The Shortest Straw
The greatest danger in times of turbulence is not the turbulence; it is to act with yesterday's logic. ― Peter Drucker
The early history of artificial intelligence (AI) is rooted in the mid-20th century, during which the foundation for modern AI was laid through theoretical exploration and initial practical implementations. In 1950, British mathematician and logician Alan Turing introduced the concept of a machine that could simulate any human intelligence, famously proposing the Turing Test as a measure of a machine's ability to exhibit intelligent behavior indistinguishable from that of a human. This period also saw the emergence of cybernetics. Norbert Wiener pioneered the study of control systems and communication in animals and machines, influencing early thoughts on machine learning and adaptive systems.
The term "artificial intelligence" was formally coined in 1956 at the Dartmouth Conference, organized by John McCarthy, Marvin Minsky, Nathaniel Rochester, and Claude Shannon. This event is widely considered the birth of AI as a distinct field of study. The conference brought together leading researchers to discuss the possibilities of creating machines capable of reasoning, learning, and performing tasks that typically require human intelligence. Early AI research was marked by optimism, with projects focusing on symbolic reasoning, problem-solving, and the development of simple neural networks. Initial successes included programs that could solve mathematical problems, play games like chess, and even exhibit rudimentary natural language processing.
However, the initial enthusiasm was tempered by the realization of AI's complexity, leading to the first "AI winter"—a period in the 1970s when funding and interest in AI research waned due to unmet expectations. Researchers encountered significant challenges, such as computational power limitations and the difficulty of programming machines to understand and interact with the real world.
Despite these setbacks, the foundational work of this era laid the groundwork for future advancements. The concepts, methodologies, and theoretical frameworks developed during these early years of AI research would later be revived and refined with the advent of more powerful computers and sophisticated algorithms.
This week, I had the chance to attend a presentation from Ulrich Bodenhofer from the Upper Austrian University of Applied Sciences about modern AIs like Chat GPT and their potential for businesses and finance. After briefly touching on the history of AI, as laid out above, he presented some present use cases of AI.
For example, he showed several pictures of birthmarks and how AI can distinguish them into "non-harmful" and "harmful" to detect skin cancer. However, he noted that AI just analyzes the pictures and runs calculations to compare them with data it was already fed.
Currently, AI is not capable of learning by itself. Hence, it's still far from what McCarthy defined as "Artificial Intelligence." Furthermore, Bodenhofer also showed some use cases for businesses and financial market analysis, such as chart analysis for forecasting. However, he noted that the technique is far from being able to forecast movements in financial markets, which isn't unsurprising because we all know that fundamentals don't solely drive market prices but also sentiment.
His final point was that AI tools like Chat GPT could be helpful for regulatory tasks and data analysis, such as analyzing business balance sheets, for example. Automatic trading AI systems are usually not advanced enough to make a real difference. Hence, he closed his presentation by saying that although AI offers many chances, it's still in an "early development" phase and won't turn the business world upside down in a year, but maybe within a decade or so.
The financial market situation has remained unchanged from last week, with market participants still in a wait-and-see mode. Regarding the introduction of AI, NVIDIA's earnings in Q1 exceeded expectations once again, and the company anticipates continued strong revenue growth. Following the earnings report, NVIDIA reached another all-time high after the close, surpassing $1,000 for the first time ever.
The broader stock market also shows no signs of weakness. European and US indices continue to trade near all-time highs, indicating an upward trend. This reinforces the notion that the short-term outlook remains bullish, contrary to the expectations of stock market bears.
Historically, all-time highs are predominantly a positive indicator for stocks. Therefore, I anticipate that the stock market rally is not yet concluded. Economic data in Europe is improving, and the possibility of an ECB rate cut should bolster sentiment. Additionally, the US economy is still far from recessionary territory, at least according to official figures.
Sentiment within the market doesn't appear overly stretched. However, some bears are starting to capitulate, such as Morgan Stanley's Mike Wilson, who recently retracted his prediction of a significant stock market drop. However, it's not that he has become highly bullish; thus, Wilson's "pivot" may not indicate immediate weakness.
