Weekly Investment Update (10/25/2024)

Market advances were more muted this week as investors absorbed solid corporate earnings, a quiet week of economic data, and shifting election polls. Although the election outcome remains too close to predict, betting markets reveal some momentum for the Republicans. Speculation around the election outcome has most notably manifested in the bond market, as investors assume a Trump victory would be inflationary, with some combination of immigration policy, tariffs, and tax cuts leading to higher prices. In part, this dynamic has driven the yield on the 10-year Treasury bond up over 0.60% (to 4.20%) since the Fed’s 50 basis point rate cut. We also note a large bid for mid-November interest rate volatility protection, as investors look to hedge themselves against the potential for a spike in interest rates by purchasing options. In our view, this means the bond market is pricing in higher odds of a Republican sweep.

Below, we discuss the dynamics of higher interest rates and the equity market in more detail. In short, we view any near-term election-driven increase in interest rates as likely to be short-lived. The trajectory of economic growth and resulting monetary policy will be the more important driver of interest rates, in our view. As growth and inflation continue to slow, we do not believe the Fed will deviate materially from its stated path. Even in a Trump victory where tariffs are indeed a priority, there is not a direct pass-through to higher rates. In fact, one could argue a dovish response to tariffs, as it may be more important to support growth versus reacting to a temporary tariff-driven supply shock. As a result, we maintain above-benchmark duration in our bond portfolios.

U.S. Treasury Yields Higher Following Stronger Economic Data and Election Uncertainty

What is happening: Over the past month, U.S. Treasuries have experienced a sharp sell-off, with 10-year yields climbing from 3.60% to 4.20%, their highest level since July. The move primarily has been driven by a resilient U.S. economy that has delivered positive economic surprises since September, including a stronger-than-expected labor market report and robust retail sales, suggesting a reduced probability of recessionary risks and, therefore, less of a perceived urgency for rate cuts. The Atlanta Fed Nowcast of third quarter GDP is projecting above-trend growth for the U.S. economy of 3.4%.

In light of stronger-than-expected data, investors have significantly reassessed expectations of further rate reductions by the Federal Reserve with bond markets now forecasting only three rate cuts over the next six months, as opposed to an expectation of six cuts just a month ago.

In addition, as the U.S. election draws ever closer, concerns over unchecked fiscal spending, from either party, may be adding further pressure to the longer end of the bond market. Furthermore, online gambling markets, which may be over-influenced by a few large bettors, have recently shown an increased likelihood of election victory for President Trump, which has led some investors to short Treasuries on the expectation that a Trump presidency would mean higher inflation stemming from tariffs and other policies.

Why it matters: Rising long-term Treasury yields typically lead to higher borrowing costs for consumers and businesses, which can dampen future economic growth. For example, 30-year mortgage rates, which are priced off 10-year Treasury yields, have risen to 7.1% from a low of 6.6% a month ago, decreasing housing affordability and further pressuring some consumer groups.

Despite the near-term back-up in yields, we believe the Fed will continue to ease, responding to lower inflation and with the aim of preventing a downturn in the labor market. Short-term interest rates are still restrictive, and a sizable number of cuts will be required to return interest rates to the Fed’s estimate of neutral. As we have stated previously, the pace of rate cuts is less important than the final destination. In our view, a continued increase in long-term Treasury yields would likely only happen if inflation or growth accelerated meaningfully from here, which is not our base case.

Easier monetary policy, along with a growing economy, will likely be a supportive environment for risk assets, in our view. All else being equal, stronger economic growth implies weaker bond prices but also a higher likelihood of the S&P 500 achieving the forecast 14% earnings growth next year, which would be supportive for equity markets.

Bessemer portfolios are overweight U.S. equities, capitalizing on the presence of market-leading global companies and strong domestic firms that we believe, over the long term, can generate strong returns regardless of the prevailing political landscape.

Semiconductor Bifurcation Strengthens in a Complex Backdrop

What is happening: In an already bifurcated market and economic environment, the semiconductor industry is no exception. Notably, demand within the industry has seen divergence: Structural tailwinds for artificial intelligence (AI)-related semiconductors remain strong, and cyclical tailwinds have been weak. While demand for AI and advanced chips is robust, legacy and non-AI semiconductors, which are more levered to global growth conditions, have not seen equivalent strength. Consumers have pulled back on purchases of mobile phones and traditional computers given the cyclicality of this demand.

Companies that have more exposure to AI-related semiconductors have seen their sales grow exponentially. Although semiconductor stocks have garnered investor attention, it has been a select few that have propelled the market to all-time highs. Nvidia has seen year-to-date equity performance of 184%, while Intel is down 55% this year. Intel’s revenue share from AI-related semiconductors is only around 23%, while Nvidia’s sits at 78%.

Why it matters: Semiconductors are the backbone of modern economies. From their role within smartphones to computers and electric vehicles, semiconductors are an essential driver of economic growth and innovation. The growth and importance of the sector has recently accelerated as a result of AI-related investments and by the large hyperscaler technology companies.

Bessemer believes that AI chip manufacturers continue to present a compelling investment opportunity compared to their non-AI counterparts. The AI chip market is expected to grow at 30% annually for the next 10 years driven by increasing demand for AI capabilities across industries ranging from healthcare to finance. In contrast, non-AI chip manufacturers face more moderate growth prospects as they cater to more established consumer markets that have more stable demand profiles and slower innovation cycles.

With dichotomies comes opportunity. To many, it may appear that AI has been an “all boats lifted” narrative within the equity market. However, when comparing the returns of the semiconductor industry index ETF to the S&P 500, we see that overall semiconductor returns have been outpaced by the S&P 500 by three percentage points this year. With the importance of any theme comes the need for stock selection. This is not to say that there isn’t an opportunity set in traditional semiconductors as some recent earnings calls have noted recent growth trends, but they have not seen the explosive growth we have seen in AI-related products. Bessemer portfolios are overweight AI chip makers such as Nvidia and underweight the traditional chip manufacturers.