Rudi’s View: Bull, Bear & Bubble; AI Is The New Kingmaker

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In This Week’s Weekly Insights:

-Bull, Bear & Bubble; AI Is The New Kingmaker
-No Weekly Insights Next Week
-Undiscovered Jewel – FNArena Windows

By Rudi Filapek-Vandyck, Editor

Bull, Bear & Bubble; AI Is The New Kingmaker

Is it a bull market? A bear? A transition between the two? What’s with the bubble in Megatech and AI companies?

Whatever the definitions used, a market that is as polarised as today’s breeds confusion among investors and market commentators.

Maybe the safest observation to make is that some parts of the markets are enjoying a positive environment whereas many others are not.

The easiest distinction between the two opposites aligns with the US bond market’s signal that economic recession in the world’s largest economy remains on the horizon. This explains why companies believed to be less vulnerable to significant loss in economic momentum are currently the beez neez for cautious investors.

Cheap valuations are only as cheap as determined by the next downgrade in profit forecasts. Economic recessions are virtually never genuinely priced in before they actually occur, because we have no idea about the how deep and how long. Which is why cautious investor behaviour is creating different momentum characteristics for distinctive parts of the market.

But wait, there’s (a lot) more.

2023 has also alerted the world to the development of artificial intelligence. Let there be no misunderstanding: this is a seminal turning point with ‘AI’ poised to shape the future in the same manner as once occurred with the personal computer, the Internet, and smart phones.

Now that we’ve gained that insight, as a global population, it should be no surprise the hottest investment options on earth are all directly connected to the new future that is awaiting us all.

Nvidia shares in the US are up some 177% year-to-date. Crazy right? This is what happens at this early stage of unbridled excitement. On the ASX, shares in data centres operator NextDC ((NXT)) are but a whisker away from setting a new all-time high. Eight months ago investors would find it near impossible to find any takers even if they offered their shares for free.

Go figure.

Even more gobsmacking is the fact shares in Appen ((APX)) are now trading well above the pricing pre-profit warning and pre-capital raising. It’s futile trying to put too much intelligence into what is essentially human sentiment feeding into share market momentum.

Play along as you like, or, if you’re more like me, enjoy the fact that NextDC and that other beneficiary, Telstra ((TLS)), happen to be in our portfolio for non-related reasons. Both were poised for good things anyway. That part certainly hasn’t changed.

It’s equally important for investors to understand what we are seeing in markets today is but the initial phase in what will plausibly turn into the most defining technological breakthrough for the rest of this decade, at least.

AI is set to change the world, just like the three above mentioned precedents did, in ways that are too much to fully comprehend today.

Macro Cycles In Productivity

Taking a macro view, economic productivity seems to move through cycles and the past two decades have seen general productivity slow down to a virtual halt – the world around.

For example: the quarterly growth rate in labour productivity in the US has averaged 0.3% since 2005 – half the rate of the average for the 1947-2004 period, according to a recent update on this matter by Morgan Stanley.

History suggests at the end of every productivity cycle there’s innovation or new technology that brings about a new boost. Morgan Stanley equally blames the GFC for the post-2004 slowdown as businesses with weak balance sheets and higher exposure to financial shocks invested less in innovation.

The boost provided by the adoption of the Internet only lasted so long, hence global productivity started to deteriorate after 2004, and has remained on a sliding slope since.

A broad adoption of AI can make a substantial change and trigger a new up-cycle, but it will require substantial investments to be made. Upfront. Hence the key factor here is ‘time’. The world won’t change overnight, irrespective of our common enthusiasm and impatience. But significant change is poised to happen in the years ahead.

Already, companies have started to communicate their fresh plans and enthusiasm to analysts and investors. At last week’s investor briefings, management at Tabcorp ((TAH)) suggested making more and better usage of its data will lead to a better users-focused business with return on invested capital (RoIC) expected to double.

The post-GFC years have been rather challenging for what was prior considered a reliable, defensive business. Today, Tabcorp has very few genuinely excited analysts covering it. But what last week’s investor briefing showed is that data plus AI can potentially usher in a completely new era for this perennial share market laggard.

The same principle applies to other companies and sectors that heavily rely on human labour and are constrained in their growth, since finding the right skills, and keeping them, is such a challenge. At the macro level, economies faced with shrinking populations might have just been given the perfect antidote with AI promising more output with less labour.

Inflation-fighting central bankers should be pleased too, even though, yet again, AI is not providing an immediate fix.