Wilson joined Surveillance this morning to talk about his latest, more upbeat outlook. His team boosted its S&P target to 5,400 from 4,500 … maybe. His real point, he said today, was that the range of potential outcomes — from a soft landing to no landing to a recession — has gotten much wider, and that the S&P 4,500 could still very well come to pass.
Wilson also expressed concern shared by many stock market bears, namely that the future movement of the treasury bond market could be a nail in the coffin for equity markets.
A lot depends on bonds. Wilson thinks valuations in stocks depend entirely on whether Treasury investors continue to finance the deficit with relatively cheap yields on government debt. He didn’t use the words“Liz Truss moment,” but that’s what he was getting at — the risk of a we-won’t-take-this-anymore reaction by the bond market. Goodbye, liquidity.
The concerns about a further decline in the bond market seem less original than many believe, despite bond bears like Jim Bianco highlighting that investors continue to purchase bonds, suggesting that bonds may not have experienced a "capitulation phase" yet, similar to what occurred in the third quarter of last year, where yields surged, putting pressure on stocks. However, it's worth noting that Bianco's stance on higher bond yields has become more neutral.
Last week, I discussed the potential implications of the relationship between stocks and bonds around turning points, showing that historically, rising bond yields coinciding with rising inflation, such as in the 1970s, pulled down stocks. When CPI dropped or trended sideways, which it has done more recently, bonds always turned and rose before stocks began to fall.
Moreover, the argument that rate cuts are bearish for the stock market holds only when central banks decrease interest rates by more than 25 basis points and when economic data indicates a "recessionary" trend. Simply put, current expectations for rate cuts do not suggest an imminent stock market weakening.
However, it must be clarified that this is only valid if expectations are accurate. Currently, solid growth in the US persists, which also benefits the accelerating Eurozone economy. The recent geopolitical shift has brought Europe closer to its US ally, evidenced by the US becoming Germany's largest trading partner.
Although bonds have retraced a significant portion of their gains from Q4 last year, they remain below their cycle highs. The situation still does not entirely support the potential turnaround in the bond market.
Firstly, Japanese 10-year yields climbed to 1% this week, rendering domestic government bonds in Japan more appealing relative to US treasuries. Secondly, inflation in the UK didn't decrease as much as anticipated in April, driving bonds close to their April lows. Thirdly, the accelerating economic data in the eurozone is also bearish for bonds.
However, I believe that US economic data and the future trajectory of consumer price inflation will determine whether the bond market is already undergoing a turnaround. Whenever inflation figures surpass expectations, bonds will experience a sell-off despite the trend indicating continued deceleration in inflation in the UK and the eurozone. Additionally, the recent broad uptick in commodity prices supports the outlook of those expecting bond yields to continue their ascent toward their October 2023 highs, potentially reaching a level that the stock market cannot overlook.
The prevailing perspective, where analysts and economists scrutinize individual price movements to detect "inflationary pressures," exacerbates the growing anxiety among market participants that the surge in commodity prices will translate into an increase in the average price level, commonly referred to as "inflation."
However, from a historical standpoint, it's important to note that despite the recent uptick in commodity prices, commodities as a whole are not exceptionally high. Even though copper prices, typically a barometer of economic activity, recently hit an all-time high, the Bloomberg Commodity Total Return Index indicates that, despite trending upward since 2020, they still hover around their historical averages.
It's true that commodity prices and inflation strongly correlated after 2010. Still, the reason for this was that wage growth remained relatively subdued throughout the QE era, suggesting that the expansion of the money supply primarily manifested itself in the commodity space in the real economy, besides increasing demand for risk assets. Additionally, a significant portion of the increase in copper prices stems from China's current accumulation of copper stocks rather than reducing them, resulting in lower supply available for the rest of the world and consequently driving up prices.
Hence, it could be argued that the recent rise in copper prices is merely reflective of speculation rather than being driven by increasing economic activity. As commodity expert Alexander Stahel recently noted, once China begins selling at these elevated prices, the copper price should resume its recent downward trajectory.
My stance on inflation remains that all these fluctuations in individual prices will have no lasting impact on the average price level, except for short-term price swings where relative prices adjust towards equilibrium. Needless to say, this viewpoint contrasts with the prevailing macroeconomic theory and the majority of market participants who determine prices in financial markets through supply and demand dynamics.
