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Jeremy Owens: Hello and welcome to On Watch by MarketWatch. I’m Jeremy Owens. After an avalanche of financial and economic news last week, the market suffered its most dramatic decline in nearly two years, fear of a possible recession and doubts about Big Tech’s ability to turn artificial intelligence efforts into actual revenue rippled across the world. More than $2 trillion was erased from the S&P 500 Index in just two trading sessions, Friday and Monday. International markets, cryptocurrency and treasury yields also got slammed. So is it time to panic? Is the AI bubble popping? These are the questions we’ll dive into today on the show. Plus we’ll take a quick look at the news stories we’re watching right now and how they’ll affect your wallet.
First, let’s talk about the market. When the monthly jobs report was released on Friday, it didn’t exactly spur confidence in the economy. The unemployment rate jumped to 4.3%, the worst reading in nearly three years and a potential signal for a recession. But I was still surprised to see the market sink after that news hit. Any negative economic data point in recent years had led to market gains as big traders looked for signs that the Federal Reserve could be forced to cut interest rates. Bad news has been good news for the market, but is it time for bad news to be bad news for the market again? And how bad is this news? To answer those questions, I called up markets reporter, Joe Adinolfi, after he was done covering the carnage. That was Monday’s market meltdown.
Well, last week, Joe, I told everybody it was a crucial week for the US economy. We had tech earnings, we had a Fed meeting, we had a jobs report. Well, of course, at the end of all that news, the market just tanked. And so I wanted to bring you on here to kind of tell us what really led into what we’ve seen in the market and reaction to all that we found out last week.
Joseph Adinolfi: Well, I think the biggest single piece of news that really sent stocks into a tailspin late last week was the jobs report. We have the monthly data from the Department of Labor, and among other kind of nuggets in that report, it showed that the unemployment rate sort of jumped higher in July. I think that made a lot of investors nervous, in kind of suggesting that the US economy is cooling maybe a little bit more rapidly than we had previously thought. A lot of investors found cause for concern in the data and they reacted accordingly.
Jeremy Owens: And that unemployment rate, it showed it at 4.3%, and 4.2% is kind of the line the Fed has drawn. They want to see it at or below that. So popping up above that was a big thing there.
Joseph Adinolfi: Right. Yeah, and it also sort of triggered this indicator called the Sahm Rule. So basically when the three-month average of unemployment rises 50 basis points above the lowest three month average from the past year, the rule is triggered. The concept behind it is that when employment starts to slow down, consumption starts to slow down, the economy starts to slow down, then you get a recession. So if you took the rounded unemployment rate, the 4.3 number, that was I think most widely quoted in the financial press, the rule was technically triggered. And I mean, Sahm herself came out and said that she felt the rule had been triggered. She doesn’t think we’re quite in recession territory yet, but certainly set off some alarm bells.
Jeremy Owens: We have had strong economic numbers continuously. So everything I see here, Joe, tells me there’s not a huge concern for the economy in the markets. It’s more like a warning light than a flashing red siren, I think is the best way for me to put it.
Joseph Adinolfi: Yeah, I mean I think there’s a lot of data to back up that view. Of course, there are a lot of economists who disagree and who are, I think, in their insistence on being forward-looking, have argued instead that the Fed should cut rates pretty aggressively in September and have sort of chided Chair Powell and his compatriots for not acting already in July. Of course, hindsight is 20/20, but I think you could argue that they did the prudent thing. They’re so focused on just making sure we don’t see a repeat of the 70s and what happened when Arthur Burns was chair of the Fed. They didn’t act decisively enough to really sort of tame inflation.
Jeremy Owens: Yeah, I want to really make this point hard drive it home for people. The market has been struggling in the past few sessions. We are still up healthily for the year, and the reason I try to separate the market and the economy, a correction in the stock market does not mean we’re in a recession. And I do want to stress to people this is not unprecedented in any fashion. In fact, we saw a bigger pullback in the second half of 2022, and that’s kind of what I’m flashing back to here. How is this different, and what do we need to see moving forward for the US to have a little bit more confidence here and get that confidence back?
