Weekly Investment Update (02/02/2024)

Events this week highlighted the divergent variables that Federal Open Market Committee members are likely weighing in their decision to cut interest rates. For example, concerns about the stability of regional banks were reignited when New York Community Bancorp (NYCB) reported a loss, raised their expected loan losses on commercial real estate, and cut their dividend. Losses were largely driven by assets acquired from Signature Bank during the 2023 regional banking crisis, and recently reported fourth quarter earnings from other regional banks reinforced the notion that New York Community Bancorp’s situation is not widespread across the industry. Still, evidence of the lagged effects of the Fed’s aggressive tightening campaign serves as an important reminder that the full impact of higher interest rates has yet to emerge, especially given the volume of debt set to be refinanced in the coming two years.

At the same time, the manufacturing sector is turning a corner, the labor market remains strong, and technology companies continue to benefit from cloud growth and generative artificial intelligence. The downturn in manufacturing appears to be reversing given the solid rebound in the ISM manufacturing index, which increased from 47.1 in December to 49.1 in January. Importantly, new orders, the most forward-looking component, returned to expansionary territory for the first time since June 2022. Despite ongoing strength in the economy, there is an important lagged impact of higher rates that remains a risk to growth. We believe the rapid decline in inflation should allow the Federal Reserve to ease policy in the coming quarters.

The Federal Reserve Pushes Back on March Interest Rate Cuts, Labor Market Shows Strength

What is happening: The Federal Reserve left the federal funds rate unchanged at 5.25%-5.50% for the fourth consecutive meeting. Although the Fed’s statement upgraded their assessment of the economy from “has slowed from its strong pace” to “expanding at a solid pace,” forward guidance for additional tightening was removed. The January employment report aligned with the Fed’s assessment of an economic improvement. The unemployment rate, pace of job gains, and wage growth all exceeded expectations. The unemployment rate for January held steady at 3.7%, and employment gains (353k vs 177k consensus) were more broad-based than in December. Additionally, the strength in January was paired with positive revisions to job growth over the prior two months, portraying an improving employment landscape compared to December.

Why it matters: As inflation has trended lower, the Fed has shifted its focus from solely combating higher prices to also managing downside risks to growth and the labor market. The positive change in tone regarding economic growth indicated that dual risks of higher inflation and weaker employment are moving into better balance. However, the Fed policy statement also highlighted the need to see further evidence that inflation data is continuing to move toward their 2% target before cutting interest rates. As the lagged effect of higher interest rates weighs on growth, we expect incoming data will be supportive of rate cuts in the coming months. It is also worth noting that the Fed has very little incentive to fully telegraph the first rate cut, as that would remove policy optionality and potentially dull the impact of eventual policy easing.

Big Tech Earnings Reports Signal Increase in Capital Expenditures in 2024

What is happening: Many of the largest U.S. technology companies reported earnings this week, including Microsoft, Alphabet, and Amazon. While the share price action for the three companies was mixed following their earnings announcements, they continue to demonstrate strength on an operational basis. Cloud computing, a key earnings driver for the three companies, saw continued growth across the three cloud providers with management teams pointing toward increased contribution from generative artificial intelligence (AI). Generative AI is expected to lead to a steady demand for cloud computing as generative AI models require substantial computing power. Notably, the increase in capital expenditures in 2024 was a key theme throughout the earnings calls with Microsoft Chief Financial Officer Amy Hood highlighting that they expect to see a material increase in capital expenditures driven by investments in cloud and AI infrastructure.

Why it matters: Growth in generative AI should be a multiyear tailwind, and the largest technology companies continue to position themselves to gain market share. While there are many approaches to benefit from increasing user adoption of this technology, one avenue is through cloud infrastructure. Though generative AI is still in its early stages of adoption, it is starting to proliferate into companies’ earnings. For example, Microsoft noted that growth in generative AI services is starting to become a more material component of cloud services revenue. For context, AI services accounted for 20% of Microsoft’s cloud services revenue growth this quarter, a notable increase from around 5% a year ago.

Bessemer’s portfolio managers believe that AI will continue to increase earnings and productivity growth. Equity teams are invested in a variety of companies that they believe are poised to benefit, from large technology players such as Microsoft, Alphabet, and Amazon, to companies well positioned within the semiconductor industry such as Marvell and ASML.