Bottom line: investors should expect a noticeable uptick in businesses spending on technology, likely once the world has moved past that upcoming US recession. A recent survey of chief information officers by Morgan Stanley in the US suggests expectations for IT spending for the coming three years are circa 2.5 times higher than levels pre-covid.

Analysts at Morgan Stanley believe there already is sufficient evidence to believe “the great productivity race is on“.

“(…) we see strong evidence that we are in the “Data Era” – a technology-driven, decade-long investment cycle centered on data and digitalization that allow businesses to gain insights, improve outcomes and drive productivity.

“We believe that Data Era tech diffusion can result in much needed productivity gains over the next five to 10 years.”

AI Everywhere

Already, Japan has reportedly announced copyright will not be enforced on data used in AI training. This is a landmark decision, and a world’s first. Clearly, the Japanese establishment hampered by a shrinking population sees the potential benefits of AI and wants as few barriers as possible to maximise the opportunity.

Japanese equities are outperforming most other markets in 2023. Coincidence?

The FNArena inbox has already received the first press releases from biotech companies suggesting AI will make their development journey so much easier.

The earlier mentioned analysts at Morgan Stanley see the bigger productivity opportunity for manufacturing industries, with many operating on relatively complex business models.

Broadly taken, the impact from AI on individual businesses and whole sectors can be distilled down to three key areas:

-Extra sales/revenues

-Increased competition

The true beneficiaries will be those who enjoy both extra growth and lower costs, while still maintaining their competitive position. Increased competition has the ability to wipe out any benefits achieved (while still forcing businesses into costly investments).

Analysts at UBS, while suggesting generative AI has the potential to cause a generational transformation of economies and businesses, put together an early attempt to identify likely winners and losers from those three key levels of impact.

Sectors that should see both top line and bottom line benefiting without increased competition include:

-medical devices
-technology hardware
-semiconductors
-telecoms
-luxury goods
-general retail
-food retail
-capital goods
-mining
-real estate

Sectors exposed to AI creating a fiercer competitive environment without a clear boost to sales, but with the potential for reducing costs:

-financials, including banks, insurers, fintechs and wealth managers
-transport
-building & construction
-IT services and support
-autos

It is not difficult to see why AI has become the new magic term on Wall Street and elsewhere, in particular as the prospect of a US recession still looms.

At the same time, AI, in most cases, is a medium-term story, at best, and there are changes taking place elsewhere that equally should be on investors’ radar.

Higher Costs Remain A Problem

Post covid lockdowns and with war in the Ukraine ongoing, most businesses around the world continue to face challenges caused by higher operational costs. With tighter credit and higher interest rates weighing on economic growth in the second half of the current calendar year, the scene seems to be set for more disappointments from corporate Australia.

That’s not even taking into account the follow-through impact from the Fair Work Commission‘s decision to increase the national minimum wage by 5.75%.

Thus far, corporate profit warnings have predominantly come from higher risk, lower quality businesses such as Bubs Australia ((BUB)) and from smaller cap retailers such as Adairs ((ADH)) and Universal Group ((UNI)) in Australia, but investors will be asking: are these companies simply the proverbial canaries that feel the pressure first?

The February reporting season left the ASX with a much larger-than-usual Second-Half-Club of companies that need a better performance in H2 to meet guidance and/or market forecasts, suggesting the number of profit warnings might well grow a lot larger before the start of the August results season.

Adding to continuous cost pressures are profound changes taking place in the energy sector, difficulties in sourcing skilled labour, rising debt-servicing costs, and generally speaking the move towards a carbon-neutral economy. Consumers increasingly under pressure from high inflation and RBA rate hikes are becoming more price-conscious, and this will affect businesses too.

According to the latest research by Roy Morgan, some 1.38 million mortgage holders in Australia are now ‘At Risk’, which marks an increase of 529,000 from twelve months ago, and almost equals the 1.4m identified in August 2008.

The researcher reports the proportion of mortgage holders considered At Risk’ of mortgage stress in the three months to April 2023 (27.8%) is the highest since October 2011 (28.3%).

Similarly, the Fair Work Commission’s decision will only further add to cost pressures for businesses across the country, particularly those where wages represent a substantial portion of overall costs. Toughening conditions imply it becomes increasingly more challenging for businesses to pass on higher costs to consumers.

Sectors in which staff wages represent at least 50% of total operating costs include transport, food production, and engineering and contractors to the mining and oil & gas industries. Businesses considered the most labour-intensive include supermarkets, builders and healthcare services.

In an update on Monday, a report by UBS identifies companies such as AMA Group ((AMA)), Collins Foods ((CFK)), Downer EDI ((DOW)), Perenti ((PRN)), G8 Education ((GEM)), and Link Administration ((LNK)) among the most labour-intensive business models on the ASX.

