Markets Brief: A Powell Boost Follows an AI Slump

US equities ended the week up 0.5%, having risen 1.7% on Friday following Federal Reserve Chair Jerome Powell’s speech, in which he appeared to be willing to cut interest rates despite inflation remaining above target. Although the speech did not move near-term interest rate expectations significantly, it seemed to cheer equity investors, especially those in technology companies, which rose 1.8% on the day after falling 2.5% earlier in the week.

That earlier negativity was attributed to a MIT report which indicated that few companies are converting generative AI projects into revenue growth. The weakening enthusiasm for technology stocks also weighed on emerging markets, which fell 0.3%, dragged lower by chipmaking heavyweights South Korea (down 2.8%) and Taiwan (down 4.5%). Chinese and Indian stocks rose 1.6% and 1.8%, respectively.

In the United States, small companies rose 2.7%, while their large peers finished the week down 0.1%, despite Friday’s boost. It is possible to interpret these moves as evidence that investors expect smaller companies to benefit more from lower rates. It could also reflect the ongoing gulf in valuations that is generating better opportunities in smaller companies. Investors’ newfound enthusiasm for cheaper, economically cyclical stocks was also evident in basic materials, which was up 2.2%, and energy, up 3.1% (with stocks trading below our analysts’ estimate of their fair value estimate on average).

This shift provides a good opportunity to review your portfolio’s diversification, ensuring it can withstand a wide range of possible outcomes. It is important to consider not only the means of the protection we seek, but also the price paid for that protection.

Are Utilities Still Defensive?

While other defensive stocks languished over the last few months, seemingly boring utilities have rallied 18.5% in the year to date, as the power demands of the AI and electrification revolutions have increased growth expectations. As a result, utilities have become the most overvalued sector. This has an important implication for portfolio construction, as the regulated nature of most utilities gives them a reputation for being defensive, making them popular choices to provide diversification.

However, the close connection between utilities and technology in the current cycle is likely to undermine utilities’ usefulness as a stabilizer if technology falls out of favor. This demonstrates the importance of understanding the fundamental drivers of returns when building portfolios, rather than just focusing on historical statistical relationships. Fortunately, other traditionally defensive sectors, such as healthcare and consumer defensives, still appear to offer more attractive risk and return characteristics.

What to Watch

The notion that the Federal Open Market Committee will continue to lower interest rates while inflation remains above target will be tested on Friday, with the release of the Federal Reserve’s preferred measure of inflation, the Personal Consumption Expenditures Index. Core inflation (which excludes volatile food and energy prices) over the last 12 months is expected to rise to 2.9% from last month’s 2.8%. Any significant deviation from this number may cause investors to reassess their interest rate expectations, leading to movements in asset prices.

The first revision of second-quarter economic growth will be released on Thursday. This is expected to show a slight increase to 3.1% from the initial estimate of 3.0%. According to the Atlanta Fed’s GDP Now estimate, growth in the third quarter also appears to be stronger than expectations, increasing the risk associated with Powell’s tolerance for higher inflation.

Nvidia’s NVDA second-quarter earnings report on Wednesday will likely dominate headlines this week. Find out what analyst Brian Colello expects, and keep up to date with data releases using Morningstar’s market calendar.