Too much optimism
NVIDIA released spectacular figures this week. The share price initially surged, but the excitement lasted less than 24 hours. The higher price triggered a wave of sell orders, causing the stock to close significantly lower the next day. Overall, the market response to the results was negative. This cannot be explained by any disappointment relative to expectations, as the figures were far above consensus. So what is going on?
As written before, equity valuations have risen to such levels that they can only be justified if the future turns out to be nearly perfect. In the case of NVIDIA, this assumption is questionable, as AI represents an entirely new technological development. No one knows whether this technology will evolve in a direction that requires far fewer of NVIDIA’s products in the future. Several experts are expressing increasing doubts about this. And how perfect does the economic outlook look? More on that below.
The major challenge for most industrialised countries is the ageing of the population. As a result, the labour force is barely growing, or even shrinking. Immigration does not compensate for this trend, as it is being significantly reduced in most countries. This means economic growth depends mainly on productivity gains. While AI developments could support productivity, not to the extent that U.S. economic growth would sustainably exceed 2% or European growth would rise well above 1%.
This must be combined with the fact that ageing populations impose enormous fiscal burdens on governments. This implies that strong economic growth is actually needed to generate sufficient tax revenues. Is the situation hopeless? No, because budget cuts or extending working lives could help. However, this overlooks the rise of populist parties in many countries. They argue that the wealthy and businesses should pay far more taxes. This has been tried many times in the past and has consistently ended in failure. Nevertheless, the message appeals to many voters. As a result, many countries face political deadlock, with government deficits rising rather than shrinking.
How serious is this? To answer that question, it is useful to look at Japan. The country is at the forefront in terms of ageing, government deficits, and public debt. Until recently, Japan also experienced deflation, keeping interest rates close to 0%. This made it possible to finance the excessive debt and deficits. But the situation has changed because Western central banks began raising interest rates a few years ago to combat high inflation. The widening interest-rate differentials caused the yen to fall sharply. This pushed up import prices to the point that deflation turned into inflation of around 3% (rising food prices did not help either).
Wage growth is now accelerating due to the shrinking labour force and very low immigration. It is therefore time for Japanese interest rates to rise. In principle, the Bank of Japan wants to do this, but it faces enormous political pressure to delay as long as possible. Understandably so: with sky-high public debt, higher rates would push interest expenses up rapidly, widening the deficit even further.
The question is whether politicians are truly concerned, as taxes are being cut to stimulate the economy, while spending is being increased to subsidise food products. The latter pushes inflation downward. Markets, however, are unimpressed. The yen continues to weaken and long-term Japanese interest rates are rising. Markets clearly fear that public finances are spiralling out of control and that the Bank of Japan will increasingly have to finance the deficit by creating additional money, effectively pursuing an inflationary policy.
We fear that the U.S., and later Europe, may head in the same direction. In that case, the future will be far from perfect. Inflation and interest rates will rise, and the currency will weaken. Economic growth will remain structurally low. None of this is favourable for today’s highly valued equities (for more concrete market outlooks, see our other reports).
