Week ahead: AI sell off, Payrolls and German elections

What a difference a month makes. The latest market rally is fueling itself on rate cut hopes and continued expectations of a soft global economic landing, even as the AI theme starts to unravels. However, this hinges on China and the US labour market. September is an important month for two reasons. Historically, it is a bad month for stock market returns, and although US markets are closed today, Emini S&P 500 futures are lower, added to this, shares in China are also weaker after lower than expected manufacturing PMI data for August. Added to this, a rate cut from the Fed at their meeting on 18th September is now fully priced in, along with expectations that they will signal that further rate cuts are coming down the line. The path was laid by Jerome Powell at the Jackson Hole conference last month; however, this week’s payrolls report also needs to play ball to ensure that the US labour market is weakening, but not by too much to spook investors. The dollar is weak across the board at the start of this week, which is good news for risk sentiment. Although stock market indices in Europe and the US had a strong month in August, there has been a noticeable shift in the past week: tech is losing its dominance, and doubts are setting in about the future of AI stocks.

Are the wheels coming off for the AI theme?

This could mark the most important week for stock markets so far this year. Nvidia may be the best performing stock on the S&P 500 so far this year, up 147%, however, its star has fallen in the past week. Nvidia’s share price dropped more than 7% last week, although it attempted to stage a recovery on Friday and was higher by 1.5%. However, it was still one of the worst performing stocks on the S&P 500, after Nvidia posted a fat, but not fat enough, revenue forecast for Q3 and even said it is seeking a $10 trillion market valuation. There are also broader problems for the AI sector brewing, which are eroding market confidence. There are concerns that AMD processors are not selling as well as the market had expected, and Hindenburg Research posted a note last week that claimed there is evidence of accounting manipulation at Super Micro Computer, the new kid on the block that joined the S&P 500 in March, and up until recently had been the best YTD performing stock on the index. The Hindenburg report caused Super Micro’s  stock price to fall 28% last week, and the seed of doubt has now been planted into investors’ minds, suggesting that the AI trade is more brittle than some thought.

Nvidia fails to sink US stock markets

The problem for Nvidia and the AI theme is that the market was looking for any excuse to sell it. This week is critical to see if the sell-off continues to gather steam and what this means for broader financial market pricing dynamics. As we have mentioned in previous notes, Nvidia and other AI stocks are much more volatile than the overall US stock market, and so Nvidia can fall 7% without dragging the broader market with it. For example, Nvidia struggled last week, however, the S&P 500 managed to post a gain, and rose by 0.24% last week, the Dow Jones rose 1%. The US stock market is not on its knees even though the AI darlings are coming under strain. This is because the correlations of the biggest stocks in the S&P 500 are nonexistent. The CBOE implied correlation for the top 50 US stocks is at a relatively low level and is below its average of the past year. Thus, even when a big whale like Nvidia has a big move, it does not necessarily drag the rest of the market down with it. This is an index that is worth watching closely in the coming days and weeks.

Why the broader market rally may bide its time

As tech struggles it could help the broader market rally to extend recent gains. The equal-weight S&P 500 is still underperforming the market-cap weighted S&P 500, however, the gap is narrowing. This gap has the potential to narrow further if the Fed does cut rates later this month and if the economy manages to avoid recession. Interestingly, the equal weighted index has not been able to catch up with the market-cap weighted index, even though the market has priced in 100 basis points worth of US interest rate cuts by December. There is a clear reason for this: 100 bps of cuts in the next four months is a huge adjustment in rates and one that would only be warranted if the US economy was to tank badly in the coming weeks. We do not believe that the stock market sentiment is as bearish as the Fed Funds market, thus, stock investors do not believe that the Fed will cut rates by as much as the market is pricing in. This could limit any broad market rally for now.

Payrolls key for rate outlook

Looking ahead, markets may be quiet on Monday as the US is on holiday for Labor Day. However, the economic data comes thick and fast after that. Manufacturing and service sector ISMs are released this week, along with Jolts job openings data and the week is rounded off with the August payrolls report. The July report was much weaker than expected at 114k, which stoked fears of a recession in the US. The market is currently expecting the August figure to be 165k, and for the unemployment rate to dip to 4.2% from 4.3%. This is likely to be due to technical factors, however, a slight decline in the unemployment rate could be positive for risk sentiment and the dollar at the end of next week, especially if it leads to a scaling back of some of the 100bps of cuts priced in by the Fed Funds Futures market between now and December.

German asset prices unscathed from politics

Elsewhere, global PMIs for August are released this week, and they will be a good gauge for how the European economies are holding up so far this quarter. Germany will be watched closely as its economy has been a massive weak spot in the Eurozone in recent years. German factory orders are also worth watching. Elections at the weekend in Germany, saw the far right AfD party win its first regional election. While this is a disaster for Chancellor Olaf Shulz, it is unlikely to upset the balance of power for Germany as a whole, as the AfD will not be able to win over any of the mainstream parties who are unlikely to form a coalition with them. Thus, for now, we do not think that this regional election result will impact the Dax, which reached its highest level for a month last week. Added to that, the Mdax, the mid-cap German index, has also been unscathed by the political turmoil at home, and is also trading at its highest level since mid-July.

Euro and GBP defy domestic issues to press ahead vs the USD

The euro opened higher at the start of the week, although it has fallen back slightly, and EUR/USD is currently trading around 1.1050. GBP/USD is back above $1.31 at the start of the week, after falling last week partly due to the doom and gloom of Kier Starmer and his desire to lay the path for tax rises. The FTSE 250 is also trading sideways. So far, the economic data has been defying Starmer’s cry of doom, and we shall see if it continues to do so with the PMI data at the start of the week. Starmer may want to remember that heavy handed tax rises can stymie economic growth and talk of doom and gloom can infiltrate down to the real economy.

China data weighs on the Oil price

Elsewhere, China’s PMIs are also worth watching as they weigh further on Chinese shares. The CSI 300 and Hang Seng are both lower on Monday, and Chinese shares took a battering in August, dropping some 2% potentially after continued reports that more foreign institutional investors are abandoning Chinese shares. Looking ahead, the focus for Chinese economic data will be how the Asian powerhouse is holding up as we move through Q3. The manufacturing survey fell deeper into contraction territory in August, which has weighed on the oil price and Brent crude oil is back below $76.50 on Monday. Thus, we may need to wait for further evidence to see if the Chinese economy can gain some traction as we move to the latter part of Q3, and whether this can help to lift the oil price.