Rate Cuts in Sight

WEEKLY UPDATE

A quiet and positive week

This week was characterized by its positive atmosphere as all eyes were fixed on Jackson Hole, where the Fed gathered over the weekend to discuss future interest rates.

An improving European service sector with industry in deep crisis

We received PMI data from Europe. The Eurozone economy is showing signs of improvement, while a broad and homogeneous recovery is yet to reveal itself. This was evident with the release of the PMI index for August. Although the overall index rose to 51.2 from 50.2 in July (where 50 marks the threshold between growth and contraction), it is telling that growth is solely driven by the service sector, while the industry continues to experience a deep and prolonged downturn.

At the same time, we saw lower than expected wage growth in the Eurozone, making a rate cut on September 12 even more likely.

The time has come for monetary easing

As mentioned, Jackson Hole was the focus throughout the week, especially with Jerome Powell's highly anticipated appearance on Friday. Investors keenly paid attention to any signals regarding the extent of potential rate cuts in the near future.

Recently, the market has built up expectations for significant rate cuts at the upcoming Fed meetings, and Powell gave investors what they were hoping for; he gave the green light for rate cuts at the next meeting and said, among other things, that "the time has come" for monetary easing, while also noting that the pace of changes in the coming months will depend on "risks that increasingly revolve around the labor market, not inflation." This tells us that the Fed is taking recent labor market reports seriously, where rising unemployment and lower hiring figures suggest that the U.S. economy is finally slowing down due to higher borrowing costs.

"We do not seek or welcome further cooling of the labor market," - Jerome Powell

Following Powell's remarks in Jackson Hole, the bond market rallied, pushing the yield on 10-year Treasuries down to 3.8%. Futures markets priced in more than a 75% chance that the central bank will cut rates by at least one percentage point, or four "standard" 0.25% rate cuts, by the end of the year.

The stock market continued its recent advance after Powell effectively declared the central bank's fight against inflation over. The Nasdaq led Friday's rally with a gain of 1.5%, while the S&P 500 rose 1.1%. The Dow Jones Industrial Average also increased by 1.1% (462 points), marking its second-highest closing level ever.

Strong Earnings

Throughout the week, several exciting earnings reports released, with the key highlights being:

Palo Alto Networks ended the year strong with higher-than-expected revenue (+12%) and operating income, and management's guidance for fiscal 2025 was also solid. During the most recent quarter, Palo Alto gained 90 new customers on their platform compared to 65 in the previous quarter, indicating that Crowdstrike's downturn has driven new customers into the arms of the competitor.

Zoom grew its revenue by 2%, and its operational free cash flow increased by 34%. This is a great business that you can buy at a P/E of just 13. We believe in the stock and have increased our position.

Snowflake, which has faced headwinds recently after a strong performance last year, reported revenue growth of 32%. Last year, we felt the stock was overpriced, and we have increased our position during the recent downturn.

Synopsys, which sells software for chip design, reported revenue growth of 13% and earnings growth of 27% at a P/E of 38. This was right in line with market expectations and did not lead to significant price movements.

Peloton had an excellent week rising about 50% following rare growth in revenue by 0.2%. Peloton hasn't been growing since the COVID-19 pandemic, and the stock is still at much lower levels compared to its peak during that time. We believe there are still several uncertainties surrounding the company and are closely monitoring whether the upcoming CEO change will lead to a more positive development.

Bill reported revenue growth of 22% and trades at a P/E of 24, which we consider a relatively low price for an excellent product where we still see strong growth.

NDI-FutureTech

Neck and neck with the Nasdaq

NDI-FutureTech is up 2.5% for the week and up 28.6% since its inception late last year (although it wasn't officially tradeable until March of this year). This is right in line with the performance of the Nasdaq over the same period. As the majority of Nasdaq, mainly Big Tech and semiconductors have experienced tailwinds, a large portion of the stocks in NDI-FutureTech have faced headwinds. These are the SaaS and small to midcap tech segments. We are pleased that we have been able to keep up pace with the Nasdaq, even as our picks haven't enjoyed the same favorable sentiment. When the tide eventually turns in our favor (towards small and midcap tech) we are likely to outpace the Nasdaq. The trigger could be rate cuts or clarity regarding the threat of a potential recession.

