GUEST BLOG / By James McCann, Senior Economist, Edward Jones Company.
KEY TAKEAWAYS
--Global markets were hit by another bout of volatility last week, with equities again finishing lower in a choppy week, continuing the worst run since the tariff driven sell-offs in April*.
--The weakness in part reflects concerns over the technology sector, with a solid earnings report from NVIDIA unable to stifle the correction emerging across these companies as investors appear to take profits amid ongoing bubble chatter.
--Meanwhile, ambiguity over the Fed's next steps is unhelpful, with the central bank continuing to struggle to get a clean read on the economy due to shutdown-driven data disruptions.
--A correction in the buoyant market looked overdue, in our view, and we think investors should not overreact to the November setback. However, we believe recent moves underline the importance of a diversified portfolio in the current environment.
--Lower entry points could provide an opportunity for investors, especially as the real returns on cash and bonds appear to dwindle.
There is an old cliche in the movies - "It's quiet, a little too quiet." This probably describes how we had felt about equity markets over recent months during a remarkably steady 40% rally in the S&P 500 from April lows*. As is typical in films, this relative quiet has been rudely interrupted by a spike in volatility through November, which has so far triggered a 3% reversal in this benchmark*
We can point to a couple of plot twists driving this upheaval. First, the boom in AI stocks, which had helped power large-cap equity-market gains, is looking vulnerable, with investors booking profits as concerns grow over valuations and a potential bubble*. Second, there is increasing uncertainty that the Fed will swoop in with rate cuts to help sooth markets*.
To stretch our analogy perhaps uncomfortably far, we don't think this is the end of the show. Spikes in volatility are normal in equity markets, and we think even less surprising given the speed and scale of recent gains. A reset in expectations might be a healthy dynamic, in our view, and present an opportunity for investors to put cash to work and diversify portfolios.
AI stocks remain under pressure
The so called Magnificent Seven mega-cap tech companies have had a tough month. In market-capitalization-weighted terms, this group is down close to 6% in November so far, pushing large-cap markets, and in particular the tech-focused Nasdaq index, lower*.
We wrote in last week's wrap that the market appeared ripe for profit-taking following an extraordinary run, particularly as concerns start to build around froth in the tech sector. There looked to be further evidence of these dynamics this week around the much-anticipated NVIDIA third-quarter earnings report.
At first glance the results were solid. Sales estimates for the third-quarter were stronger than expected, guidance for this quarter was revised higher, and there were bullish signals that the company could exceed the $500 billion uplift in revenue projected over 2026*.
However, after an initial rally in NVIDIA stock helped drive a 1% bounce in the S&P, we saw a swift and sharp reversal in sentiment that pushed markets lower*. Since 1957 we have only seen eight instances in which an opening rally of this magnitude has closed in the red*.
There might be a couple of factors driving this disappointment:
-- First, while sales-growth projections remain strong, these are expected to slow in coming years, potentially closing the run of exponential-feeling growth in the sector*; and
--Second, despite NVIDIA CEO Huang's attempt to push back on the AI-bubble narrative, the market is seemingly increasingly uneasy over the sustainability of current investment rates and their long-term payoff*.
We flagged last week that certain tech companies are starting to build leverage to finance AI investment and shifting to more asset-heavy business models**, posing risks to margins and free cash flow. On this theme, we saw a further rise in the CDS spread - a measure of credit worthiness - for Oracle this week, a potential gauge of these worries*.
Despite these changes - and what looks to be a broader uncertainty around the long-term payoff from AI investments - we don't think investors should overreact to the wobble in short-term sentiment around the sector. Mega-cap stocks have consistently delivered strong earnings growth, the near-term investment outlook remains robust, and valuations, while elevated, do not look stretched to extremes as seen in the lead up to previous bubbles*. However, we think further sentiment- or valuation-driven setbacks are likely possible, despite these still strong-looking fundamentals.
