MARKET OUTLOOK
AI Spending Accelerates. Productivity Follows.
BY EVAN MANCER , CFA
AI continues to be the main driver of global equity market returns, supported by unprecedented spending from hyperscaler companies such as Amazon, Microsoft and Google to build datacenters and expand computing capacity. Because semiconductors account for more than half the cost of the average data center, chip companies have been the largest beneficiaries, but a much broader group of businesses in sectors such as power, cooling, electrical work and financing have also benefited. The result was an exceptionally strong quarter across global markets. The top performing markets were the S&P 500 and the Japanese Nikkei 225, up 15.2% and 11.2%. The German DAX 40 and French CAC 40 jumped 10.2% and 10.1% while the S&P TSX and the UK’s FTSE 100 were up 7.0% and 4.0%. Australia’s ASX index was the weakest market, increasing just 1.7%.
The strong showing in the recent quarter is far from an anomaly. In fact, over the past three years, many developed countries have enjoyed returns nearing 20% annually, causing some of our clients to ask if equity valuations have gotten too high. Compared to long-term averages, valuations are currently about 20% higher relative to earnings in Canada and the U.S. Such higher valuations make it unlikely that the next three years will be as good as the last three, but high prices alone are not historically a good predictor of bear markets.
If there is a market downturn, the most likely cause would be a loss of confidence in the awesome and accelerating AI capital spending. There are no signs of that today, and every CEO we speak with has a ready list of examples of how AI is making their business more efficient. The key risk over the next six months is that AI-related spending will need to begin showing a positive return on investment. If that does not occur, investors could start to price in a deceleration of AI spending.
We do not think that an AI driven downturn would be long lasting. Over the next five years, the pace of improvement in AI should provide a major boost in productivity and economic growth and many of our companies will benefit. Canada does not have any significant hyperscaler or chip companies, but many others, like utilities and pipelines, are critical parts of the supply chain. Banks have also reaped rewards from the frenetic pace of financing that has been necessary to keep building.
Although the Iran conflict appeared to be over at quarter-end, it has since resumed. We have been somewhat surprised by the Iranian regime’s high tolerance for economic and military pressure. It is difficult to determine how decisions are being made in Iran, or even who the key decision-makers are now, given that previous leadership was largely removed and military command appears to have splintered into smaller groups. As a result, we now think the conflict may last somewhat longer than we expected last quarter. This probably means oil prices trading in the $80 to $100 range, modestly above our previous forecast.
We do not expect prices to skyrocket, however, because traffic through the Strait of Hormuz is likely to continue intermittently, and Gulf producers have proved creative in getting oil to market through alternatives such as trucking and pipelines.
Higher oil prices are already putting upward pressure on inflation in the U.S. and Canada. This has shifted the market narrative from how many interest-rate cuts there will be this year to whether increases may be needed instead. For now, we think the Bank of Canada and the U.S. Federal Reserve are treating higher inflation readings as temporary, but that stance could change if oil remains above $100 for a sustained period.
The Canadian dollar ended the quarter just over $0.70, down from $0.72 three months earlier. The weakness in the Loonie is probably due to interest-rate differentials. The U.S. overnight rate is 3.5%, versus 2.25% in Canada, and until recently investors had expected faster cuts in the U.S. However, the U.S. economy has been growing much faster than Canada’s, so investors are now pricing in a higher chance of rate increases in the U.S. than in Canada. Despite the Loonie’s cheapness, we are lowering our expected range to $0.70 to $0.75.
