TRANSCRIPT 🔗
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Welcome back to Fourth Lane's Off the Charts podcast, where every two weeks we cover three market headlines that matter.
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I'm Andrew Sarner, Portfolio Manager.
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And I'm Vanessa Huey, senior client advisor.
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Three big things to cover this week rate hikes, midterms, and pockets of pain.
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So, Andrew, the Fed held rates steady last week while the Bank of Canada raised rates for the first time in over three years.
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What's driving these decisions and where do interest rates go from here?
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Number one, the big thing that both the Canadian Central Bank and the Fed are going to be looking for is inflation, and they don't want to see inflation get back out of control like it did back in 2022.
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We are seeing signs that inflation is beginning to re-accelerate.
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Core PC has re-inflected upwards.
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For the purpose of this discussion, let's consider US and Canadian inflation to be similar.
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There are going to be nuances around the edges, but more or less in the globalized world, they're going to be driven by similar factors.
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So there are two big things driving inflation.
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It's going to be energy and AI supply chains.
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On the energy side, really being driven by Iran, and there's not enough energy and rising energy prices flow through, not only directly to that inflation number, but secondly, there are derivative impacts such as transportation prices across the economy.
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And then AI supply chains, there's just so much demand that supply can't keep up.
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But this is really isolated and shouldn't be impacting other parts of the economy.
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So I come at it from a logical perspective.
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Raising rates isn't going to produce more energy or reopen the straits.
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So from a practical perspective, I don't really get the attempt to raise rates in order to stop inflation in this instance.
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I get it.
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Maybe you could kill demand that is going to slow consumption, that will make energy prices less impactful.
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But still, at least the initial wave, it doesn't really matter unless you're seeing derivative impacts like wages begin to spiral.
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Then I get it.
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I think the Fed raised just for credibility purposes.
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The market sort of pushed them up against the wall.
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And in order to not be seen as a lame duck, the Fed decide to hike.
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It didn't really matter, but I think it really comes down to those credibility purposes.
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This week we saw them hold.
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They were a little less hawkish.
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And I don't think there's really a reason to be overly hawkish because we're starting to see the first signs that AI investment might be beginning to slow.
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And you know, that was the major bright spot of the economy.
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So I think it makes sense.
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And this is what the Fed really echoed that they're going to wait for more data to come out.
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Now turning our attention to Canada, this one I really don't get.
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So we have headline inflation that is slightly above target.
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I think it's 3.2%.
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Measures of core inflation are directly in line within the range at 2%.
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It's not like the economy is overly strong.
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The consensus is really 1% real GDP growth in 2026.
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And then you have a labor market shedding jobs.
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So any of the reasons why you would historically want to hike prices, such as a very tight job market and the economy running too hot, they just don't exist.
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So with inflation already within range, I don't see the need to hike.
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So this is only going to further weaken the Canadian economy, especially in the cross areas, would be those rate-sensitive sectors like real estate.
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So deals were already not penciling, they're only going to further not pencil.
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And in terms of just even residential sales, it's going to be slower.
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You have that impact to consumption because if you just think of a regular household, if they're floating rate, they're going to be now paying more to their mortgage that they could be spending in the economy.
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And the only real benefit I see to hiking it, and this is really the only argument you can make, is it strengthens CAD.
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But I would rather see an economy firing on all cylinders before we considered hikes.
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So we'll see.
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I think it's a mistake, but I get it.
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They're trying to catch up to the U.S.
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still doesn't make much sense.
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For a second topic, we know the U.S.
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midterm elections are taking place this week.
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Andrew, what are the potential implications for financial markets and what should investors be watching most closely?
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Load full transcript
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Yeah, Trump is one of the most unpopular presidents in U.S.
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history.
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The thing I would take with a grain of salt is just the other week, we saw a very big surprise in Brazil with Lula winning.
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When Trump ran against Hillary, we saw pollsters be very wrong.
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The last presidential election, pollsters were really wrong.
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So maybe we should be thinking about the fact that these polls prior to the actual election, there is a larger error than we think.
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So there is a chance we could get an outcome out of nowhere.
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I just want people to think about that.
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But historically, any outcome is good for markets.
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The market doesn't necessarily have a huge preference.
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We can get into the nuances, but it's really the uncertainty being removed from markets that the market tends to celebrate, uh, celebrate.
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You look back at other midterm years, and markets tend to bottom around now.
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So this suggests that maybe it's time for investors to shrug off the negative headlines and get long.
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But here are the two things I'm worried about.
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Number one, Iran escalation.
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So the midterms were acting as a deterrent for the current administration to escalate it even further.
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They didn't want voters or even polite glads to be able to latch on to the Republicans are bombing Iran again, a war no one wants.
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And then on top of that, the Iranians, the Chinese, the Russians had every incentive to sort of escalate before to push Trump out.
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The one thing I do know is the status quo isn't really working.
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If we remain with the status quo where there is no deal, I can tell you oil prices are going to probably$150 because the world is short oil in this current structure and there needs to be change.
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So that occurs probably either via peace deal or via regime change.
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Nonetheless, this is a big overhang for Marcus that all of a sudden the one deterrent that the administration had to not escalate is gone.
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So I would think if there was going to be action, we see it in the next couple of weeks.
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Obviously, if they decide to re-escalate, yeah, it was probably not going to be good for oil prices or the market.
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Secondly, the other tail risk or potential tail risk, I don't even know if it's a tail risk or not, it could actually be good for markets, would be if Democrats come to power, they
could become very hawkish on data centers, which could slow development.
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Now, from a US perspective, I think it's important that if you were leading the AI race, you want to stay ahead in that AI race.
