Source: Xuetao's Macro Notes
Author: Song Xuetao, Lin Yan

This year, US stocks continued to be strong last year, reflecting the reality that economic fundamentals are resilient. Despite recent signs of cooling in employment and inflation, there has been no significant weakening in the main chain of wage income, consumption growth, and service sector output.

Over the past two years, the logic of the US economy was very clear, and policy instruments for monetizing deficits were constructed on the basis of a strong dollar — a deficit rate of 6-7% each year was used to “make up for shortcomings” and “build a long board.”

Both consumption and investment have surpassed the historical trend before the pandemic. As a result, inflation and neutral interest rates have risen to a level higher than before the pandemic. Judging from the results, the Federal Reserve did not raise interest rates excessively. Interest rates are basically in line with inflation, and the US economy is in a positive cycle of high inflation, high interest rates, and high nominal growth rates.

Moreover, the long-term pricing of US stocks is also basically effective, and the profit growth rate reflects the overall resilience of the economy. The S&P 500 EPS growth rate continues to be better than analysts' expectations, and no interest rate cuts have had an impact on US stock profits. Profit growth can outperform inflation, and shareholder returns are still improving. In the context of the economy not landing, interest rate cuts are of course more friendly to small US market capitalization companies that are under pressure on valuations, but not cutting interest rates will not affect the US stock market index.

The growth structure of US stocks also reflects the stagflation structure of the economy. The sectors with the highest increase in US stocks this year were technology and stability (utilities, telecommunications services, finance), representing the two types of assets that outperformed stagnation and outperformed inflation, respectively.

To outperform, we need to improve total factor productivity through technology. Today, what seems most promising is AI. To outperform inflation, there must be an unrepeatable monopoly, such as Buffett's heavy holdings$Occidental Petroleum (OXY.US)$and Japan's top five trading companies.

In fact, the same is true for A-shares. However, there are relatively few globally attractive technology companies that can “outperform”, and there are relatively many listed companies with a monopoly on resources that can “outperform”. Dividends and Chinese characters cover most monopoly industries.

However, if you take a close look at the structural performance of US stocks, you will find that the differentiation is becoming extreme.

First, there is a growing differentiation between small-cap stocks and large-cap stocks.

S&P and Nasdaq continue to reach new highs, mainly due to the contributions of leading technology companies. Small-cap stocks, such as Russell 2000, have a yield of only 1.7% in the first half of this year, which is not much different from the Shanghai Composite Index's yield of 0.2% in the first half of the year. If you make a mistake in choosing the right time, you will face losses.

The trend in small-cap stocks reflects the fact that the high interest rate environment is not friendly to everyone. For example, regional small to medium banks have weak debt-side management capabilities and are prone to liquidity crises. There are also interest rate sensitive industries, such as commercial real estate, credit card loans, etc., which may perform poorly under high interest rates.

Second, there is a growing divide between tech stocks and non-tech stocks.

The biggest increase in the first half of this year was among technology leaders, among the “Seven Sisters”$NVIDIA (NVDA.US)$A cumulative increase of 149.5% in the first half of the year,$Meta Platforms (META.US)$A cumulative increase of 42.7%,$Alphabet-C (GOOG.US)$A cumulative increase of 30.5%,$Amazon (AMZN.US)$A cumulative increase of 27.2%,$Microsoft (MSFT.US)$A cumulative increase of 19.3%,$Apple (AAPL.US)$A cumulative increase of 9.7%.

However, leading stocks related to clothing, food, lodging, and travel performed mediocre.

The one you “wear”$Nike (NKE.US)$Recently, stock prices plummeted after financial reports came out, and clothing consumption was pressured by inventory removal and declining subsidies.

Of “food”$McDonald's (MCD.US)$Recently, a $5 “poor guy package” was launched. Low-income consumers are more sensitive to rising animal protein (eggs, chicken, beef) prices.

The one that “lives”$Home Depot (HD.US)$Stock prices and performance are affected by high interest rates on real estate sales and construction, and the correlation between building materials, home furnishings and hardware products and the real estate cycle is very high.

Of “OK”$Tesla (TSLA.US)$It also fell 20.4% in the first half of the year. Recently, the stock price rebounded strongly with Robotaxi and Robotics, but if we only look at its electric vehicle sales, according to Cox Automotive estimates, Tesla's sales volume in the US fell 6.3% year on year in the second quarter. Automobile retail sales across the US fell 2.9% in June.

There is also a clear division between AI and non-AI within technology stocks.

The “Seven Sisters” account for about$S&P 500 Index (.SPX.US)$30% (according to market capitalization estimates on June 30), but the stock price trend of technology companies with low correlation with AI is relatively weak. According to weight estimates, the S&P 500 index, which does not include the “Seven Sisters,” rose only 3-4%.

The demand for telecommuting that software companies have accumulated during the pandemic has gradually subsided. In terms of hardware, Intel and Nvidia are chip companies, but in the AI era, the stock price trends of CPU manufacturers and GPU manufacturers are double ice and fire.

The divisions within the “Seven Sisters” are also getting bigger.

Nvidia's growth rate was outstanding among the “Seven Sisters”. Nvidia's gross profit growth rate in the most recent quarter reached 78.9%. Maintaining a high level of gross profit requires large companies to continuously add infrastructure to the existing framework. According to Dealroom statistics, the “Seven Sisters” invest as much as 400 billion dollars in cutting-edge technology every year.

When a market shows more and more structural divisions, the bubble may be a sign that positive feedback is accelerating, and traditional US stock indicators also show signs of a bubble in the stock market.

For example, the famous Buffett Index (total market capitalization of US stocks compared to US GDP) was 206% as of July 12, a new high since March 2022, which is far higher than the dangerous value. Buffett also mentioned at the shareholders' meeting,

“Berkshire has about $180 billion in cash reserves, and there are currently not enough attractive investment targets.”

People who questioned Buffett over the past few decades have basically disappeared in a cycle after cycle.

As of early July, the risk premiums for S&P 500, Dow Jones, and Nasdaq were in the historical quantiles of 35%, 18%, and 16%, respectively, at 0.53, 1.10, and 1.15 standard deviations below the median.

The basis for the US economy to have a virtuous cycle of high inflation and high interest rates is the monetization of deficits supported by a strong dollar. The bottom layer of a strong dollar is technology and military, so the AI narrative is not only the support for US stocks, but also the foundation for the US dollar, US debt, and the US economy to maintain resilience.

Conversely, the AI narrative is also one of the vulnerabilities of US stocks, US debt, the US dollar, and the US economy. In particular, as more and more indicators show that US stocks are bubbling and positive feedback is accelerating, it is extremely critical whether the AI narrative can continue to diverge.

Risk warning:

US monetary policy exceeded expectations, global economic growth fell short of expectations, US elections and geopolitical risks exceeded expectations

Editor/Somer