Foggy conditions for the Fed
Alongside booming AI stocks, one of the themes helping drive the market higher in 2025 has, in our view, been the resumption of interest-rate cuts from the Federal Reserve. However, following two consecutive rate cuts in September and October, there appears to be considerable uncertainty over the Fed's next move in early December*.
In part, this ambiguity reflects a hangover from the recent record-breaking government shutdown that disrupted the collection and release of economic data. The September payrolls report finally dropped last week, but this raised more questions than answers.
On the plus side, hiring was better-than-expected through September, with payrolls up 119,000, helped by improvements across a broader range of sectors***. However, there were familiar downward revisions to past hiring data, and the unemployment rate continues to drift concerningly higher***
This is the last official labor-market data the central bank will get before it decides interest rates December 10. The October and November reports will be delayed until December 16, with only part of the October edition published due to missed data collection***.
Similarly, the Fed will not get an October CPI report, with the November reading also due after its December gathering*. For a central bank targeting inflation and employment, we think this shortfall is far from ideal.
The minutes from the October meeting appear to show clear concerns at the Fed around these disruptions - "various participants expressed concern about‚ the ability to accurately assess economic conditions because of limitations to the availability of federal government data"****.
Additionally, following two consecutive rate cuts*, and with inflation at 3%*, well above the Fed's 2% target, the more hawkish members of the committee seem to be becoming uneasy with further policy easing - "Most participants noted that, against a backdrop of elevated inflation readings and a very gradual cooling of labor market conditions, further policy rate reductions could add to the risk of higher inflation becoming entrenched"****.
Against this backdrop, market expectations for a cut in December have been on a wild ride*. In late October a cut was seen as a done deal, with pricing in money markets putting close to a 100% chance of a 25 basis point (0.25%) move*. These odds slid to a low of 30% early last week, before bouncing to 70% on Friday amid some dovish commentary from New York Fed President Williams*.
We think the decision will be finely balanced, with numerous dissents likely in the case of a cut or a hold. Further forward, we remain confident that the path for the fed funds rate is lower as the Fed reverses the post-pandemic tightening in monetary policy, which should help support U.S. growth and corporate earnings, particularly in the interest-rate-sensitive small-cap sector. However, against the backdrop of solid growth, and potentially persistent inflation, we think market expectations for rates to bottom around 3% next year* might be a little optimistic, and instead we see the fed funds rate falling to between 3% - 3.5% instead.
We think this gap between our expectations and market pricing could pose a risk to small-cap equities. However, if the Fed is cutting by less because of a solid, or even improving economic backdrop, these dynamics might compensate for the higher interest-rate costs in the sector, in our view.
Diversification can soften shocks An outbreak of volatility following a period of calm can feel unsettling. Movie directors use these sudden shifts to keep viewers on the edge of their seats.
However, we shouldn't be shocked into taking drastic changes to portfolios following the recent market reassessment. Instead, we think these dynamics can provide some useful reminders in the value of diversification.
The AI-led sell-off over recent weeks has sparked some rotation in the market toward unloved sectors, like health care and materials/energy*. We believe these companies could offer further potential for catch-up growth should we see further AI selling, especially given their lower valuation.
More broadly, we think exposure to U.S. mid-cap stocks, international small and mid-cap developed market equities and emerging-market equities can provide additional diversification, especially given our view of an improving economic outlook overseas and more attractive multiples*. Importantly, we think these opportunities look attractive alongside a continued exposure to the AI theme via large-cap U.S. stocks.
Finally, should we spring into action in the face of this shock? Speak to your financial advisor about potentially taking advantage of this market dip, if appropriate. With inflation running around 3%, the real return on cash-like investments is now running at less than 1%*. Based on your time horizon and risk tolerance, we think the latest pullback could offer some more return potential from strategic allocations in equities and bonds, especially if the three-year bull market continues into 2026 as we expect.
Looking Ahead
Important economic data for the week ahead include housing and consumer confidence data. Government data that were impacted by the government shutdown are expected to gradually resume over the coming weeks, now that the shutdown has ended.
