Insights

A roadmap of possible US election outcomes and their context versus market fundamentals.

Key points:

• A benign US election process with a quick and clean result would be the least disruptive outcome for capital market but this appears to be a relatively low probably scenario.
• Given that parts of the market look abnormally stretched, we think it’s prudent that investors should have a plan should market uncertainty and/or volatility escalate.

History shows that US equities in the very short term tend to trade flat into elections but then rally out the other side as investors have more certainty on forward policy and leadership. US equity markets appear to be in a mood to do the same in 2024, with typical seasonal strength into Christmas likely to become the market narrative should the election go smoothly. However, the current circumstances look less than typical.

History shows that US equities in the very short term tend to trade flat into elections but then rally out the other side as investors have more certainty on forward policy and leadership. US equity markets appear to be in a mood to do the same in 2024, with typical seasonal strength into Christmas likely to become the market narrative should the election go smoothly. However, the current circumstances look less than typical.

First let’s consider what a win might look like on either side. There is a mountain of opinion about what election outcomes might mean for the US. The reality is that no matter who becomes President, investors will face ongoing uncertainties about policies which have potential to mould the US economy. Should Harris prevail, it looks unlikely the Democrats would control the US senate, making the passage of reformative legislation more difficult. The “status quo” might actually be the most benign outcome. Should Trump prevail, there is greater uncertainty about whether pre-election policy rhetoric – particularly on high potential impact policies around trade tariffs – are actually enacted.

At this point it does look like the policies of both parties though would entail more Government spending than capital markets currently expect. This could re-assert upward pressure on US inflation and might mean that the pace of US rate cuts could be slower than markets currently hope.

It’s quite notable that the pricing of US Treasuries have reflected this very potential in recent weeks, with yields trending higher. It’s equally notable that equity market behaviour looks to be in disagreement with bonds, arguably disregarding risks around the US rates trajectory. Other market valuation metrics also look somewhat dislocated.

US credit spreads have narrowed to levels not seen since June 2007. This decline mirrors the strength in equities but also reflects expensive valuations and can indicate some complacency in the market's assessment of credit risk. Absolute US equity valuations are at decade highs. Equity valuations relative to bonds as measured by the equity risk premium look the most stretched, with the ERP at multi-decade lows below 1%. Stretched valuations does increase the market’s vulnerability to unforeseen events or uncertainty.

It's prudent to be prepared

The US is among the biggest success stories in the global economy. To achieve disinflation without much disruption to growth or employment is no mean feat. US corporate earnings have also been strong and resilient, projecting compound growth of 12-15%, which is really important here. However, several measures of capital market strength are looking stretched and/or abnormal with the disagreement reflected in bond yields the most notable. Getting US elections out of the way is typically good for markets. However, several various potential scenarios around the election could easily lift uncertainty and spike market volatility at current levels. Confirmation of the election process itself could include material delay, challenge, dispute and/or unrest. We think investors should prepare accordingly.

Domestic stocks, themes and opportunities that we have recently be advocating for investors include: trimming banks exposure, rotating exposure into resources (BHP & RIO), value in energy (Woodside), US rates leverage via James Hardie and opportunities in stocks on weakness in Lovisa and Eagers Automotive.

International stocks currently on the Morgans US focus list include Meta Platforms, Nike, Coca Cola, Starbucks, Honeywell and Berkshire Hathaway.

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.

Jensen Huang, the rockstar CEO of NVIDIA, recently described Artificial Intelligence (AI) as ‘the most transformative technology of the 21st Century’ which ‘will affect every industry and aspect of our lives’. The CEO of Alphabet, Sundar Pichai, went further, saying AI is ‘probably the most important thing humanity has ever worked on’. Amid all this hyperbole, it can be daunting to know where to start as an investor looking to get exposure to AI. We offer one framework for thinking about this in the Month Ahead for November. We recommend investors start making sense of AI by considering stock opportunities in these three distinct areas:

Artificial Intelligence Providers

It is no coincidence that the world’s leading Cloud Service Providers (Microsoft, Amazon, and Google) are leading the race to commercialise Artificial Intelligence and Large Language Models (LLMs), alongside that technological shapeshifter Meta Platforms. These companies are also known as ‘Hyperscalers’ due to their technical expertise in operating computing infrastructure at levels of complexity that would make your head spin.

The Hyperscalers are typically well funded and cash generative. Their ‘ownership’ of business and personal data puts them at the forefront of building, training, and ultimately monetising LLMs. Collectively, these companies are expected to spend a staggering US$700bn in capex over the next three years, the bulk of which relates to AI.

