corporates. The bond market is back to an interesting level, the treasury market anyway. We have 10-year yields at 4.5%, 30-year is at 5%. These are areas that have been attractive entry points over the past several years. And so given what you said about the Fed maybe sitting on its hands for a while, not necessarily hiking rates, do you think this is another buying opportunity in bonds?

JACK JANASIEWICZ: And I think there's a case to be made for that. What's interesting, I think, to really focus on maybe first off, is just the shape of the curve. We've been getting somewhat of a bearish flattener. The long end has been fairly stable, but the two year has really been pushing higher, reflecting the market, repricing of those rates.

So that's creating that bearish flattener. But when we start to decompose the return in the 10 year, for example, or the move in the 10-year nominal yield, we're actually seeing inflation expectations coming down. So it's really a function of real rates pushing higher.

And so from our perspective, is that a repricing of the growth outlook? Maybe. Or is it just a combination of the market repricing growth outlooks, as well as consecutive rate hikes further out on the curve? You're talking, obviously, the 10-year trajectory when you start to talk about 10-year yields.

So again, it's not necessarily inflationary impulses that are pushing the yield higher right now. It's real rates. And that's a function of growth. And probably the market repricing maybe a higher backdrop going forward. That's a good thing. Market can handle that.

BRIAN HESS: Well, I think the levels are pretty interesting, 4.5% and 5% for 10s and 30s, respectively. I wonder if we're at the right phase of the cycle for a big bond rally. And I think that's what you're getting at here with highlighting what's driving the rate increase. It's real yields, which could be a reflection of better growth prospects, or just could be the fact that the market's acknowledging there's a greater chance for hikes.

But without a big slowdown in growth and with inflation still above target, it's hard for me to envision a very sizable drop in yields or a big bond rally. Would you agree with that?

JACK JANASIEWICZ: Yeah, and I think this goes back again to that framing we always talk about. It's like, what's the skew here? Maybe rates are, maybe, in a tighter range. But is it more probable that rates rally from here or push higher?

And so I think you could probably make the case that maybe the bias has shifted a little bit towards the potential for it to drift higher, if we talk about those things that we just were pointing to-- oil bleed through, stronger wage growth, stronger labor market. That puts some upward pressure on the front end of the curve, in the middle part of the curve, as well.

BRIAN HESS: At the same time, given what I just said about having a hard time envisioning significantly lower yields, it's hard for me to envision a big sell off in bonds either, like a dramatic rate increase, given the starting point, which I just highlighted, and the fact that-- sure, the Fed might hike once, or maybe they hike twice.

But we're not looking for something like what happened in 2022, 2023 where they went on this prolonged hiking cycle. And even if the Fed were to hike and get out in front of it, that could be perceived by the long end as a good thing. You mentioned how the curve has been flattening. Well, it could just continue to flatten, as the Fed builds credibility.

The other twist is that we have a new Chairman, Kevin Warsh. And so there's a possibility, I suppose, that the market tests Chairman Warsh and doesn't want to cooperate with that flattening and we get a little bit of weakness at the long end because of that. Are you worried at all about the market testing the Chairman?

JACK JANASIEWICZ: Yeah, there could be there's some precedents for that. It seems like, at least the equity markets certainly seems like a test—

BRIAN HESS: Yeah, we'll get to that.

JACK JANASIEWICZ: --to the new Fed Chairman every time. But I think you hit on an important point there and that, again, the long term, back end of the curve, I should say, I think probably remains fairly stable because of Fed credibility. You look at those inflation break evens, the forward curve, however you want to look at forward inflation expectations. They're still fairly benign.

And so I think that needs to move significantly higher for the back end to become unanchored.

BRIAN HESS: So you want to see inflation fears in order for there to be a big sell off.

JACK JANASIEWICZ: I think that's the key. I think that's the key. Exactly.

BRIAN HESS: I agree with what you said earlier, that the bias probably is towards slightly higher yields for now, but I think it's slightly higher. So we probably do want to be trying to figure out how do we take advantage of this kind of an opportunity. How do we want to extend duration? Do we want to do a little bit now, a little bit later? Or is there a level where it becomes like it's time to start acting, or is it just let's wait for some evidence of a slowdown in the economy, and then we proceed?