Joseph Adinolfi: I think for one, we’d want evidence that the labor market isn’t going to really fall off a cliff here, that maybe if unemployment sort of stabilizes around or just slightly north of current levels, I think that would help sort of revive investors’ confidence. They definitely want to see the Fed cut rates, and there’s a lot of expectations that corporate earnings are really going to grow pretty substantially in a pretty broad fashion over the next year or so, and especially during the second half of this year. And I think so long as companies can kind of meet or surpass these expectations, I think that could easily sort of put a floor under stocks if they haven’t found their footing already.
Jeremy Owens: And we’ve mostly talked about the US here, but a lot of the bigger effects are happening outside the US. I look at Japan. On Monday, the Nikkei just got absolutely slaughtered. So many stocks there getting hurt, and Europe also got hit a little bit harder than the US as this was happening. What is the difference between the confidence in international markets versus the confidence in the US markets right now?
Joseph Adinolfi: Well, I think just so far this cycle, the economic growth in the US has been much more robust than it has been overseas. Japan is still digging itself out of this long sort of deflationary funk. They didn’t really have the same issues that we struggled with over here with inflation because the sort of uptick in price pressures that they saw was almost more like welcome news because it sort of allowed them to see slightly better, although not stellar growth numbers. I think that’s kind of just the big difference between the US versus Europe and Japan is we’ve had much stronger, much more consistent economic growth stateside than we’ve seen abroad.
Jeremy Owens: There’s been a lot of talk of the carry trade, and I don’t want to get too into the weeds on this, but can you kind of explain to me what this carry trade is and why it would most specifically turn up in Japan?
Joseph Adinolfi: Well, the carry trade, basically it’s a strategy employed by hedge funds where you borrow in one currency where you can borrow relatively cheaply because of low interest rates, and then you swap that currency for another currency where interest rates are higher and you invest it in some higher yielding assets like bonds denominated in that currency, or I guess even stocks.
Jeremy Owens: Yeah, that’s been brought up a lot in the decline of NVIDIA. There was a thought that a lot of people were using this trade to buy into NVIDIA, and since the yen appreciated it as almost like a margin call. They had to sell that NVIDIA stock to settle their loans with yen before it moved too much higher.
Joseph Adinolfi: Right. Yeah. The idea is that people were leveraging up positions in NVIDIA and the other mega-cap tech names using yen that they could borrow much more cheaply than they could borrow in dollars and they’d swap the yen for dollars, put the money to work in US stocks. But when you do that, of course you’re left with a short position in the currency you’re borrowing, in this case, the Yen. And the Yen really appreciated pretty rapidly over the past month since it hit its lowest level against the dollar in almost 40 years at the beginning of July. And the carry trade has come undone pretty quickly here, and a lot of people in markets kind of see a pattern there. As that trade is unwound, stocks have gotten more and more volatile, so they’re sort of sensing sort of a connection there.
I think one of the drawbacks of the rally over the last 18 months or so is just how dependent it has been on the AI trade and tech and these sort of tech adjacent sectors that have a much heavier weighting to these magnificent seven stocks. I think the market kind of needs tech to perform at least moderately well for the index to kind of keep on rising here. I think the question of whether the AI trade is appropriate or whether it may be a little too frothy is something that investors started to kind of confront this earnings season after we had the results from Alphabet and some of the other big mega-cap companies. Some questions have been raised about how long it’s going to take for these sort of heavy investments in AI related infrastructure to pay off.
Jeremy Owens: And that’s what we’ll talk about next. And Joe, as this keeps going on, we might have you back again. Thank you so much for joining us today.
Joseph Adinolfi: Appreciate you having me Jeremy.
Jeremy Owens: After that conversation, the markets bounced back a bit on Tuesday, staving off some of the panic. In my eyes, this market is going to sustain as long as there’s still hope for AI and Big Tech. So we’ll talk about that next, stay with us.
