What can investors learn from Q2?

Characterised by a relatively benign economic backdrop that allowed the stock market to rise, the second quarter of 2024 left investors waiting for interest rate cuts while drama in the political arena overshadowed market activity.

Overall, though, global equity markets made modest gains while bonds lost a little value. In recent months, expectations of interest rate cuts have been pushed further back because the economy has continued to perform better than expected while the progress of inflation towards target has been more nuanced.

Inflation has subsided

In the UK, the inflation rate has fallen from over 10% in 2022 back to the Bank of England’s (BoE) target rate of 2% in May this year.

However, the improvement is slightly sullied by the persistence of inflation in the services sector. This is because, while many prices are essentially set by global demand and supply, most obviously the oil price, other prices are determined more by the strength of the domestic economy.

That can include goods, but given many of these are imported, services inflation tends to be a purer reflection of shortages or surpluses of workers within an economy. An economy that is overheating is one in which the demand for staff allows candidates to negotiate ever higher wages, which companies then recoup by raising prices. The labour-intensive services sector is particularly prone to this.

The good news is services sector inflation has also been slowing, but it remains well above target. This persistence has caused a dilemma for the BoE’s Monetary Policy Committee. While collectively it would like to cut interest rates because it expects economic momentum to slow, some members want to see services inflation slow further before cutting. Others point out that by that time, it may be too late to avert a recession.

Interest rates have started to fall

The dilemma seen in the UK is repeated across Western economies. It has generally been the reason interest rates have not fallen as fast as expected. However, a few central banks did manage to make a start at cutting rates during the quarter, the most significant example being the European Central Bank.

In the UK, anticipation of the BoE cutting interest rates saw mortgage rates start to decline, but delays to those cuts have seen them creep back up in recent weeks. This discourages new house purchases and raises costs for those needing to remortgage. Companies seeking to borrow also find it more expensive and may feel less inclined to invest.

Most bonds will benefit from falling interest rates because they pay fixed interest, so these delayed cuts were a headwind. However, for bonds issued by companies, the stronger economy reduces the risk of non-payment, and they rise in price to reflect that.

Generally, companies continue to hire staff and those staff are now earning more. At the same time, inflation has started to slow, allowing consumers to rebuild some of their savings. Moreover, the pockets of households in financial distress due to higher interest rates are relatively few and businesses seem inclined to hold on to their staff.

Stocks rise unevenly

Over the first few months of the year, companies experienced sales and profit growth, with the better economic and earnings outlook leading to continued gains. The coming weeks will reveal the extent to which this continued into the second quarter.

Perhaps unsurprisingly, in the first half of the year artificial intelligence (AI) began to be cited on earnings calls from companies in many different sectors, as investors became focused on which would survive, and which would be left behind by this increasingly widely adopted innovation. Unfortunately, investors tend to become over-excited by individual themes, which often fail to live up to their hype. AI certainly runs this risk.

A theme that has delivered on its hype is that of increasing semiconductor production. Semiconductors are the underlying technology that allow modern electronic devices to function. As computing demands have risen, the volume and type of semiconductors required have increased exponentially.

The AI “gold rush”

AI has the power to become a transformational and ubiquitous technology. However, that does not necessarily mean that everything touched by AI will turn to gold for investors. In fact, during the 19th century Californian gold rush, hundreds of thousands of people headed to California to seek their fortune, with most failing.

In retrospect, it was the merchants supplying the prospectors with picks and shovels who made the most money. As we’ve previously highlighted, the equivalent of picks and shovels for the AI gold rush includes semiconductors, which have the added advantage of being more broadly applicable in an increasingly digital economy.

Semiconductors became a bottleneck during the pandemic lockdown, as suppliers grossly misjudged the demand for products and suffered supply constraints. Certain categories then became oversupplied as the economy reopened. But over recent months, demand has once again caught up with supply, helping many companies involved in the supply of semiconductors to enjoy strong profit and share price growth.

The most eye-catching of these firms is Nvidia, a chipmaker whose products first gained popularity for driving the very impressive graphics on high-end gaming and media computers. They have now evolved to become the equivalent of brain tissue for many implementations of AI.

In recent weeks, Nvidia has broken all sorts of records and briefly became one of the largest companies in the world. It’s now one of the “Magnificent Seven”, joining other tech-enabled behemoths Microsoft, Apple, Amazon, Alphabet, Meta and Tesla as the largest and most influential technology stocks (at the time of writing, Tesla has rather fallen away from this group).

Some of these companies are amassing large amounts of data while others are providing cloud computing services. Semiconductors, data, and the cloud can all be considered picks and shovels for the AI gold rush, although they all have other strings to their bows.

Beyond technology

It’s of no surprise then that technology stocks were the best performers in the second quarter. But other assets performed well too, such as UK and Asian stocks, while less fashionable sectors, such as energy and utilities, also enjoyed moments.

A digital world may seem divorced from the natural world but increasing demand for computing power also brings increasing energy needs. However, the environmental threat of climate change and the economic threat of renewable energy sources have left companies reluctant to increase their fossil fuel energy production. Less new investment supports prices and will partially reduce some of their historic volatility and the volatility of energy company profits.

Political turmoil

It would be remiss not to mention the major political news of the quarter – the two surprise elections called in the UK and France. Both resulted in significant changes within their respective parliaments, although the French legislative elections do not affect President Emmanuel Macron who will remain head of state until his term expires in 2027.

In the UK, a new government was formed, led by the Labour Party. This result had been clear from polling for many months, with only the eventual size of the majority remaining to be determined. Thus ended a 14- year period of Conservative rule, which few would have foreseen in 2010, when the Conservative-led coalition government began the job of recovering the UK from the financial crisis. Later years proved particularly erratic for a government that negotiated Brexit and navigated the pandemic.

Age-old challenges

Markets were little moved by the change in UK government and remain focused on the U.S. As the quarter ended, the viability of President Joe Biden as an electoral candidate was being tested following a stuttering performance in the early televised debate he held with his challenger, former President Donald Trump.

The debate performance helped Trump take the lead in the race to the White House. A disconcerting feature of President Trump’s agenda is his threat to impose tariffs on all imports to the U.S., a move which would undoubtedly trigger reciprocal tariffs from trading partners.

From an investor’s perspective, when governments change, the focus tends to be on their plans for tax and government spending. The Labour government has maintained that it will be fiscally responsible, although independent assessments struggle to make its sums balance. Investors are paying close attention given the UK recently experienced the ire of the bond market during a mini-budget that did not appear fiscally sustainable.

As the quarter ended, the U.S. president’s age remained a hot topic of conversation. Biden, currently 81, would be the oldest president to win a term in office. His opponent, at 78, would run him a close second. The third oldest president of the U.S. was Ronald Reagan, who was a sprightly 73 when he won his second term. It showed when Reagan was challenged about his age and replied…

“I will not make age an issue of this campaign. I am not going to exploit, for political purposes, my opponent’s youth and inexperience”

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