The September rate cuts are becoming a reaction

Hello, reader.

Thomas Yeung here with today’s Smart money.

Over the past few months, you’ve heard us talk a lot about Road to AGI – the path to creating a hyperaware artificial intelligence that could arrive in two to five years. The reality of AI with superhuman cognitive abilities (and common sense) will render entire industries obsolete. Taxi drivers…lawyers…executives…no job is truly immune to AGI disruption.

That’s why Eric has hammered out ways to prepare for this increasingly inevitable future.

However, the Road to AGI will presents bumps along the way. No technology ever progresses in a straight line. And often, macroeconomic cycles are to blame. Economic booms and busts have long disrupted everything from finance to consumer demand, creating headwinds (eg the 2008 financial crisis) and tailwinds (eg the meme stock bonanza of 2021) that can determine the fate of otherwise promising sectors.

That’s why I’d like to take a moment this week to focus on a rather non-AGI problem that’s now sending waves of panic through the AI ​​world: Federal Reserve meeting in September.

I’ll also talk about why this event has become so hyped… and why we’re still excited about what we’re calling the third frontier of the IT revolution.

Fed meeting of the decade

The September Fed meeting on September 17 and 18 will likely mark the first rate cut this economic cycle. And investors will keep a close eye on its size — a single 25-basis-point decline versus a 50-basis-point “jumbo” one or more — and use it to forecast trajectory of future discounts.

It’s hard to overstate the impact this small difference will have. All firms are valued based on the net present value of their future cash flows (that is, how much profit they will eventually make), and higher interest rates cause cash to come in. today much more valuable than the cash received tomorrow. (There’s a financial theory behind this that we’ll save for another day.)

What is important is that AI startups with profits in the future (ie, cash tomorrow) will see their values wave in September if the Fed cuts interest rates. Markets will assume we are on a path to 3% interest rates by mid-2025 and change their expectations accordingly. You can expect to see shares of artificial intelligence captures, such as the AI-based gun detection firm Evolv Technologies Holdings Inc. (EVLV), increase of 10% or more for no other reason.

On the other hand, a one-time rate cut of 25 basis points will naturally do the opposite.

Stock investors are betting on a Jumbo discount…

Over the past month, equity investors have become convinced that a jumbo rate cut is on the way. Actions of ETF Global X Robotics and Artificial Intelligence (BOTZ) they are up 7.5% in the past month, and several speculative pieces are up even more. The broad S&P 500 has seen its price-to-earnings (P/E) ratio increase by two full standard deviations since April to 28.9X.

That tells us that equity investors still believe that the weak employment numbers released last month will lead to a double rate cut. Share price gains have outstripped earnings revisions in recent months, and that’s because equity investors are unconsciously reducing their default discount rates to fit a dovish narrative.

… But bond investors are skeptical

Bond investors, on the other hand, are much more muted in their assessment. Since the beginning of August, they have reduced their double discount bets from 85% to 44%.

The ADP jobs report released earlier today now lowers that probability even further to 37 percent. Although private sector jobs rose by just 99,000 — well below the economic forecast of 145,000 jobs — earnings of those employed rose more than expected. Those who remained in their current jobs saw an average year-over-year salary increase of 4.8%, while those who changed jobs saw their earnings increase by 7.3% .

That means the Fed may not be in such a rush to cut rates. Inflationary expectations among employers are notoriously difficult to quell, and bond investors believe the Fed is willing to suffer short-term pain to restore its inflation-fighting credibility.

Beneficiaries: Health and Tech

This will-they-or-won’t they rate cut speculation will only deepen tomorrow when the Federal Bureau of Labor Statistics (BLS) releases its “official” jobs report. We can expect to see the news media pouring over every possible number and breaking down every market move.

However, the most important aspect of today’s economy is not the difference between a rate cut of 25 and 50 basis points. In fact, no one will remember this figure until October!

Instead, it’s more important to see any rate cut in September as the moment when the US economy moves from an early stage of expansion to a middle one. Inflation has been tamed, unemployment is stabilizing, and rate cuts are much like an autumnal equinox marking the start of this new investment season.

Historically, two sectors are special beneficiaries of interim recoveries: technology and healthcare. These two industries feature firms with high upfront R&D costs that eventually generate low-cost revenue streams (think blockbuster drugs and chip factories). Lower interest rates benefit these companies by giving them lower borrowing costs.

The outperformance is particularly noticeable over long periods. A study by Fidelity found that the IT sector typically outperforms the market by an annualized rate of 15% during mid-cycle recoveries, with healthcare doing 7% better. Rate reductions during these periods are beneficial, no matter how quickly they happen.

That’s why we’re so excited about some incredible companies that are combining both technology and healthcare in what we believe will become the third frontier of the IT revolution. Some of them are using AI to harness the power of genomic data to develop new drugs. Others are even redefining what the $11.9 trillion global healthcare industry is all about.

At best, the Fed tells us so now now is the right time to intervene. We are at the economic stage where the difference between a 25 basis point rate cut and a 50 bps rate cut is a reaction. So if you don’t mind a bit of short-term volatility, then long-term gains await.

Sincerely,

Thomas Yeung, CFA

market analyst, InvestorPlace.com