Welcome back to On Watch by MarketWatch. Before the break, we talked with Joe Adinolfi about stocks and ended with how important earnings from the largest US companies will be for the market. Now we welcome tech analyst, Maribel Lopez to talk about what we’ve learned from recent earnings reports.
Before that though, we should discuss how we got to this moment. The last time the market had us tough a time as it did Friday and Monday was in 2022 when inflation fueled corporate profit gains were calming down. But Big Tech turned all that around with massive layoffs that goosed earnings along with promises of an AI revolution. That turned about a half dozen companies into behemoths that really determined the overall course of the market. But so far, the only massive AI revenues have been coming from Big Tech, not going to them as they take the money they no longer have to pay employees and funnel it to Nvidia for AI gear. That is why these quarterly earnings reports are so important right now. Big Tech has to show returns from all those investments soon or Wall Street is going to get impatient and take trillions away. So here is Lopez Research’s founder and principal analyst to discuss what we learned.
Maribel Lopez: All eyes were on tech earnings this quarter to see if people could continue to overperform at the level that they had. What we have seen is that cloud came in slightly softer for most organizations in terms of growth rate than we thought. There was a lot of talk about AI, very few numbers were placed on the table. Unless you were a chip company, in which case most of the chip companies blew the doors off in terms of selling AI. What we’re really seeing is this is a market that we’re waiting for the transition from things like cloud computing and into AI revenue, and it hasn’t happened yet.
Jeremy Owens: Stocks have really tanked as these earnings were finishing up last week. Is that general market fears or is that specifically fears of an AI bubble and people trying to get out?
Maribel Lopez: I think it’s both. I think what’s happened is over the course of the past several quarters, we’ve really seen a heavy focus on tech and tech carrying the market. And then at the slightest blip in any aspect of a tech company’s earnings, immense fear comes in. So I think the expectations for growth were overstated. Yet I can still see how there’s this gap between what everybody expected to be billions of dollars of AI revenue coming into organizations by now. And what we’re really seeing is billions are being spent to set us up for long haul potential revenue growth, but the gap between those is pretty significant at this point.
Jeremy Owens: And there’s nothing Wall Street hates more than seeing companies spend billions of dollars without being able to specifically voice how they’re going to get those billions back, plus some on the other side. And what they heard from Mark Zuckerberg and others this quarter was, “Oh, just trust us. We’re going to spend this money and you’re just going to have to believe that it will pay off years down the road.”
Maribel Lopez: Well, the other plan is we don’t spend the billions on AI, we don’t have AI, and we get ourselves trounced by someone else. That’s the alternative.
Jeremy Owens: Exactly what Intel is experiencing. Yes, the fear is the other side where Intel didn’t invest in this stuff a couple of years ago and now they’re having their lunch eaten by Nvidia and AMD.
Maribel Lopez: So Jeremy, what you’re really saying is there’s no win scenario at that point, right?
Jeremy Owens: There’s no win here. There’s no wins.
Well, Maribel through all this AI hype, what I’ve tried to convince people is not to fall into the hype, but to look for the money: how and when are people going to spend money on generative AI? And I think the easiest way to get that across to people is to think about how they’re going to spend money and talk about the iPhone. So Apple is going to introduce Apple Intelligence into the iPhone in the next generation. Well, how is that going to make money?
Maribel Lopez: I think we have a serious problem with money and AI at the moment. I think AI is one of these things that we understand conceptually that this is the next wave of product innovation, that if you don’t have AI in your product, your product isn’t going to be interesting to consumers moving forward because you’re just going to expect a certain level of intelligence in it. But can you charge for that intelligence? That was exactly the question you posed. And right now, I’m seeing limited ability for anyone including Apple to charge for intelligence. They could charge for software updates that’s extremely doubtful. They could charge for new media services, new healthcare services. That’s actually more likely on the AI front.
