“Soft landing” is the base case, but deploying capital is still hard. This week we highlight signs of fragility in the AI theme, the potential for an extended rally in U.S. small caps, and the top semiconductor stocks to own in a pullback. We also discuss how an AI-driven productivity boom in Korea could offset the drag from aging demographics.
The July Global Fund Manager Survey (FMS) confirmed continued investor optimism, driven by confidence in rate cuts and a “soft landing”.
Chief Investment Strategist Michael Hartnett notes that 62% of FMS investors predict at least three Fed cuts in the next 12 months, starting in September, while 68% expect a soft landing. As a result, positioning is skewed ‘risk-on’ with allocators 33% overweight stocks, concentrated in mega-cap tech behemoths. Head of Research Investment Committee and ETF Research Jared Woodard argues the AI-induced embrace of large cap equity benchmarks could be easing. With a record $18.3 trillion in cash (+40% since 2019), U.S. households might be looking to diversify—Jared recommends owning value stocks vs. an increasingly fragile S&P 500 and public credit over private, where high-yield defaults are >8% this year.
The recent rally in U.S. small caps could be an early indication of broadening performance.
On first glance, the rally was driven by short-covering as short interest factors gained 13-14%. But (long) buying was also strong as small cap funds recorded $9.9 billion of inflows last week, the 2nd largest ever. Head of U.S. Small & Mid Cap Strategy Jill Hall has been highlighting two necessary conditions for a broad and sustained rally in the Russell 2000: continued evidence of easing inflation, which came with June CPI (Consumer Price Index) data, and confirmation of stronger profit expectations. Coming into the year, analysts expected +16% profit growth for small caps in 2Q24. Today, 2Q24 earnings forecasts have been revised down to -3%y/y with a significant pick up not anticipated until 4Q24. Consensus expects small cap profits to grow around 20% through 2025 compared to 13-15% for large caps. Jill suggests owning quality value stocks and stocks with positive estimate revisions as improved guidance could augment the rally.
Semiconductor stocks had a difficult week as possible further trade restrictions, Taiwan concerns and rotation weighed on shares.
The volatility could continue with upcoming earnings, the November election and stretched positioning. But U.S. Semis analyst Vivek Arya points out that fundamentals remain strong, drawdowns for the SOX (Philadelphia Semiconductor Sector Index) are not unusual and on average, the semiconductor index has rebounded 28% in the 6 months following a 5% daily decline. AI is still the strongest and most dependable area of capex, driven by U.S. tech companies with solid balance sheets and mission critical imperatives.
Economist Benson Wu believes Korea is one of the few economies in the world that is already seeing an AI-driven boost to growth.
In the first half of 2024, Korea semiconductor exports grew more than 50% and semis accounted for much of the 9% growth in overall exports. Korea accounts for nearly the entire global production capacity of high bandwidth memory (HBM) and demand for training and inference has led to a 200% surge in HBM demand this year. Productivity benefits from AI could be quite meaningful for Korea over the long-term because of high R&D (Research & Development) intensity and because efficiencies could help to offset the decline in the labor force that we expect in the 2030s and 2040s. Services sectors, from financials to education, are ripe for AI-driven productivity gains. And having many young workers could be an issue in case labor is substituted for AI, but Korea has less risk there.
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