Remy Blaire: The AI trade is facing its most severe reality check yet. While cash-rich megacaps like Microsoft and Alphabet have largely ignored the climb in borrowing costs, the marginal debt-reliant players financing the AI boom are cracking. Now [unclear: “now called”], the Nvidia-backed neocloud provider carrying an estimated $35 billion in debt, became the poster child for this vulnerability after its high-yield bonds traded near distressed territory this week, and those shares rebounded. We are looking at shares pulling back yet once again, and the debt rout exposed a dangerous rift in tech valuations.
Joining us on this Friday ahead of the weekend is David Busch, CIO of Trajan Wealth. David, good afternoon. Thank you so much for joining us. Well, let’s start out by talking about the AI trade, especially as we’re looking at the major stock averages in the red on this Friday. So do you think we’re witnessing a permanent divergence between the cash-rich hyperscalers and the heavy upstarts that are funding the AI buildout?
David Busch: Yeah, that’s a great question, Remy. And I think we are. And essentially, what’s happening is that divergence is really being caused by higher interest rates. We have an increase in capital expenditures required to build out the infrastructure. Meanwhile, borrowing rates have increased, actually, year to date.
And so what’s going to happen is higher rates generally shake out the weaker borrowers, or the weaker companies. Meanwhile, the cash-rich large-cap tech companies, they can absorb it. But investors will be watching their earnings closely to see if they’re able to monetize the AI investment, and if there’s going to be any margin compression due to the increased capital expenditures in light of higher interest rates.
Remy Blaire: Yeah. And of course, moving forward, there are a lot of question marks here. The first phase of the AI boom was about scarcity and also capturing hardware at any cost. But with this competition heating up and financing being extremely pricey, how dramatically do equity valuations need to reset as investors out there eventually demand actual returns on invested capital?
David Busch: So the bears out there, they have an argument based on higher interest rates and lower valuations. But the bulls, their argument is that as long as earnings keep pace to support these valuations, then this rally can continue, or at least we may not have a dramatic sell-off. And so I’m going to be watching earnings releases closely, particularly around the large-cap tech, the hyperscalers, to see how they’re able to monetize this technology. And if there is earnings compression, and if any of these companies miss earnings or lower forward guidance, I expect to see a lot of volatility around those announcements because of that.
Remy Blaire: Yeah. And speaking of volatility, it’s been quite the week across the markets. And we did get economic data and inflation, both from CPI as well as PPI. And we’re looking at the 10-year yield hovering right around 5.13% on this Friday. So given where we’re looking at yields as well as fed funds futures, investors ultimately dictate long-term rates. Does a Fed pause actually provide any meaningful relief for financing or mortgage borrowers out there?
David Busch: It may. But right now, inflation is taking hold in our economy, and I think that’s what the Fed is most concerned with. This higher inflation, caused by geopolitical risks with the conflict in Iran and higher energy prices, is permeating the economy. And that’s not something that the Fed can fix on their own.
I mean, when we look back to post-COVID, post-pandemic inflation, that was demand-driven. Now it’s scarcity-driven, meaning higher energy prices. We consumers feel it, the pain at the pump. But also, these higher diesel prices are becoming embedded within the economy, because diesel flows through agriculture and manufacturing and industrial, all different sectors, and the Fed is watching that closely.
And so they may pause in October. The comments yesterday from Waller, I think, helped quite a bit. But ultimately, I think we’ll get another rate hike potentially in December, and maybe one or two next year. But again, all the Fed can do is just try to reduce demand from consumers and businesses. They can’t actually fix what’s causing the inflation.
Remy Blaire: Yeah, that’s a key component of the equation when we’re talking about inflation, for sure. And David, while I have you here, I do want to get your take on big bank earnings, which we got aplenty this week. So beyond Goldman’s equity trading surge, what are you watching when it comes to loan growth as well as funding costs that might signal higher rates are indeed hurting the financial system at this point?
David Busch: Yeah. With banks, as long as we see credit creation, and if the curve is steep, meaning the front end is lower than the long end, banks do really well in that environment. Unfortunately, what we’re seeing today is more of a flattening of the curve, particularly in that area that banks normally play in, right? So it’s the overnight out to roughly the 10-year. And so higher fed funds rates will cause them to have to increase deposit rates, which will compress net interest margin.
So what I’m looking for is, are they able to also make loans, you know, high-quality loans, and book the interest off of those? Trading desks, you know, I know Goldman, and I think JPMorgan as well, if memory serves, showed that trading revenues were higher, which is great. But actually, the fundamentals of a bank are taking deposits and making loans, and that’s what I’m looking for. And also the health of the underlying borrower. And we’ll see that data when it’s published by the Federal Reserve. But that gives a really good glimpse into the overall health of the economy.
Remy Blaire: And as you mentioned, David, hot wholesale inflation as well as elevated diesel prices continue to squeeze the economy. And when we take a step back and look at the S&P 500, it is up triple digits this year, year to date so far. But we’re looking at the energy, IT, and health care sectors outperforming the index itself. And that’s not surprising, given where energy prices are. So what does all this mean for the American consumer as we head into year-end?
David Busch: Yeah. I would expect the consumer to slow demand. And when we look at the S&P 500 and the composition of it, it’s roughly 80% of the market cap of the US economy. So the S&P 500 is a good indicator. But the ten largest companies in the S&P 500 represent roughly 35% of the index. And what that means is they’re all the tech-related names. So if we do see a drawdown in the tech sector, then it can bring the average down. It can bring the index down.
So I would be watching tech earnings closely, especially for any passive investors that are in the S&P 500, because it has concentration risk as an index itself. But when I think of higher energy costs and higher health care costs, I truly believe that it’s going to cause the consumer to pull back. And the consumer is still the largest engine of the US economy. And so when they start to pull back, we could start to see economic growth pull back as well.
Remy Blaire: And finally, David, before I let you go, you mentioned economic growth. And there were key data points this week that were overshadowed by the bigger reports, including CPI and PPI. But we got retail sales out earlier this week, and of course that was an interesting figure. Not surprising to see those gains in energy affecting retail sales. But what is that telling you, especially on the heels of the producer prices, which were much higher than expected?
David Busch: Yes. So lower retail sales in light of higher energy costs shows that consumers are pulling back. The other metric that was released earlier this week was average hourly earnings, which actually was a negative change. And so that shows that consumers are becoming more stressed in their spending, and they have to choose, you know, how they’re going to spend their dollars.
And so I’m watching labor markets. I’m watching average hourly earnings, because remember, the Fed has a dual mandate. And unfortunately, right now we’re starting to see labor markets that are not as solid as they have been in the past. I’ll put it that way. And so what I think we’ll see for the rest of the quarter is consumers pull back, consumers make the decision how they want to spend their dollars. And ultimately, it could impact how businesses spend, and thus slow the economy.
Remy Blaire: Yes. Well, a lot to keep our eyes on as we count down to the midterms and, of course, the holiday shopping season out there. So appreciate your time, David. Thank you so much for joining us, and have a great weekend.
David Busch: Thank you. Thank you, Remy.
