Two questions facing investors in AI

The war escalates again

The US-Iran war continued to escalate over the weekend. On Saturday, the US announced that two soldiers had died after an Iranian attack on a base in Jordan and another US soldier had been killed during a ‘controlled detonation of unexploded ordnance’ from a downed Iranian drone, according to the BBC.

The US responded by bombing Iran for the ninth consecutive night. Iran, in turn, has attacked Bahrain, Kuwait and Jordan. The result is that traffic through the Strait of Hormuz has practically come to a halt.

At the time of writing, oil prices were up 2.5%, taking West Texas Intermediate to $84/barrel and Brent to $90/barrel. Refining margins continue to grind higher, too. As a result, US gasoline prices have increased too and the previously good news story on global inflation may well reverse in the next two months.

There’s been a drawdown in momentum stocks

There have been two primary questions about the artificial intelligence (AI) theme: what will be the return on investment (ROI) for all capital spending? And how much competition will there be in the large language model (LLM) space?

There has recently been increased uncertainty about both. Investment has surged, eroding free cash flows at hyperscalers, and given uncertainty about ROI, there is greater uncertainty about the trajectory of investment spending. This has weighed on semiconductors. While the S&P 500 is 2% off its 12-month high and the S&P 500 equal-weight is less than 1% off its 12-month high, the Philadelphia semiconductor index is down 20% off its 12-month high, down nearly 10% over the past week alone.

More broadly, there has been a sizeable reversal in the performance of momentum stocks (stocks that are driven by sentiment and market trends rather than fundamentals). The reason for the change in direction is probably the shift in the narrative about capital expenditure. The scale of the move may be linked to increased leverage, both through exchange-traded funds and margin accounts.

At the same time, there is increased concern about competition in the LLM space. In what could be another DeepSeek moment, there has been another LLM released by China’s Moonshot AI, called Kimi K3, which rates highly in performance and cost.

We have already seen a sizeable shift from US to Chinese LLMs. The underlying point is that competition may well erode any margin for LLMs – bringing further questions about whether the scale of current capital spending is justified.

Given how capable the latest models are, it seems regulation is on its way in the US. 

Global inflation slows in June

So far, 39 of the 50 largest economies worldwide have reported inflation figures for June. Median inflation slowed for the second consecutive month to 3.2%. The outlook is still uncertain, but at least inflation has declined, even if temporarily, taking some pressure off global central banks.

Nearly 50% of countries that have reported saw inflation prints below the consensus estimate. Last month, just over 50% surprised on the downside, too. This inflation shock has been smaller and much more in line with expectations than that in 2022.

US inflation slows

The US was one of the many countries to see inflation come in below expectations, at 3.5% (down from 4.2% in May) and below the consensus forecast of 3.8%.

Monthly inflation was -0.4%, largely due to a decline in fuel prices. Encouragingly, core inflation declined too, to 2.6%, below the consensus forecast of 2.8%. Core sticky inflation (items that don’t typically change much from month to month) declined, too, as did core services inflation.

In effect, there was enough in the print to give the Fed reason not to hike soon. Inflation may well tick up again this month, given the escalation in Iran, but if core inflation is heading towards 2%, that should give the Fed enough reason to pause. Even so, the market is still pricing in one hike by December, with an above-50 % chance of another by March next year.

The US budget deficit comes in at $120bn

The US federal budget deficit in June was $120bn, slightly better than the consensus forecast of $129bn, but still large. Over the past four years, the rolling 12-month budget deficit has regularly been between $1 trillion and $3 trillion.

It doesn’t seem like the deficit is getting to the White House’s 3% target anytime soon. 

Chinese GDP slows

Second quarter GDP growth was 4.3%, below the consensus of 4.5% and down from 5% in the first quarter. It was the softest GDP growth rate since 2022.

Exports have ramped up, though, up 27% year-on-year. It seems that the Chinese authorities are unable to stimulate domestic demand effectively.

Chinese inflation is at just 1%, below the consensus forecast for the second month in a row. There is ample need and space for stimulus in China, but at this point, it seems there is little government appetite for it. 

Earnings update

According to data provider LSEG I/B/E/S, 49 S&P 500 constituents have reported so far for the second quarter and of those, 89.8% have beaten on the bottom line. If that pace continues, this quarter will have the highest percentage of beats in at least 25 years. The average beat so far this quarter has been 12%.

As things stand, the current consensus forecast is that earnings growth for the S&P 500 will be around 26% year-on-year.

While the season has been good so far by any of the usual measures, there has been one wrinkle. Companies that have missed have been harshly punished. On average, companies that have missed have been down 9% according to FactSet vs an average historical response of -3%.

This week, 83 companies are due to report. 

Betting markets boom

Trading volumes on prediction market platforms Kalshi and Polymarket have risen to over $40bn in June alone. Both platforms offer a range of markets to bet on.

One particularly relevant market for South Africans is who will be the next mayor of Johannesburg. At this point, according to the bets placed on Polymarket, it is a fairly close race between Helen Zille and the ANC’s likely candidate, Frank Chikane. 

More signs of rising inequality

The richest 1/100,000 (0.001%) of Americans now have wealth equal to 12% of national income, by far and away the highest portion since records began in the mid-1800s.