Since the 1980s, central bank statements have become crucial for investors' decision-making, as evidenced by how market participants dissect every word of a central banker when commenting on the current market situation. Central banks have been perceived as guiding lights for the market, akin to the North Star guiding sailors. Speculations about the market direction naturally intensify when that 'North Star' is absent.
I would argue that relying on an incorrect theory exacerbates this situation. It's somewhat disheartening that we find ourselves in the aftermath of the first significant inflation wave of the 21st century, which many central banks and mainstream economists failed to foresee or are still employing the same economic models to predict the future inflation trajectory, albeit belatedly.
Within these models, rising prices in specific sectors of the economy are interpreted as 'inflationary pressures,' akin to observing water boiling in two pots at different temperatures without recognizing that it’s not the pots causing the temperature rise but rather the fact that the stove is turned on. As long as central banks disregard past changes in monetary aggregates, they won't fully grasp inflation and will remain passengers rather than drivers in navigating economic policy.
Consequently, central banks and market participants focus heavily on lagging indicators such as the labor market and overall inflation. However, inflation itself is a lagging indicator, which increases after the money supply expands and economic activity rises. Moreover, government official data relies heavily on statistical models for estimation, often overlooking subsequent revisions if the original release proves incorrect.
While lagging indicators suggest the economy is on a solid path, other indicators doubt this narrative. For instance, the latest earnings from Target, a US grocery company, missed estimates, reporting a 3% drop in sales compared to the previous year.
On a call with reporters, CEO Brian Cornell said the company’s results reflect “continued soft trends in discretionary categories.”... [Target] wants to make sure it offers customers value and communicates that in a clear way, with moves like its relaunched loyalty program. Target also announced Monday it was cutting prices on thousands of everyday items, including milk, bread, paper towels and diapers.
Although it remains to be seen if this trend also extends to Target's competitors, it implies a cooling demand. Decreased demand translates into lower prices until companies are compelled to cut costs and lay off workers. Notably, consumption remained robust for a considerable period due to consumers benefiting from pandemic stimulus money, which they subsequently depleted to maintain consumption levels.
This brings us to the interconnections within certain economic aspects. While a strong labor market may support a certain level of consumption, declining consumption weakens the labor market. The pandemic exacerbates this situation as businesses grapple with rehiring challenges and opt to retain workers for as long as possible, a phenomenon known as “labor hoarding.”
Stimulus-induced demand boosted profits and labor demand, driving wages upward. However, with inflation rendering several life goals unattainable, consumers have shifted towards short-term gratification: increased consumption. Now, as companies like Target realize their inability to sustain profit margins through price hikes, it signals consumer exhaustion.
Reduced mortgage payments relative to income offer relief as long as income remains stable. However, suppose these gains are channeled into consumption to counter inflation. In that case, consumers may resort to increased credit card spending for consumption, reaching a point where they can no longer sustain it. This is evident from rising delinquency rates experienced by an increasing number of individuals.
Granted, delinquency rates are still significantly lower than their highs during the Global Financial Crisis, but it's reasonable to anticipate that the upward trend will persist. However, the current advancement in AI could lead to a markedly different outcome compared to previous periods of heightened layoffs. While past downturns predominantly affected blue-collar workers, AI now presents an opportunity for businesses to potentially trim higher-paying, white-collar positions, impacting individuals with typically higher consumption levels. White-collar workers may find themselves particularly vulnerable in this scenario, pulling the shortest straw.
Therefore, I find it improbable that the economy will maintain its strength and anticipate further weakening in the months ahead. Consequently, I am skeptical that bond yields will rise close to or surpass their highs from October. On the contrary, the strain on consumers could precipitate an unexpectedly sharper decline in inflation, initially buoying risk assets before significant central bank interventions dampen stock market performance. This could also trigger an abrupt halt to the European economic recovery.
Shortest straw, challenge liberty
Downed by law, live in infamy
Rub you raw, witch hunt riding through
Shortest straw, the shortest straw has been pulled for youMetallica - Shortest Straw
Have a great weekend!
Fabian Wintersberger
Thank you for taking the time to read! If you enjoy my writing, you can subscribe to receive each post directly in your inbox. Additionally, sharing it on social media or giving the post a thumbs-up would be greatly appreciated!
All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.