MARKET RETURNS: Prices for most assets continued to rally in the third quarter. Emerging markets led global equity gains with a double-digit return and have now taken the year-to-date lead over their developed market peers, which appreciated nearly 4.8% during the quarter. U.S. large company performance in between those two numbers was not enough to overcome the performance deficit vs. foreign stocks from earlier this year, most of which is attributable to the decline in the dollar. Smaller companies outperformed within the U.S. during Q3, finally joining most other areas of the equity markets in making new all-time highs. High quality U.S. bonds generated a 2% return, maintaining their first half pace. Foreign bonds were the lone major asset class with negative performance, as the currency component more than offset gains in local terms. Cash continued to yield slightly over 4% annualized, although that number should come down as the Fed resumes cutting rates. The environment remained highly favorable for precious metals, with silver outpacing gold.
LOOKING FORWARD:
Dot-Com 2.0? We’ve been hearing more questions regarding an artificial intelligence bubble lately. Given notable outperformance for related stocks, both off the April market lows and over recent years, the topic has been coming up both in client meetings and financial media. Our view is that it is not yet a full-blown bubble akin to the dot-com experience, although stock prices reflect exuberance and therefore warrant a degree of caution.
There are several similarities between this period and the late 1990s. A revolutionary new technology has captured public fascination and has the potential to dramatically change how people live and work. Capital is pouring into the sector, financing a massive infrastructure buildout. The return on those investments is highly uncertain and dependent on widespread adoption.
Yet there are also important distinctions. Business models and monetization plans tend to be better defined today. Companies are less dependent on capital markets access, with the AI “hyperscalers” financing their capital expenditures from revenues tied to cash-cow core businesses (see chart) as opposed to unprofitable dot-coms going public. Past technological advancements have also laid the groundwork for faster AI adoption, in contrast to otherwise viable internet ideas that proved premature due to delivery constraints (network capacity, smartphones, etc.).
We find the telecom analogy more apt than dot-com. Most of the focus for AI spending is on infrastructure rather than products and services, at least for now. Nvidia is the poster child for AI, analogous to Cisco during the tech bubble. The main question for investors is whether these expenditures will prove excessive and lead to a period of subsequent underperformance or whether the companies will see more immediate returns on their investment as applications drive utilization.
Tariffs and Inflation: Inflation readings have remained remarkably subdued following the announcement of “Liberation Day” tariffs in early April. Understanding why has proven challenging due to delays, deviations from announced policies, and decisions by importers to temporarily insulate themselves or absorb costs.
Tariffs are unquestionably inflationary, in our view. While they may lead to more of a one-time shock than sustainable price increases, they should still drive prices higher and the impact may be more protracted due to the factors mentioned above. It’s true that they represent a type of tax and taxes tend to reduce growth and inflation, but they act through the transmission mechanism of higher prices.
So why haven’t we seen their impact show up in higher inflation readings? The market reaction to Liberation Day prompted a 90-day pause, meaning most tariffs weren’t effective until July and should only recently begin to be reflected in official measures. Policy has also been a moving target due to implementation challenges or lobbying efforts by affected firms. Finally, many companies stockpiled supplies or chose to absorb costs, which they could afford thanks to historically robust profit margins.
These influences are likely to diminish eventually, leading to observable increases in consumer prices. Other factors such as a weaker dollar and a contraction in labor supply from immigration restrictions should also be inflationary. Less restrictive monetary policy and political pressure on the Fed could increase the risk of a potential policy mistake that could result in a second inflation wave like in the 1970s (see chart). While we wouldn’t expect a return to levels seen when inflation spiked in mid-2022, inflation is worth monitoring from a risk management perspective.
Conclusion: After another strong quarter for global markets, it’s important to remain mindful of both opportunities and risks. The fact that many stock indexes are near all-time highs doesn’t preclude further gains. Yet elevated valuations relative to fundamentals don’t leave much room for error, particularly for AI-related companies. Momentum-driven markets can be especially perilous to navigate as being prematurely cautious is often indistinguishable from being wrong. Intermediate-term bond yields remain attractive, but inflation or deficit concerns could cause them to move higher still. Owning assets that benefit from inflation can help address the risk of higher prices, although a fiscal course correction will require action from Washington. Overall, we’re happy to make hay while the sun shines so long as we’re also prepared for the inevitable rainy day.
We wish you and your loved ones all the best as the holiday season approaches!
Index Descriptions:
S&P 500 Index TR is a market capitalization weighted index which represents the broad market for large company U.S. stocks. Returns reflect the reinvestment of
dividends.
The MSCI EAFE Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developed market stocks excluding
those from the U.S. and Canada. Returns reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.
The MSCI EM Index NR USD is a market capitalization weighted index which represents the broad market for large and mid-sized developing market stocks. Returns
reflect the reinvestment of dividends and foreign withholding taxes and are translated into U.S. Dollars.
The Bloomberg U.S. Agg Bond Index is a market capitalization weighted index which represents the broad market for taxable investment grade U.S. dollardenominated
bonds. Returns reflect the reinvestment of interest.
The US Treasury Bill Auction Avg 1-month is an index comprised of short-term U.S. government-issued investments with yields collected weekly and can be considered
a proxy for cash.
Portfolio performance, characteristics, and volatility may differ from the benchmarks shown. Opes portfolios are managed according to their respective strategies
which may differ significantly in terms of security holdings, industry weightings, and asset allocation from those of the benchmarks. Benchmarks are unmanaged and
provided to represent the investment environment in existence during the time periods shown. An index is not available for direct investment, and does not reflect
advisory fees, any of the costs associated with buying and selling individual securities, or any other fees, expenses, or charges. Past performance may not be
indicative of future results.
The opinions expressed in this article are for general informational purposes only and are not intended to provide specific advice or recommendations for any
individual or on any specific security. All opinions expressed herein constitute the judgment of the author(s) as of the date of the report and are subject to change
without notice. The material has been gathered from sources believed to be reliable, however Opes cannot guarantee the accuracy or completeness of such
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