JACK JANASIEWICZ: And I think the other key there is, does it make more sense to play points on the curve, as opposed to absolute duration? So you're going to get these pivots on the curve, as opposed to the entire curve shifting. And those are some of the things, I think, investors need to think about going forward.

BRIAN HESS: Right. Of course, assuming that they can use leverage. Because if you want that bang for your buck and you're unlevered, you need to be buying the long end. All right. Well, this is something I think we'll be keeping a close eye on for our own investing for our models. But it's an important thing for markets, overall, since we saw what higher rates can do to the stock market just a few years ago.

All right. So that brings me to our next topic, which has to do with the million dollar question right now. Let me just take a sip of water before this one. And what I mean by the million dollar question is that, I know you're hearing it. I'm hearing it. There's a lot of talk of whether we're in an AI bubble.

And we've talked about this on the podcast before. And up to this point, we've said, we don't think so. But there's a lot of signposts that suggest, that we might be. We've had parabolic price action and anything AI related. So that's number one. That happens a lot, though. It doesn't mean there's a bubble.

We have a very narrow market now with many defensive sectors and other less exciting industries being left behind. So there's lots of sectors or industries where you look at them, and they haven't really done that much over the past few years. And a lot of money has been going into this AI-related sector, which has been doing very well.

We have several mega IPOs coming from SpaceX to Anthropic to OpenAI, all tech and AI related, and they're coming at highly aggressive valuations, which speaks to limited risk premium and a lot of optimism about the future. On the more anecdotal side, I just read an article recently about Samsung Electronics offering $370,000 bonuses to, I think, it was $78,000 of its memory chip workers. I mean, that's pretty extreme. And this is in South Korea, $370,000 annual bonus.

And lastly, we're seeing our active equity managers, those in our models and the ones across our lineup here in Natixis, most of whom invest with some sort of a value discipline. So they tend to focus on evaluation and a margin of safety. We're seeing them, basically, exhibit unprecedented underperformance, both in magnitude and in uniformity across the lineup, where very few of them with any kind of value discipline are managing to outperform, which would suggest that valuation, at least in its traditional sense, is not mattering for markets right now.

So I think there's a decent chance that in a few years' time, after the memory shortage has faded, which I mean, it should be a commodity, like in part. I'm not an expert on this, on AI or technology, obviously. But it does seem like this memory has commodity aspects to it. After that's faded, when we look back, it could be very easy for us to say, with the benefit of hindsight, oh yeah, that was clearly a bubble. Obviously. What do you think? It's like the longest intro to the question. I'm sorry.

JACK JANASIEWICZ: There's quite a few things to unpack there. But I think the bigger takeaway, the first one, it's tough to time these sort of tops.

BRIAN HESS: For sure. And I'm not even saying we should try to do that, but yes.

JACK JANASIEWICZ: These things can run for quite some time. And maybe at the end, you end up missing out and so the opportunity cost of sitting on the sidelines, actually hurts performance. Whereas if you wrote it up and then just sold it—

BRIAN HESS: Wrote it back down.

JACK JANASIEWICZ: Yeah. You're in and out. Still make some money on that thing. So that becomes tricky. I think the second one to think about there too, though, is defining the bubble in a sense that if we start to see earnings slow, to me, that just probably means maybe a slower ascent of equity prices.

So there's a difference between an equity bubble popping and then just, are the expectations that are set too frothy and then we just won't get there. And so the latter, to me, means earnings estimates start to come down. And then, sure, we might get a correction, a proper correction, but that just means you're growing at a slower pace.

A popping of the bubble, to me, in terms of dotcom era, means you, basically, have stuff going bankrupt, which that's a significant drop. Basically, some of these companies go to 0. So I think there's a little bit of a nuanced response in terms of how we think about that. And again, are our expectations overinflated to a point where they can't be met? Are those expectations going to have to come down? And if they do, does that just slow the ascent of equity prices going forward?

The last piece here, the trick on all of this, is that I don't think you're looking at excessive valuations across the board. There's pockets of it. But in aggregate, I think what the S&P is trading at 21, 22 times. So it's not like you're up around 40, which is roughly where we were during the dotcom days. You're not stretched from that valuation perspective. So E starts to slow, maybe you can grow into that multiple a little bit easier, which just means the rate of ascent is just slower.