Jeremy Owens: And that’s from a consumer perspective. And I completely agree with you, that consumers are going to expect AI level compute without wanting to pay for that AI level compute. Businesses are a little bit different because the question there is if they can get a return on their investment with generative AI. We’ve kind of seen this play out through Microsoft Co-pilot. This is the big test of will businesses pay extra for generative AI programs. Now Microsoft’s cloud growth kind of disappointed in their earnings last week, but they did talk up co-pilot.
Maribel Lopez: One of the things that’s really important in the AI landscape is the AI is only as good as the data. And right now everybody’s using the generic foundation models that we’re trained on everything in the internet. When we move into corporate use cases, one of the things that’s really important is, can we use AI to unlock the power of that data? So when you look at what companies are going to be successful, they have to have a combination of both AI and access to really relevant data. So what this means is someone like Microsoft where you already have a bunch of your information in their collaborative suite and Teams, but you might also have a bunch of your information in Azure and you can leverage both those information pools to make generative AI really work for you.
So if you think of parts of the organization where they have a lot of data that might be in multiple applications and various formats, this is where something like a co-pilot really starts to add value. You still have to get to the point where users know what questions to ask and they can get that value. But one of the things Microsoft mentioned in their earnings call was about Ernst & Young, which is a global professional services firm, and how they’re actually looking at giving it to all 150,000 of their employees. And why would something like that happen? I mean, this is an organization that has a lot of employees, a lot of knowledge workers that have access to a lot of data, and they can actually really see the value of using co-pilot to find and organize all that data to help them do things more effectively.
Jeremy Owens: And what we’re seeing elsewhere is everybody else trying to develop their own co-pilot, all of these software companies are getting AI abilities through the cloud usually with Microsoft and Google and Amazon to try to develop their own version of co-pilot that they can then charge more for. And the question is, do they find the same level of support as Microsoft has with co-pilot, and does all of that maintain and continue to add to their revenue?
Maribel Lopez: So one of the things I think is brilliant about what Microsoft did was at the outset, they were like, “We’re going to charge for this.” This is something we feel adds value. They took that head on. What we’re seeing a lot of other organizations make mistakes with is a lot of other software companies are putting in these highly sophisticated AI agents that are basically spending a lot of money of cloud resources and foundation models in the back end, yet they’re not charging any extra for the organizations. And in fact, the organizations are getting accustomed to the AI is going to be free from certain companies.
And this is where we run into problems, because eventually all that cloud computing, all that use of foundation models, you have to pay for it somewhere somehow. So if you’re not charging for it, then you’re paying money on the back end and it’s going to impact your margins, and eventually if you’re a public company, your stock price.
Jeremy Owens: What you’re describing there is precisely why there are fears about an AI bubble right now. As we see the stock market get hit, all these companies are spending a lot of money. Even Microsoft, which is making money on selling co-pilot, the amount of money they’re spending is so far beyond that because they’re buying all this Nvidia gear, they’re upgrading their data centers and they have to pay so much for this equipment that there’s a lot of concern that there’s a lot of money going out and not a whole lot of money coming in.
Well, there is one sector that is seeing that top line AI driven growth, and that’s chips. And there have been concerns. Nvidia has been the standard-bearer of this AI boom because Microsoft and Google and Amazon, everybody else is spending billions of dollars on their gear. Are there concerns about how long that can last?
Maribel Lopez: There’s a lot going on with Nvidia, so let’s unpack it in a couple of different ways. If we look at the actual fundamentals of Nvidia, I think they’re going to be able to sell everything they produce for a year or more without a doubt. The tech community’s really gone heavily into AI, so the demand is just off the charts. What I think some of the challenges are in the market is the market seems to have an unrealistic expectation of the overperformance of Nvidia.
Jeremy Owens: I mean, for the last year they’ve been doubling or tripling sales and profits, like every quarter year over year. But now we are getting to the point where it’s lapping where it really exploded last year, and can it grow beyond that incredible growth last year? Can it still show huge growth rates when the growth rate last year was so phenomenal?