The Possible Consequences of AMD's Acquisition of ZT Systems

AMD is acquiring data center manufacturer ZT Systems. AMD will sell off the production division and retain the system design part of the business. Recently, they acquired Silo.ai, a Finnish software company that builds AI models.

This means chip manufacturer AMD is about to start selling AI systems instead of just chips. This is vertical integration. Vertical integration is when a company handles multiple stages of the value chain. The opposite is modularization.

When products are new, immature, and not good enough, vertical integration works much better than modularization. The speed of innovation needs to be high because companies can compete by creating better products than their competitors. However, when the products are good enough, the pace of innovation slows, and companies start competing on price. In this phase, modularization offers competitive advantages because specialized companies can excel in cost-effectively producing the individual components of the finished product.

A good example is the car. In the early days of the automobile, manufacturers produced all the components of the car themselves. As the pace of innovation slowed, specialized producers began making tires, clutches, valves, seats, etc.

The computer industry has become modularized over the years, and we have become accustomed to talking about modules like hardware and software. This modularization has made sense because computers were good enough, and innovation in the computer or smartphone (also a computer) had slowed.

AI, on the other hand, is a product that is far from fully developed and not good enough yet, so companies can compete on innovation power by developing the best product, which calls for vertical integration. We will no longer talk about modules like software and hardware but rather about AI systems. The new emerging AI systems industry includes companies like NVIDIA, AMD, Intel, Google, Microsoft, and Amazon. Future competitors include, for example, OpenAI, which is rumored to be developing microchips, likely because they also need to vertically integrate. At NewDeal Invest, we have long talked about the two major trends within ‘compute’ being vertical integration and the resulting ‘heterogeneous’ compute. This means a range of different solutions to deliver AI systems with custom-designed chips accompanied by software and built into finished systems.

What Are the Implications for Investors?

The answer, unfortunately, is uncertainty. The seven companies mentioned above are about to compete for a massive future business opportunity by building their own AI systems. When the AI systems industry is mature in 10-20 years, there will likely be 2 or 3 winners and at least 4-5 losers.

These large companies, which have recently been reliable, stable 'cash cows' in the internet era, will now transform (despite their size) into companies with finances resembling those of younger companies, with significantly reduced or, in periods, negative cash flows. If uncertainty increases, the valuation of these companies will fall. This doesn't necessarily mean that prices will drop, but perhaps simply that the stock price increases in Big Tech will be smaller over the next 10 years. At the index level, this could result in a secular bear market. Secular bear markets occur when the index-heavy companies don't perform well for a period. The last secular bear market lasted from 2000 to 2010 (the market within the red rectangle on the chart). It was followed by a new secular bull market when internet companies became heavy enough in the index to pull it up into the secular bull market we've had for the last 14 years.

In a secular bear market, index investing doesn't work, but stock picking of tech stocks is just as good as ever. In the 2000s, there was a rapid development in internet companies (see the chart with FAANG compared to Nasdaq), and in the next 10 years, there will be a similar rapid development in AI companies.

THE COMING WEEK

NVIDIA earnings and more

The coming week is likely to be dominated by the earnings report from one of the major players, NVIDIA, on Wednesday. There are huge expectations for the company, and analysts expect a revenue increase of more than 113% to a staggering $28.7 billion if the stock is to be rewarded with further price increases. Naturally, we will be following this closely, but also news about the delayed Blackwell chip could cause significant movements on the day of the earnings release.

In addition to NVIDIA, we will also see earnings reports out of Pinduoduo and Salesforce, with Pinduoduo kicking things off on Monday and Salesforce on Wednesday. Analysts expect Pinduoduo to report revenue of CNY 100 billion, an increase of 91%, as their e-commerce platform Temu continues to successfully connect global consumers directly with Chinese factories.

Salesforce is expected to report relatively low revenue growth of 7% for the quarter, as their customers remain focused on minimizing IT costs everywhere except within AI investments.

Inflation Data

As indicated at the beginning of this newsletter, there is still a close watch for any signs of the extent of upcoming rate cuts in both Europe and the USA. Therefore, it will be interesting when we receive inflation data from Germany, Spain, and the rest of the Eurozone on Thursday, which together could give an indication of whether the rate cut at the ECB's meeting on September 12 will be 0.25% or 0.50%.

Across the Atlantic, we will get the FED's preferred inflation data, the PCE, on Friday afternoon, which, in addition to providing clues about the size of the rate cut at the FED's meeting on September 18, could also cause major market movements.