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So if they block data center development, this could allow other countries such as China to catch up.
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It's just a politically popular topic to latch on to because there's broad fear about AI job displacement and we see negative headlines week after week.
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So it would make the US weaker.
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But you know what actually could be a good thing for stock prices of the hyperscalers because all of a sudden they don't have to be concerned about overspending, which would allow them to monetize some of their investments and give the market more certainty that they're actually going to make money from this.
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You would see the AI CapEx beneficiaries suffer, but look, that's eventually going to happen.
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So these companies would be like the chipmakers and stuff like that.
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And if the hyperscalers are spending less money building out data centers, this would fall off.
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Yes, the US has some exposure to this, but the hyperscalers are the big portion of the US index.
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And then from a user perspective, an AI CapEx overbuilt is actually probably a good thing for users.
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It means that there was too much compute built and consumers get abundant cheap AI.
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And this is like what happened in the dot-com rollout.
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Everyone got access to the internet.
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And then the other analogy, investors are beginning to contrast the AI build out to is the shale build out.
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So some of the cash flow projections for the hyperscalers are reminding investors about the shale overbuild, which was very bad for energy producer stock prices, but it was great for the broader economy and consumers of that cheap natural gas.
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So while it could be bad for stock prices, it could ultimately be good for the consumer.
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But if things change from the current trajectory, I think there's probably just some tail risk that exists because we don't know exactly how things are going to play out.
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For our last topic, the SP 500 fell less than 1% last week, but that headline number masked a lot of what was happening beneath the surface.
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Andrew, what's the real story across markets?
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As I wrote about last week, I think there's many pockets of pain.
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It's actually been extremely frustrating that at the index level, everything has looked totally okay.
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And the reason why this is happening is the top 10 companies in the US make up such a large portion of the S P 500.
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It's almost 40%.
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So what that means is depending on how these 10 companies are going to do, that's really going to dictate how the market is performing, even if the other 490 companies are selling off beneath the surface.
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So this is what we've sort of noticed the past couple weeks is that you actually have the technology sector down and every other single sector up.
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And the index, the SP 500, would be down, but from a breath perspective, the majority of companies were up.
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So that signifies to me that looking at the SP 500 performance is not necessarily indicative of what is actually happening in financial markets or the broader economy.
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It's really looking at SP 500 performance.
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It's what are these 10 companies doing?
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So with that being said, there's actually been a ton of pain under the surface.
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So last week, a handful of companies were down over 20%.
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ServiceNow was down, I think it was like 25 to 35% in just a single week.
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Earlier this year, we saw AI CapEx beneficiaries suffering the same fate.
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And this really hurt the hedge fund complex.
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So according to Goldman, long short managers were down 3.3% last month.
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Tech focused managers were down 12% last month.
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And reminder, these managers are supposed to be hedged.
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Earlier in the year, we saw even generalist hedge funds get involved in the AI trade.
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And it was a cheap, easy way to get outperformance over the index if you could latch onto some of these high flyers.
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But we're now seeing that work in reverse and hurt some hedge funds.
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Active management is just such a difficult game.
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Last month, it wasn't tech, it was biotech getting annihilated and it still hasn't recovered.
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And then over the past two weeks, what we've seen is credit and converse getting hurt.
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So Bloomberg last week had a headline about a$35 billion credit hedge fund called a Rini that was down 26% year today.
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I saw a chart this morning.
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European triple Cs now have a yield to maturity of over 20%.
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Now there's some idiosyncratic events going on there, but still looking at that broad index over 20%.
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That's extremely high and signifying extreme amounts of pain.
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We spoke to some of our managers last week and they were hearing about pods being liquidated at the multistrats.
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So what is happening in this instance is these multistrats, how they're able to deliver these returns is they run extremely tight risk limits.
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So if you're a portfolio manager there, you draw down 5%, they just say your job is gone, you're done.
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There's no second chances in a lot of these instances.
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It's just like you're done.
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When that happens, the multistrat takes over the portfolio and they just sell at whatever cost to limit risk.
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Now, the issue, we've seen this happen a few times in various instances in public markets, but public equity markets are more liquid.
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The issue with credit markets is there's no liquidity and there's no natural next buyer.
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It takes time for that liquidity to return to market.
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And I think that's what we're seeing in credit markets right now is this technical selling is you know what you have a couple four sellers that are pushing the market lower and there's just no buyer there.
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So the market goes lower and lower, forcing other people to be liquidated.
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This tends to be an interesting buying opportunity.
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So that would be one of my investment takeaways in this situation is things aren't selling off for fundamental reasons in some of these instances.
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There's going to be pockets of opportunity where, for technical reasons, things are selling off.
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And that tends to be a reason to buy.
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Converts also look interesting.
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They were looking quite rich, but due to for sellers, that market valuations have normalized.
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And then lastly, just as I mentioned before, investing is hard.
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So it's frustrating to see it looks like very calm waters at the index level, but under the surface, there's actually a decent amount of pain.
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And that index is going to continue to be driven by what is happening with the hyperscalers.
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And while things look okay right now, and at the index level, there aren't any issues.
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I think investors should be thinking about just how much binary risk.
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Because if you see these pockets of the market blowing up, the index has been immune.
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But there will come a day where it's the AI and hyperscalers that are taking it on the chin, and index investors won't be too happy when that happens if they're very concentrated.
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So to summarize, Fed held rates steady and the Bank of Canada hiked.
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In our perspective, though, the Canadian rate hike didn't make much sense.
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Secondly, we have a catalyst this week for equity investors with midterm elections taking place.
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And finally, the S P 500 only being down 1% is doing a poor job of describing what is happening across equity and credit markets.