In many ways, Microsoft (NASDAQ: MSFT) is the most uniquely positioned. As the key supplier of business productivity tools in the world, it has the vast technical expertise, data and customer base best suited to benefit from the rise of AI. As more and more businesses embrace AI we expect they will embrace Microsoft’s AI offering and both parties should benefit. Microsoft reported its September quarterly result on Wednesday and indicated Microsoft AI is on track to be its fastest ever product to reach $10bn in annual recurring revenue (less than three years).

Digital Infrastructure

Digital infrastructure companies power the data centres, cloud computing and research activities that are integral to the digital ecosystem and the rise of AI. Internationally the best-known name in the space is AI chip supplier NVIDIA, which is widely held to be best in class and a unique value proposition.

Enjoying all the benefits of the AI growth opportunity with less volatility are the operators of data centres. Data centres are facilities that store, process, and manage the vast amounts of data foundational to AI, ensuring secure and efficient data flow, backup, and recovery. The largest operators in the world are Digital Realty and Equinix. Digital Realty recently reported a record sales quarter during which it sold double the data centre capacity of its previous high and about four times more capacity than it usually sells in a quarter. This reinforces our view that the significant demand for cloud computing and AI-related digital infrastructure is going to unpin attractive returns and long-term growth.

Here in Australia, the data centre space gathered recent attention following the recent $23bn purchase of private data centre operator AirTrunk. In the listed arena, NEXTDC and Goodman Group are the largest data centre operators on the ASX. Our preferred exposure is NEXTDC (ASX: NXT). It has 17 operational data centres in Australia and nearly a dozen under construction or about to be built across Australasia and Asia.

Data Networks

AI needs a combination of technical expertise, computing power, data centre space and data. An extremely large amount of data is needed to train an AI agent or LLM. Once the training is complete the AI agent also needs to be given regular up-to-date data in order to remain relevant and useful. This is where traditional data networks (such as telcos like Telstra, TPG Telecom, Superloop and Megaport) come into play.

Traditional telecommunications companies will benefit from the astronomical growth of data around AI. Telstra for instance is building a specialist inter-capital network with a A$1.5bn capital budget to fund this project. However, our preferred exposure is through the more specialised and capital-light Megaport (ASX: MP1). Megaport is a global cloud connection network and the leading Network as a Service provider. It operates the largest data centre connection business in the world, connecting to 850 data centres through a fully automated, on-demand telco network. We think it is uniquely placed to help business move data globally and benefit from the growth of data related to both cloud computing and AI.

Morgans clients receive exclusive insights such as access to the latest stock and sector coverage featured in the Month Ahead. Contact us today to begin your journey with Morgans.

There's been much discussion regarding Donald J. Trump's intention to increase tariffs on imports into the United States. Many economists have commented on how this would raise prices in the US and drive up inflation. However, few have examined the strategy behind Trump's comments, which can be found in a book by his trade adviser, Dr Peter Navarro, titled *The New Mega Deal*. Released a few months ago in conjunction with the Republican Convention, it's surprising that so few economists discussing Trump's tariffs seem to have read it.

Navarro, who taught at Harvard before joining Trump’s first administration, previously ran the White House Office of Trade and Manufacturing Policy. His recent book lays out Trump's trade policy in detail, particularly between pages 26 to 29. Navarro highlights how countries trading with the US operate under the World Trade Organization's most favoured nation rule. He starts with the example of automobiles imported into the US, where the tariff is just 2.5%. In stark contrast, when US cars are imported into the European Union, they incur a 10% tariff—four times higher—and a 15% tariff in China. In Brazil, the tariff reaches 35%, despite all these countries facing a mere 2.5% tariff when exporting cars to the US.

Navarro then examines the case of rice. When rice from Malaysia is imported into the US, it pays a 6.2% tariff, whereas US rice entering Malaysia faces a hefty 40% tariff. He also notes that European milk imported into the US incurs a 15% tariff, while US milk going to the EU faces a staggering 67% tariff. From a strategic game theory perspective, Navarro argues that the WTO's most favoured nation rule provides little to no incentive for high-tariff countries to lower their tariffs, allowing them to maintain their tariffs while benefitting from lower US tariffs.

According to Navarro's analysis during his time in the Trump White House, there are 132 countries whose tariffs on products imported from the US are higher than the tariffs imposed by the US. He suggests that if these countries reduced their tariffs to match those of the US, it could lower the US trade deficit by nearly 10%. This insight is crucial for understanding Trump's negotiation strategy. Should these countries refuse to reciprocate, the US could increase its tariffs to match theirs, resulting in a similar reduction of the trade deficit.