BRIAN HESS: I think it would have to be that the estimates are way off, that there's just way too much optimism here about the perpetual pricing of memory or chips or whatever other part of the AI chain. And instead of earnings rising dramatically, there's a major miss, and they get revised much lower, and the market de-rates on top of that. And it creates the possibility of some significant downside risk, like we had in 2000.

And that ended up resulting in-- I mean, this is a whole other-- I don't know if we have time to get into all this, but if AI is a bubble and the CapEx cycle bursts along with the stock market bubble, that poses a serious risk to the economy.

Because if you look at the contribution to growth from this tech spending, it's its big as consumption right now.

JACK JANASIEWICZ: Yeah, and that's one of the things that we're using as a signpost. Are we paying attention, or are we seeing a slowing of CapEx intentions coming from the hyperscalers? Right now, given what they're telling us, no. It's still pretty robust. I look at memory chip prices every morning when I come in. I look at, all the GPUs, the CPU prices. They're still holding up firm.

So there are things that we're paying attention to try to monitor the supply and demand imbalances. Is demand slowing, is supply finally catching up, those sort of things. And again, based on what we're seeing right now, things are still OK. And can that persist for a while? Maybe. But certainly, something we're on guard for.

Having said all of that, I think the nice part about this, though, is, what you've just highlighted here are plenty of concerns that I'm hearing on my calls with clients. There's very few people in here that are certainly looking to get how can I get even longer. It's more so like I'm worried, what should I be doing? And I think that's also a key ingredient for that bubble to form where you just basically ignore-- there's no risks to this trade.

It's going, trees grow to the sky sort of thing. And I feel like that's certainly not the sentiment that we see in the market right now.

BRIAN HESS: All right. Well, imagine if that develops and there's even a lot more upside, I guess, which speaks to your point about how if you try to time it and you're early, you could really miss out. I think in summary, what we can say here is that, basically, we don't want to call it a bubble yet. It sounds like you're saying. The evidence is building, though.

If we had this conversation six months ago, which I think we may have, we said it's probably not a bubble, and it's continued on, and that was a good call. But the evidence is starting to pile up. It's a little bit more extreme that things had been. That said, even if it is a bubble, trying to time them is risky.

But what's not risky, I think, during periods like this is to be willing to look outside the area where all the money is flowing to and just look for opportunities. Look for multiyear opportunities, if you have the ability to invest with that longer horizon. And I think that's what a lot of our value managers-- not even our value managers, our active managers, in general, are focusing on.

They're like, OK, what's being left behind, while everyone focuses on AI? And maybe AI will continue to generate these earnings growth into perpetuity, and these companies will continue to hold their valuations. But it doesn't mean that all these other companies have to necessarily be the losers that are being forgotten about right now.

And so that would be my thing. It's like don't short the market because trying to short a bubble can be so reckless. But just be mindful that there are some risk building and that there's a lot of other opportunities out there, probably outside of AI.

JACK JANASIEWICZ: Yeah. And I think to echo that same point, if we look at the median EPS estimate for the S&P 500, so the median company estimate, those are still pushing higher right. And so yeah, you've got a handful of names that are putting up very, very big numbers. A lot of the chip names, for example, come to mind with that.

But again, take a step back and look at the broader market through the median, those are still pushing higher. So to your point, there s opportunity elsewhere, maybe not be growing quite as fast, not putting up the eye watering returns.

BRIAN HESS: But the valuations are also going to be lower commensurate with that.

JACK JANASIEWICZ: Exactly.

BRIAN HESS: And the margin of safety will be presumably higher.

JACK JANASIEWICZ: Yep.

BRIAN HESS: All right. That's great. And we've had no model trades since the last time we spoke, so nothing to report on there. I mean, we're keeping an eye on the treasury market, which we just talked about. We're keen to see if the volatility from last week, which did have a pretty big momentum, unwind a pretty big tech unwind on Friday.

Keen to see if that continues. But otherwise, I think we can leave it there for this month.

JACK JANASIEWICZ: Sounds good.

BRIAN HESS: Thanks, Jack. See next time.

JACK JANASIEWICZ: All right, Brian. Good.