January 27, 2025

QuickTakes

Stocks Stay Afloat In Deep Waters

DeepSeek took a bite out of semiconductor, other tech, as well as nuclear power stocks today. Many of these AI plays dropped by double-digit percentage points, and Nvidia fell 17%. Other than the impact of the largest US stock nearly entering a bear market in one day, plus some collateral damage in other large stocks, the broader market held up just fine. The S&P 500 fell less than 1.5%, the Dow rose 0.7%, and the CBOE volatility index (VIX) finished the day at a historically low 18.0.

There's still plenty of uncertainty over what the true demand for state-of-the-art chips, semiconductor fabrication plants, and energy will be. Earnings conference calls this week from Microsoft, Meta, Tesla, ASML (all Wed), and AAPL (Fri) may provide more clarity on what DeepSeek means for big tech. They may signal that cheaper AI spending will help cut costs and therefore maintain their collective profit margin of 25.5% (chart). Meanwhile, other companies in the S&P 500 may be able to boost their profit margins thanks to cheaper and quicker implementation of AI.

We’ve been favoring the S&P 493 as a cheaper way to play AI and its positive impact on productivity and profits margins than the Magnificent-7. So we were pleased by today’s action. The market absorbed a significant body blow to Nvidia remarkably well. We don’t think that Nvidia is down for the count. Indeed, the company’s statement praised DeepSeek’s breakthrough and noted that it would create more work for its GPUs.

As of now, we're in the camp that says cheaper AI is a good thing for the US economy and stock market. Here's more on today's action:

(1) Bonds and the Fed. The 10-year Treasury yield fell 10bps today to 4.535%, its lowest level since December 20. That was right after the Fed's most recent 25bps federal funds rate (FFR) cut. We do not think that move represents increased recession expectations but perhaps less expected inflationary pressure from AI infrastructure spend. Of course, some investors selling Nvidia shares likely rotated into Treasuries.

A few days ago, bond yields started to reach oversold territory outside of our expected range of 4.25% to 4.75%, and in our opinion are settling closer to their fair value with a roughly 2.0% inflation-adjusted TIPS yield (chart).

The futures market also showed higher odds of more Fed rate cuts this year. While the FOMC will more than likely keep the FFR unchanged on Wednesday, Fed Chair Jerome Powell may signal that more rate cuts are likely as long as inflation continues to fall. With the unemployment rate right around 4.1%, essentially representing "full employment," we think the FFR is good right where it is (chart).

(2) Manufacturing. The Dallas Fed regional manufacturing survey jumped 10 points to 14.1 in January, its highest reading since October 2021. That's boosted the average of four key regional M-PMIs to well into expansion territory, which suggests the national ISM M-PMI will breach 50.0 either this month or next (chart).

A rolling recovery for manufacturing would be welcome after it has lagged the services sector since the Fed began raising rates in April 2022. Coincidentally, the Dallas Fed new orders index rose 6 points to 7.7, its highest level since exactly back then.

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