Inside Markets — AI Trade

The public release of Chat GPT in November ’22 kicked off an AI arms race that still looks like it is in its ‘early innings.’  The beneficiaries of any arms race are always the arms dealers – in this case it’s the companies that sell the semis, servers and switches to hyperscalers, tier 2 cloud providers and large enterprises.  The year-long leadership, unknown ROI for many AI applications and conversational popularity of the theme is generating questions about its sustainability.  Skepticism is a healthy investor instinct, but we should also acknowledge that calling a top is often more rewarding (financially and emotionally) than calling for the status quo.  Option implied volatility (sigma) on NVDA shares heading into Monday’s GTC keynote raised concerns the event could generate a sell-the news response and increase broader market volatility.  NVDA’s lack of volatility (up or down) coming out of the event should be considered a reassuring near-term development for the AI trade and for risk assets in general.  The long-term fundamental driver of the AI arms race and demand for accelerated compute is coming from enterprise verticals.  These businesses may not have perfect clarity of the ROI, but they understand the competitive consequences from a lack of investment.

With an eye out for bearish triggers, the official Fed statement exiting tomorrow’s meeting is expected to be little changed from the January meeting. The ‘risk’ for this meeting likely comes from the Summary of Economic Projections and updated dot plot where we see ~60% probability for the median ’24 dot to reflect a reduction from three cuts to two.  We also see increased likelihood for the long-run median dot to be revised from 2.5% to maybe 2.75%. This outcome would add to dollar strength, generate bearish yield curve steepening and become an incremental headwind for equity markets.

For the moment, two and 10-year Treasury yields remain anchored just below key inflection points of 4.80% and 4.35% respectively. An upside break in either benchmark will likely remind investors of the narrow path to a soft landing and reinstate the negative stock/bond correlation. The impact would be far more acute if an upside break in yields was accompanied by disappointing growth data. Note that February ISM manufacturing and February retail sales were fairly significant recent disappointments. The recent lift in nominal yields followed hotter-than-expected Jan/Feb inflation data. The only way to stay on the path toward a soft landing is to see near-term inflation data cool. February PCE is due next Friday 3/29 but is unlikely to change the narrative around sticky core inflation. Any change in the inflation outlook will likely have to wait for March CPI due on April 10.