Inflation, AI, and banks: Why uncertainty is back

How are markets reacting to a higher-than-expected inflation?

Inflation

Inflation accelerated in September, with the U.S. Consumer Price Index (CPI) rising 3.7% on a year-over-year basis.¹ The market reacted negatively, as it should. For us, this data highlights that the conversation around interest rate increases will continue and that the pressure on the lower-end consumer is likely to ratchet up. Some companies appeared to be holding off on price increases while monitoring the CPI to see if it would come down. With inflation staying sticky, however, the expectation is that these companies’ rising input costs will now get passed down to the consumer rather than be allowed to eat into the companies’ profit margins. We would expect this to occur over the next two-to-three months, and it is likely to have an impact on consumers’ spending patterns; in particular, companies that cater to lower-end consumers may see less volume. Sector-wise, the areas with the lowest margins are going to be impacted the most, with Consumer Stapes the most likely to see a downtick. Any industry that is directly affected by higher oil prices—transportation, for instance—could also experience some turbulence. We’d expect Technology to be less affected, even though it did experience a big pullback on the day of the CPI announcement. Many of the services that Tech companies provide function almost like a utility in that they are essential for day-to-day work and life, and Tech customers also tend to be on the higher-end side rather than the lower. That said, if interest rates are raised, then Tech would be impacted, as the discounted cash flows would be lower and hence the multiple would need to come down. Speaking of the interest rate outlook, we don’t think this inflation data meaningfully changes the U.S. Federal Reserve’s (Fed) calculus, though it probably does marginally increase the chance of a rate hike in October. Our view, however, is that the Fed doesn’t particularly want to raise rates and will try to find ways to push an increase out until December in hopes that inflation will come down in the interim.

Bottom line: Markets were warranted in their negative reaction to the latest CPI data, and our expectation is that Consumer Staples and transportation will be most affected by rising input costs being passed along to the consumer.

AI

The artificial intelligence (AI) theme’s momentum has stalled recently, with companies like data centre operator CoreWeave getting hit particularly hard on investor concerns about debt-heavy balance sheets.² While the numbers are an important part of the story, it may also be worth playing a bit of armchair psychologist to understand how markets are reacting. In our view, investors are tip-toeing around Tech at the moment; while many still like the theme and want to invest in it, they are also wondering whether revenues will be strong enough to justify the companies’ spending. The fact that the bar for earnings is so high is also likely factoring into markets’ skittishness. There is a segment of the market that could potentially run for the hills at the first sign of alarm bells. That said, there are still many investors who strongly believe in the AI story and remain all-in on AI stocks. As this debate plays out, our expectation is that investor nervousness will continue to cause more volatility for any company tied to Tech or AI. We expect this uncertainty to affect the upcoming IPOs of Anthropic and OpenAI as well, which could see similar ups-and-down as we saw with SpaceX.

Bottom line: Some investors are nervous about AI at the moment, which we expect will cause continued volatility in Tech and potentially accelerate a rotation to non-Tech names.

U.S. banks

U.S. banks have taken a beating recently, in part driven by the US$1.2 billion in fines levied against Bank of America for money laundering violations.³ This is the kind of negative story that investors, ourselves included, likely couldn’t have anticipated. That said, we remain fairly bullish on U.S. banks, and if anything, we are viewing this pullback as an opportunity to add to our Financials position. In addition to the fines, a selloff in the bond market driven by interest rate uncertainty has also shown up on U.S. banks’ earnings reports.⁴ Our evaluation, however, is that if you believe the consumer will remain relatively healthy—as we do—then you still want to own Financials. Higher bond yields might start causing investors to move from equities to bonds. But given that Financials offer decent yields in addition to upside potential down the road, we might see less movement out of that sector.

Bottom line: Like Tech, U.S. Financials are paying the price for a nervous market, but we view this downturn as a good entry (or re-entry) point for investors.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Trick or treat? Stubborn risks meet market optimism.