Equally noteworthy: when it comes to filling job vacancies, the two industries most challenged in Australia are hotels and food services.

The sizable increase in Australia’s minimum wage has also seen economists adding one extra RBA rate hike to their forecasts for the months ahead.

Change Is The New Dynamic

The emergence of AI, now mature enough to be applied across industries and across the globe, may in the future well be seen as having laid the seed for the next bull market in equities. For cautious investors, however, there remain plenty of signals that tangible risks have not all of a sudden disappeared.

This year’s extreme concentration into a small number of megatech and AI winners in US equities is seen by some as a signal the rest of the market is about to catch up, which, at face value, is a scenario that is at least equally plausible to the bearish alternative that sees the few winners coming back to earth on too much exuberance.

I think the optimistic view likes to think there won’t be a recession, which remains a dangerous premise given the combination of (sharply) inverted bond yields and tightening credit has historically been a reliable signal for economic recession. Even the milder version of economic recession can still cause mayhem in financial markets.

As an investor, it is equally worth keeping in mind not all companies will suffer, or suffer equally, when tougher times come along. Plus there will come a point, of course, when markets will no longer look towards, but beyond the upcoming slow downs/recessions.

AI is injecting the promise of a better future into medium term prospects, which is unlikely to change in the months ahead, recessions or not. Shorter-term, its impact is another contribution to extreme polarisation in asset moves and prices.

With time on their side, investors might as well start reading up on, and preparing for the next business and societal transformation that will add even more changes to our world beyond this year.

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FNArena already published its first story involving AI last week:

https://www.fnarena.com/index.php/2023/05/31/healthcare-meets-technology-a-new-age/

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More reading:

https://www.fnarena.com/index.php/2023/05/31/rudis-view-a-lesson-in-quality-and-investing/

All-Weather Model Portfolio

The FNArena/Vested Equities All-Weather Model Portfolio took a hit last month when a change in language tests for foreign students looking to study in Canada triggered a sudden sell-off in shares in IDP Education ((IEL)), currently the only one to organise such tests.

One can always trust the share market to go overboard when such unforeseen events occur, which I believe has yet again been the case with IDP Education. The Portfolio has doubled its exposure in the turmoil.

Offsetting weakness in IDP Education has been strength in NextDC and TechnologyOne ((TNE)) shares, while others including Goodman Group ((GMG)) and CSL ((CSL)) added small gains.

In the end, the Portfolio managed to stay in the positive for the month (0.28%) while the ASX200 Accumulation index retreated by -2.52%.

The numbers are equally in favour of the All-Weather Portfolio over 3, 6 and 12 months with returns of respectively 2.42%, 5.75% and 8.31% versus -0.85%, -0.53% and 2.97%.

Do note those numbers are ex-fees, which differ between portfolios.

As indicated previously, the Portfolio continues to hold a sizable allocation to cash (20%) and gold (5%).

As the outlook for bond yields is changing this year, I have been more comfortable adding suggestions to the curated list of great dividend paying companies on the ASX.

The All-Weather Model Portfolio predominantly picks from the curated lists that are available 24/7 to paying subscribers on the dedicated segment of the FNArena website:

https://www.fnarena.com/index.php/analysis-data/all-weather-stocks/

No Weekly Insights Next Week

Due to next Monday’s public holiday in Australia, Weekly Insights will take a week off and re-appear the following week.

Undiscovered Jewel – FNArena Windows

There’s more to FNArena’s suite of services and tools than initially meets the eye. One of the sections that probably remains undiscovered by most subscribers is FNArena Windows.

This particular tool allows subscribers to research the share market through specific topics and sectors, and compare companies with peers in the same segment.

Starting point are three general roots of the Australian economy: Commodities, Financial Services, and Industrials, after which researching investors can start digging deeper into each channel.

Continue digging deeper and deeper, and ultimately one lands with a basket of companies that are all linked to new battery materials such as lithium and cobalt. Below are the first ten in that particular basket, but one can change the settings and allow for up to 100 companies in alphabetical order.

FNArena Windows can be accessed via the drop down menu starting from FNArena News on the horizontal black belt that runs near the top of the website.

Scrolling down towards the bottom of the front page equally ends up at FNArena Windows on the bottom left.

FNArena Subscription

A subscription to FNArena (6 or 12 months) comes with an archive of Special Reports (20 since 2006); examples below.

(This story was written on Monday, 5th June, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena’s see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: contact us via the direct messaging system on the website).

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