Nvidia and the Fed. That seemed to be all investors cared about last week – Nvidia, to gauge whether the AI frenzy would continue, and the Fed to gauge how much higher interest rates can go. By the end of the week stocks finished mixed with an outperformance in tech and growth stocks while Treasury yields moved higher on the short end and were unchanged on the longer-end (the 10-year Treasury yield went as high as 4.37%, hitting the highest level since 2007).
Earnings results from Nvidia crushed analysts’ estimates. It reported revenues that grew over 100% from a year ago, driven by its data center segment that saw a 171% jump in revenues. This segment is associated with the AI chips it makes for tasks like machine learnings and large language models, where a single unit sells as high as $40k. There has been a massive wave of investment in this area as no company wants to get left behind and the potential productivity and efficiency improvements it may provide. The company forecasted revenues of $16 billion for the current quarter, well above the average estimate of $12.4 billion. Obviously Nvidia is the largest beneficiary of the AI investment wave to date.
It appeared to be a buy the rumor sell the news event though as much of the current and future growth potential may be priced into the stock. Shares were up 9% the first three days of the week heading into the earnings, were up another 8% after its results were released, but ended up closing unchanged.
The bigger and more anticipated event was Federal Reserve Chairman Jerome Powell’s speech at the annual Economic Symposium at Jackson Hole. Powell gave a 15 minute speech that started with how inflation got so high, and factors causing it to move lower recently, and what is still keeping it too high. There has, and was again during the speech, a greater focus on the largest component of the inflation index – nonhousing services. This includes a range of services such as health care, food services, transportation, and accommodations. Powell said downward progress is needed here to restore price stability.
The second part of the speech focused on the outlook. Economic growth has been resilient with Powell acknowledging the “economy may not be cooling as expected.” Persistent better than expected growth could put “further progress on inflation at risk” and warrant additional rate hikes. He made similar comments on the labor market. If data shows continue strength as it has over the first half of the year, it would warrant more rate hikes as well.
The final part of the speech related to risk management and the path forward with policy. Despite some speculation the Fed may adjust its inflation target and move it above 2%, Powell reiterated 2% “is and will remain” the inflation target. There are several things that make its price stability goal more difficult – uncertainty about the lags in which higher interest rates effect the economy, the uncertainty on the effect of selling securities from its balance sheet, and the dislocations that are unique to this cycle due to one-time pandemic related events.
The ending message was what we expected the speech to be about; the Federal Reserve will be data dependent. If data comes in stronger than expected, it would warrant tighter policy, i.e. higher interest rates. If it comes in as expected the Fed could afford to pause rate hikes. As Powell concluded, the Fed is “navigating by the stars under cloudy skies.”
We may sound like a broken record talking about the Fed and its comments week after week, but we do so because it is one of the main topics markets care about. The expectation on what direction interest rates will go, or in this case how high rates will get, have a large impact on fixed income and equity markets, as well as on the consumer and economy. If interest rates are expected to go higher, bond markets will be quick to price this in and as a result, since consumer rates are highly correlated to Treasury rates, consumers will see higher rates on loans such as mortgages, auto loans, or even personal loans and credit cards. A rise in interest rates historically leads to lower loan demand, lower economic growth, rising unemployment, and eventually a recession.
On the other hand, if investors believe the economy will slow and fall into a recession, there is the expectation the Fed will soon cut rates and bond markets will begin pricing that in with lower longer-term rates.
Right now, the Federal Reserve is faced with the task of finding the level of interest rates that will be restrictive enough to slow demand and economic growth enough that brings inflation lower and to its annual 2% target without pushing the economy into a recession. The idea is bringing supply and demand in balance – right now inflation is too high because there has been too much money still chasing too little goods/services.
With its data dependent mindset, this week will be a big one for forecasting what the Fed will do next. We will see several reports on the labor market including the monthly employment report on Friday where the consensus estimate sees another 170,000 jobs added in August. Figures on the economy come with the second estimate of Q2 GDP and manufacturing surveys on Friday. In addition, we will see a reading on the Fed’s preferred inflation measure Thursday morning with the PCE price index. It may end up being a lose-lose for stocks. We would expect higher bond yields and lower stock prices with better than expected data but worse than expected data could be seen as an economy weakening more than expected and raise recession probabilities. As such, we see continued pressure on stocks.