Maribel Lopez: This is where I think there’s a mismatch between reality and market expectations. To expect a company to continue to grow at that phenomenal, not just a how high growth rate, phenomenal growth-
Jeremy Owens: Yeah, it’s mind-blowing.
Maribel Lopez: That just doesn’t even make sense when you think about it. And it’s a similar thing when you look at a company like Apple. We are… They’re into what? iOS 18 now? We’re well into the years of the smartphone, and yet every quarter, it’s like how much more can they pump out? So I think that there’s some unrealistic expectations of growth in certain aspects of the tech sector, and those would be two of them.
Jeremy Owens: And even when we get into chips, when we mentioned Nvidia, it’s still going great. AMD looking like they’re getting a lot, but then there’s Intel, and that might’ve been the most surprising earnings report of last week. Intel said it was going to lay off 15,000 people. Their numbers are not good. They’re making a very expensive push into trying to build more chips, and they’ve kind of gotten left behind in AI because of that. That seems to be where they’re suffering the most. They can’t catch up in AI because they’re dedicating so much focus and money and everything else to the foundry effort.
Maribel Lopez: Well, this is the classic long game short game discussion, and I think the long game is always taking longer than we think it will with Intel. I do believe over time that the foundry business is the way to go. They’re trying to make the foundry efforts and their existing manufacturing efforts as efficient, as fast as possible, but that created a tremendous amount of short-term pain. And so we’ll see what happens. And out of the chip companies, they were the only one that really didn’t have a good quarter, and that was surprising to everybody.
Jeremy Owens: Right. They cut the dividend, they’re not going to pay a dividend anymore. I believe Intel had been paying a dividend consistently since 1992, if I remember correctly.
Maribel Lopez: Well, and this is a big issue for certain investors, because certain investors, their portfolio is based on the fact that they have consistent dividend generating properties. For example, telecom companies fit nicely into that category of one of the reasons you buy them is because of the dividend.
Jeremy Owens: Thank you for joining us Maribel, we’ll talk to you again.
Maribel Lopez: Thank you.
Jeremy Owens: Before we go, it’s time for What We are Watching, a look at the news you need to know for the rest of the week and beyond.
Alphabet has more problems on its hands than a need to show some fresh AI revenue. A Department of Justice antitrust lawsuit against Google’s Parent Company was successful this week with a judge ruling that the search giant inappropriately used its monopoly power in striking a multibillion dollar deal with Apple. The effects of this could be far-reaching for the entire tech industry, but actually could have the biggest financial effect on Apple. That company receives about $20 billion a year from Google right now to use Google as the default search engine in the Safari web browser. But any effects could still be a few years off. The judge will decide what should happen as a result of the ruling next year, and Alphabet does plan to appeal.
With most of the Big Tech earnings out of the way, Nvidia being the main holdout, the spotlight switches to retail chains next week. Home Depot and Walmart will be the reports to watch for a temperature test on American consumers. We saw some executives promise price cuts last quarter as consumers balked at paying inflated prices after years of increases. So look for margin pressure and any promises of more deals to come.
Speaking of inflation, the latest reading for the Consumer Price Index arrives next Wednesday. While the jobs report was a signal that the Fed could cut rates soon, the board will want to see that the pricing pressure and cuts top execs mentioned last quarter are leading to lower inflation. Economists expect CPI to show 3% price increases from the same time last year while the Fed is looking for that number to move toward 2%.
And that’s it for this episode. Thanks to Joe and Maribel. To keep following the latest on the markets and earnings, head to marketwatch.com. You can subscribe to the show wherever you get your podcasts, and please do. If you like what you heard, please leave us a rating, a review, it really helps others discover the show. And let us know what you want to hear from us. You can reach us at On Watch at marketwatch.com. The show is hosted by me, Jeremy Owens, and produced by Alexis Moore and Jackson Cantrell. Isaac Gaines mixed this episode. Melissa Haggerty is the executive producer. We’ll be back next week with a new episode, and until then we’ll be watching.
