Monthly Market Commentary

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i-squared Wealth Management Inc. Market Update

September could be remembered as the month that two important mistakes were made. The first by the Fed. The Fed raised rates with the market odds that this will be a hiking cycle. While the hike helps the new Fed Chair with credibility, the hike is unlikely to have a meaningful impact on inflation. The inflation problem is a supply problem. Supply of oil, food, and other commodities due to the two wars. Supply of semiconductors and other AI infrastructure. Supply of housing. Rate hikes won’t solve these issues. If anything, rate hikes raise financing costs that prevent new supply from coming. Rate hikes flatten the yield curve, which hurts banking activity, especially at small and mid-sized regional banks. The yield curve has flattened considerably recently. We are not that far away from it inverting, which would send a clear message that the Fed has made a mistake.

Breakeven rates across the curve have moderated, after peaking in early May. The 5YR breakeven rate is 2.3%, not far from the 2% target. Core PCE over the last three months is running at the 2% target. Core PCE is expected to decline meaningfully next year. One-time factors from portfolio management, software, war and tariff impacts peaked this summer and are expected to roll-off. As oil and diesel cool off, it will have a meaningful impact on inflation. The stock market is often the best economist. It is sending a clear message that hikes are crushing housing, retail, banks, transports, and consumer discretionary. Even names such as Walmart, Costco, and McDonalds are down nearly 20% from their highs. Other, more discretionary areas such as cruise liners, restaurants, homebuilders, and retailers are down much more.

The other mistake looks to be from frontier AI lab executives making doomsday predictions. These warnings could be for commercial reasons. Reasons such as regulatory capture, liability protection, and burden of care. It is clear that they are losing share to open-source models. They are realizing that they don’t have much of a moat. These types of doomsday warnings will and already have hurt them. Anthropic is losing public trust very quickly. This is ultimately a trust business. Recent polling says that just five percent of people trust Anthropic with their passwords. Many corporations will be hesitant to hand over their data to Anthropic. Latham & Watkins, the nation's second-largest law firm, bought its own Nvidia GPU servers and started customizing its own AI models not using OpenAI or Anthropic. The firm's chief information officer said they don't want to put their client information on any cloud vendor's platform.

Tighter monetary policy, distrust of frontier labs, and the release of Meta’s Muse is driving investor capital to large cap tech names. Narrow breadth has benefited market-cap-weighted indices to the detriment of equal weight and smaller caps. The market cap weighted S&P has outperformed both equal weight and small caps by nearly 5% over the past month. Investors prefer the secular growth of large cap tech and AI infrastructure when the Fed is in a hiking cycle. An additional headwind for many of the names outside of tech is that they could be a candidate for disruption from consumer AI agents. Names across insurance, travel, banks, brokerage firms, and retail sold-off upon the release of Muse. Valuation for the market cap weighted S&P is not demanding. The gains for the year have been entirely through earnings growth. The multiple is down 13% for the year, while margins are near 17%, an all-time high. The ratio of P/E to margins is at levels of major bottoms such as in 2008, 2011, 2018 and 2022. The PEG ratio is the lowest in 30-years, meaning you are not paying much for the earnings growth.

The frontier labs and companies such as Google and Meta will battle to be the preferred consumer AI agent. The ultimate winner will be the semiconductor companies. There simply isn’t enough compute to fully utilize consumer agents for large user bases such as from Meta. Bank of America expects the semiconductor industry to double by 2030. Citi expects the memory undersupply to last until 2031. Goldman expects the hyperscalers to increase capex by 54% in 2027, a significant amount of which will go to semiconductors. Analysts expect semiconductor earnings to grow 73.5% in 2027 with 51.2% margins. Korean customs data offer the earliest and cleanest reading on global technology demand. The numbers are astounding. The latest semiconductor exports surged 259.4% from a year earlier! Semiconductors continue to trade below a market multiple. Most trade below a 1.0 PEG ratio. Shareholder return of capital is high. Nvidia announced the largest buyback in history. Expect a large one from Micron in December. Positioning has been cleaned up from the Situational Awareness led sell-off over the summer. Semis have built a beautiful base that they are ready to breakout from. The bottom line is that the AI buildout is the largest capital expenditure in history and semiconductors are one of the biggest beneficiaries.

Looking forward the market will focus on earnings, geopolitics, AI, yields, and a Fed meeting.