This approach could potentially create hundreds of thousands of new manufacturing jobs in the US, thereby strengthening its industrial and defence sectors. Trump aims to pursue this strategy through the proposed US Reciprocal Trade Act, which was initially introduced in the House of Representatives on 24 June 2019 but was blocked by Democrats. If Trump is re-elected, his administration will likely attempt to pass this bill again. Interestingly, Trump has claimed that he does not actually need this legislation, which might be his way of setting the stage for negotiations, suggesting he could use the threat of higher tariffs to encourage other countries to lower their tariffs on American goods.

In recent weeks, we've been discussing growth in the Indo-Pacific, specifically Southeast Asia and India. We believe that growth in this area will replace the growth in demand that has traditionally been provided by China, particularly for the kinds of products that Australia exports.

In this issue I will examine some recent slides from the International Energy Agency's, World Energy Outlook report. The first slide outlines projections for world oil demand between now and 2030. Demand which is expected to reach just under 104 million barrels per day by 2030. Recently, oil demand has been growing by around a million barrels a day, but that growth has recently slowed to about 0.8 million barrels per day. Even with this slower growth, our projections suggest oil demand could reach 105 million barrels a day by 2030, indicating that the IEA estimates might be slightly conservative. Still, they still show a steady increase in demand for oil.

From 2015 to 2023, the biggest single increase in oil demand came from China, with an increase of 5 million barrels per day, followed by India, which saw growth of over 1 million barrels per day. Southeast Asia and Africa also contributed, each with increases of about 0.3 million barrels per day. Conversely, demand in Europe has decreased by about 0.9 million barrels per day, while North America has seen steady demand and Japan and Korea have experienced declines.

Looking ahead, the landscape of oil demand is changing significantly. The International Energy Agency notes that the rapid growth in oil demand in China has come to an end, largely due to the electrification of vehicles powered by a dramatic expansion of nuclear power and renewables. While oil demand in China may stabilise, there is a rapidly increasing demand in India, projected to grow by 2 million barrels a day. Southeast Asia and Africa will also experience growth, each by about 1.3 million barrels per day.

Between 2015 and 2023 the demand for liquefied natural gas (LNG) also rose. Between 2015 and 2023, the European Union saw a demand increase of over 100 billion cubic meters, followed by China with a growth of 74 billion cubic meters. India had smaller growth, while Southeast Asia's demand was flat. Japan’s demand fell.

The future looks different, with significant demand growth expected in the Indo-Pacific. From 2023 to 2025, China will still see a rise in demand of just under 50 billion cubic meters.

Indian LNG demand is projected to grow by about 54 billion cubic meters by 2035, and Southeast Asia, driven by increased manufacturing, is expected to see a rise of 104 billion cubic meters in demand by 2035. Japan is anticipated to see a decline in the demand for natural gas.

Overall, global LNG production is set to increase dramatically, from 600 billion cubic meters in 2024 to about 840 billion cubic meters by 2035. Australia, as a major LNG exporter, will play a crucial role in meeting rising demand, particularly driven by manufacturing growth in the Indo-Pacific, including in countries like Vietnam, the Philippines, and Indonesia.

Over the past couple of years, I've been very interested in that there’s been a US consensus of economists that the US was about to go into recession. The majority of market economists believed that for the previous couple of years. The reason for that was that the yield curve was inverted. Short term rates were higher than long term rates.

My argument was that even in that circumstance, you couldn't have a U.S. recession because the budget deficit was so large. There was so much stimulus being provided to the U.S. economy that it would keep growth strong. I talked about it as being “a wartime stimulus in a peacetime economy”.

Now, the rather startling result of that US budget stimulus, particularly the Inflation Reduction Act, which encourages building electric cars in the United States and spending on the energy transition and the Chips Act is that you've had an enormous explosion in expenditure on Factory building. Here's the chart shown from the Federal Reserve Economic Database showing that dramatic explosion. There are a number of different slides which are less dramatic, but I thought that this would be showing how heroic this amount of spending was.

The rise of factory building, in the scenario that I provided a couple of months ago, was supposed to top out in the second quarter of this year and then start falling. Unfortunately, it decided to continue to go up. We think that after a 31% annualized growth in this spending in the first quarter, this was followed by a 22% growth in annualised spending in the second quarter. Hopefully in the part of the chart you can't see because it hasn't happened yet, the current scenario now is that this forms a plateau. It drops from about 20% growth to about 1% growth and no growth in the final quarter, and then next year, it begins to decline.

