For those of you with kids or grandkids, you might have had the pleasure of watching the third installment of the Chipmunks film series, oh about 13 years ago. The usual fare. Everyone is having a great time until Alvin gets up to mischief. This year has felt like a replay of this film, with equities enjoying generally positive momentum, with soft or no-landing views supported by expectations of upcoming interest rate relief. Waters got a little choppy in April and then again in the second half of July and early August. After a brief return of optimism, sentiment has again soured. Heading into the critical U.S. jobs report this morning, the S&P500 was on pace for a 2-1/2% decline on the week and the NASDAQ was looking at a 3-1/2% drop. Something is just not behaving.

Similar to four weeks ago, there have been concerns over the state of the economy, fueled by weak labour force data and business sentiment metrics. Wednesday’s ADP payrolls report came in well below expectations at +99K for August and Challenger Layoffs showed a sizable increase to 75.9K or basically triple the pace seen in July. These effectively brought back the recession anxiety that emerged at the start of August, but a look at the various segments of the market tells us that it is really the return of tech anxiety that is driving things this week – specifically chipmakers.

Of the large-cap companies that were down more than 5% on the week, as of Thursday, four were in the semiconductor space, led by Intel (down 11.8%), Nvidia (down 11%), Broadcom (down 5.3%) and Advanced Micro Devices (down 5.2%). The above chart shows the Philadelphia Semiconductor index and as of Thursday’s close, it was down about 8% on the week. Don’t get me wrong, that’s a hefty move, but still relatively small compared with the 25% pullback that we saw from July 10th through to August 6th.  There are some company-specific factors that contributed to the malaise.

For Intel, it has been forced to look at restructuring its global operations in the wake of a disappointing quarter, where it suffered an actual loss and lowered its outlook for the coming year. Since the start of 2022, the company has experienced negative cash flow in all but three quarters, reflecting lower sales and higher spending. There is even speculation that the company will either have to hive off its manufacturing or at least cut back on its global expansion plan. This is also adding a wrinkle to the fact that Intel was set to receive $8.5 billion in grants and $11 billion in loans from Washington as part of the Chips Act and a further $3.5 billion earmarked for defense.

This week, the Department of Justice issued subpoenas to Nvidia Corp. as part of its investigation into suggested violation of antitrust laws. While this investigation isn’t really news, it comes at a time when the stock has reached extremely lofty levels and street expectations have moved up accordingly. So much in fact, that even though the last quarter’s results were decent, they failed to beat what the street estimated. This is why investors are beginning to question whether the degree of take-up in artificial intelligence will meet the massive investments in chip infrastructure.

After the bell on Thursday, Broadcom reported third quarter revenues and earnings that beat market expectations, but strength in the company’s AI segment was offset by weakness in broadband sales. This was enough for the company to lower its estimates for fourth quarter revenues. At the same time, Broadcom increased its estimate for annual AI by a billion dollars to $12 billion.

Given the reaction to recent earnings reports and reflection on where the global economy is, it is possible that analysts will lower the bar for upcoming quarters. There are crosswinds to be sure. If we indeed see slower growth across most segments of the economy, this might impact corporate profitability and the ability to invest in AI and other technologies. That could put a real crimp in demand for the products and services among chip companies.

This morning, there was a second straight miss on U.S. non-farm payrolls, with the headline monthly increase for August coming in at 142K, as seen in the above chart, and the prior month revised down to a gain of only 89K (vs the original estimate of 114K). These combined to bring the 3-month average to 116K – less than half the pace that we saw in March and the slowest since 2019. We might infer that the softer employment data is indicative of a transition from an employee market to one tilted towards employers, and that this implies less room for wage growth. Perhaps, though this morning’s report showed a stronger than expected 0.4% gain in average hourly earnings.

Assuming that we do see a further moderation in wage growth, this has two benefits from a profitability perspective. One, it allows for a resurgence in net income growth that helps alleviate cash flow impacts from required additional investments. Second, it reinforces the disinflationary trend already in place that ultimately brings interest rates down. After this morning’s report, traders raised the probability of a half-percent Fed rate cut this month to 50%. Even if the Fed sticks to a pattern of quarter-point moves, this will still provide stimulus to the economy and should support valuations in the tech sector, including semiconductors. Note, a recovery in this segment does not detract from our underlying thesis that leadership in this equity bull market will still broaden out as interest rates decline. It's just that we aren’t going to see a chipwreck.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.   

Andrew Pyle