Correction or rotation?

Another bruising week for technology stocks closed out the worst month for the Nasdaq index in a year and a half. But the broader market held up better. Plausible cases can be made for both a healthy broadening out of the ongoing bull market or the early stages of a wider correction for shares.

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Mixed messages

The numbers tell an interesting story. Last week, the S&P 500 fell by 0.6% and the tech-heavy Nasdaq was 2% lower. But the Russell 2000 small cap index was 1.3% up on the week.

For the month of October as a whole, Nasdaq was 5.3% down, much worse than the S&P 500’s 0.9% decline. The Dow Jones Industrials index rose by 1.7%.

The S&P 500 has now gone sideways since June. But the equal weighted benchmark, which removes the index’s bias to big tech stocks, has caught up.

It’s too early to tell whether the shift in sentiment towards tech stocks will remain a sector specific concern or lead to more general risk aversion.

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Tech wobble

Certainly, though, it was not a good week to be over-exposed to the AI theme. Investors have stopped marvelling at the potential for artificial intelligence and starting to worry about whether the massive investment in AI infrastructure will ever deliver an acceptable return.

Last week, Alphabet and Amazon were punished for their extravagant capex. Intel delivered disappointing forward guidance. And Nvidia came under pressure as the durability of the AI boom was interrogated.

Investors are no longer in doubt that growth is coming, but they are starting to question whether they have paid too much for it.

The AI investment boom is bumping up against a rising cost of capital. As even the massive cashflows of the US hyperscalers are drained, the industry is becoming increasingly reliant on the kindness of the equity, and more important, the bond market. With yields at or above 5% the case is harder to make.

Where next for central banks?

Which links the AI theme to the other big investment question at the moment - inflation and interest rates.

Last week’s hold by the Federal Reserve - at 3.75-4.0% - looked like a pre-mid-term pause. With inflation well above target and likely to stay there as oil remains above $100 a barrel, the direction of travel for US interest rates is likely to be up, starting in December.

Likewise, the Bank of England is very likely to raise rates by a quarter point this week to 4%. It may be a dovish hike, pointing to a slower pace of rate rises next year as growth slows. But it adds to the pressure on households, businesses and the government alike.

In Europe, too, this week’s inflation report - probably close to 4% last month - makes the case for another hike from the ECB, especially in light of stronger than expected GDP growth in the third quarter in the region.

Increasingly, good economic data is starting to look like a mixed blessing for investors, as it makes a stronger argument for interest rates and bond yields to stay higher for longer.

The political cost of higher bond yields

Which leads to the other big market-moving story of the autumn - politics. Last week we saw just how big a constraint a high cost of borrowing can be.

The UK’s Budget, the first of the Andy Burnham era, was a timid affair, aimed largely at keeping the bond market onside. That makes sense. When the cost of interest on government borrowing stands at £109bn a year, the best way to balance the books is not to raise taxes or cut spending but to keep a lid on bond yields.

The other big takeaway from the Budget is whether or not a fiscal statement littered with small but politically appealing measures paves the way for an early general election in the spring. The government says no, but a divided opposition vote, split fairly evenly between Reform and the Conservatives, may make the case for seeking a new mandate sooner rather than later.

Mid-term watch

From one potential election to a certain one on the other side of the pond this week. The mid-terms look like being the most consequential in years in America, with a high chance that the Democrats will regain control of the House of Representatives and a slimmer one that they will win back the Senate.

What it means for investors is less clear. Gridlock can be good news for the markets if it reins in fiscal expansion. But the key market drivers of trade and tariffs, and foreign policy, remain in the President’s hands.

The more important elections from an economic perspective may be the many state governorships up for grabs. With data centres at once an electoral liability and an economic tailwind, who runs the individual states may matter more than usual next year.

Three big questions

So, the key questions in the markets this week are:

Will the AI stock correction remain narrowly focused or spill over into a wider equity pullback. The answer lies in large part with third quarter earnings season, which continues in full flood this week. Forecast growth remains supportive.

Second, will the mid-terms change the economic outlook or come and go with no real impact on financial markets? Key to that could be whether getting the election out of the way opens the door to an intensification of fighting in the Gulf, with a knock-on impact on the oil price.

Third, and related to this, can central banks regain control of inflation without undermining economic growth? The trade-off is becoming harder.

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