The rate of decline of this manufacturing construction spending in 2025 is pretty significant: 24% annualised in the first quarter, 12% in the second quarter, and 12% in the third quarter and then gradually, it drips away. As that happens, the U.S. economy slows down. So, the U.S. economy in the second quarter of 2024 grew faster than we thought, 3% annualised. That should slow to 2.8% annualized in the third quarter, 1.9% annualised in the fourth quarter.

What that means is that for a full year in 2024, the annual growth rate of GDP is 2.7%, and that drops to 2.1% next year.

Well, that’s stronger growth. I thought does that knock over our forecast for cuts in the Fed Funds? So, I ran the Fed funds rate model.

Our Fed funds rate is still allowing for very significant cuts in the short term because it's not about growth. It's about the falling inflation, which is driving the Fed funds rate model down.

So, the fed funds rate currently stands at 485 basis points, which is after a 50-basis point cut. Our model says fair value is 349 basis points. That means a cut of 1.35% from where we are now. I think rates will fall at 25 basis points every meeting pretty until we reach that level near 3.50%.

We compare that to our RBA model, where the model is at 4.2% and the actual rate is 4.35%. So, there's really no prospect of rate cuts in Australia for the next couple of quarters.

For those interested in policy or prospective policy in the US election, I'll do more about this in future meetings. But there was a terrific interview, which you can find on YouTube, between Trump and John Micklethwait, who is one of the toughest guys on Bloomberg. It was interesting for me because it was for the Economic Club of Chicago. If you've been to Chicago, you've seen the Trump Tower. You'll see Trump has a significant presence in Chicago. It was an extremely interesting discussion about tariffs.

John Micklethwait took up the issue that there's a economists' consensus that inflation will be higher under Trump than under Biden Harris. That is not my view. I have written about this before. If you look at the record, when Trump was doing the exact same sort of policies that he's talking about introducing now, in his first term, the average inflation rate was 1.8%. But running the numbers this morning again, prices were up so far by 22.2% under Biden/ Harris. And the average inflation rate is 4.4%. The Biden /Harris level of inflation is two and a half times the level under Trump.  

That happens because of very large amounts of Biden/Harris deficit spending.

This is providing “A wartime stimulus in a peacetime economy”.

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Investment Watch is a quarterly publication produced by Morgans that delves into key insights for equity and economic strategy.

This latest publication covers

• Economics – A brighter outlook for Australian resources
• Fixed Interest Opportunities – 2024 Additions
• Asset Allocation – A decisive turn in the global rate cutting cycle
• Equity Strategy – Reweighting ASX 20 exposures
• Resources and Energy – China monetary stimulus impact
• Travel - Demand trends still solid
• Technology - Rate cuts lend support but fully valued overall
• Telco - Still seeing better value elsewhere
• Property - Nearing the peak

It has paid off to put cash to work this year with equity markets touching all-time highs and bonds benefitting from rate cut expectations. Looking ahead, the fundamentals remain supportive. The US economy is slowing but not stalling. Employment is also slowing but job losses are still minimal, while consumer spending is boosted by falling inflation. In our view, this is not the time to play defence and we continue to expect growth assets such as equities and real assets to do well. This quarter, we look at tactical opportunities on the back of a global push for policy stimulus which include: commodities, emerging market equities, and across the Australian equity market (resources, agriculture, travel and technology).

A brighter outlook for Australian resources

There has been much discussion about the slowdown in growth in China. Last year, Chinese GDP grew by 5.2%. We think growth will slow to 4.6% in 2024, just short of the official 5.0% target. However, it is still growing much faster than the United States, Japan or any major Western European economy. China has the largest steel industry in the world. This industry produces a little over half of all the steel in the world annually.  Chinese steel production indeed peaked in May 2021 at an all-time high of 99.5 million tonnes per month, and production has moved sideways since then. Yet, this still generates a very strong demand for Australian iron ore. Our model estimate for the equilibrium price of iron ore in August 2024 was $US106.42.

The standout economy is India. India will be the strongest and the most rapidly growing economy this year. In 2023, GDP grew by 7.8% and is expected to grow 6.8% this year. However, India is not the only economy producing this kind of growth and in fact this rate of growth has been produced by other countries in the Indo Pacific.  One historian has referred to these countries as the “Indosphere”.* This group of rapidly growing countries includes Vietnam, the Philippines and Indonesia. Vietnam is expected to grow by 6.0% this year and 6.4% next year. The Philippines is expected to grow by 5.7% this year and 5.9% next year. Indonesia is expected to grow by 5.7% this year and 5.1% next year.

Morgans clients receive exclusive insights such as access to our latest Investment Watch publication. Contact us today to begin your journey with Morgans.