Dark clouds gathering above global stock markets

Will the coming stronger earnings season really matter?
From circular investments among AI giants which have raised grave doubts about the sustainability of this massive investment cycle, to continued US government shutdown that looks set to continue as long as Republicans don’t compromise on health care spending issues, to the latest collapse in Japan’s coalition government and re-emerging fears of another trade spat with China, we think there are plenty of reasons to adopt a more defensive posture in the weeks ahead given the massive rally we have seen in global equity markets.

Although from a bottom-up point of view, earnings season surrounding AI stocks which have led global markets higher should indeed prove positive as demand remains solid from big spending on data centres that have spanned outlays from AI to memory chips, storage solutions, optic fibre networks and higher bandwidth optimisation, electric power generation and even water supplies for chip cooling applications, the bigger picture concerns on sustainability of such high intensity capital investments, which according to some accounted for over 90% of US GDP growth in H1 of this year, could weigh heavily on sentiment, at least in the near term.

Having seen in the previous quarter hyper-scalers dramatically raising their spending plans for this year on AI-related applications, followed by big initial plans from sovereign states, worries about the simple law of large numbers that raises doubts about required cashflows (which mainly come from advertising revenues) and external financing needed to sustain such colossal spending trajectory going into next year are all part of our more cautious tone for the rest of the year regardless of the likely better corporate earnings which in any event, look increasingly factored into share prices.

The above picture together with growing concerns over the law of diminishing returns, a more AI specific issue related to only incremental improvements in learning abilities of large language models we have seen thus far and more worryingly, their continued hallucinations and deceptions observed in responses of AI bots, are all parts of some key top-down issues which we suspect add to the growing anxiety among investors.

We also think last February’s DeepSeek moment which we viewed as a Black Swan event at the time, when the Chinese AI specialist sent jitters through global tech stocks by claiming to be able to compete with Open AI with fraction of costs of its US competitors provided an interesting glimpse of market’s sensitivity to anything that may disrupt the big spending plans of hyper-scalers.

We would argue that market is now far more sensitive to anything remotely negative that may suggest a slowdown in growth in outlays which we think is only inevitable. One particular name that epitomises the current exuberance in the AI space in our market in Japan is Softbank (9984) which we think provides a great short hedge against the potential downside risks in this segment.

Japan’s ruling LDP another step closer towards disintegration
Ever since the abolition of factions within the LDP following the slush fund scandal in November 2023, we have argued for the disintegration of the party whose factions represented various sections of the political spectrum that had been loosely held together not by ideology but by money.

With the ruling coalition which included the Buddhist backed Komeito party having lost their majority in both Upper House and Lower House parliaments in the past year, we have argued that the probability of LDP’s break-up was only increasing.

Although Japan’s stock market had most recently celebrated the nominations of Takaichi-san as the next LDP leader by rallying further, her admiration for the late Shinzo Abe and her promise to resume Abenomics policies of keeping with low interest rates and big government spending had us very worried about the renewed trend of depreciating Japanese currency as well as spiking JGB yields.

In our view LDP’s latest leadership pick was its answer to growing far right populism that was sweeping the country rather a more sensible look at what the economy really needed in the medium term which in our view is big reforms, more essentially a stronger yen policy to put pressure on BOJ to normalise its unorthodox and loose monetary policy and a far more disciplined approach towards fiscal policy given Japan’s whopping debt to GDP of nearly 250%.

We think last week’s shock exit of the Komeito party from the ruling coalition has not only brought us a step closer to LDP’s demise in its current form but for the nearer term, it has casted major doubts about the parliamentary approval of Takaichi’s nomination as Japan’s next and first female prime minister. Although Komeito’s departure was mainly blamed on questions regarding LDP’s future financing methods, it is worth noting that historically, the junior coalition member was never comfortable with Abe’s policies such as opening casinos in Japan and more importantly, his attempt in changing Japan’s pacifist constitution.