AI CORNER
The new Sputnik moment
Gavekal’s Louis-Vincent Gave reminds us that China was already ahead of the West on 5G, high-speed rail, solar panels, EVs, batteries, drones and robots, before the revelations of the competitive open source DeepSeek model.
(…) It now looks as if the hundreds of billions spent by the giants of US tech is essentially so much capital that will never see any returns—the “metaverse” fiasco all over again, only larger.
This marks an important shift in market narratives. Essentially, DeepSeek has taken a hot needle to the AI bubble, and the air will now be leaking out. This possibility raises the question whether the deflation of the AI bubble will remain a concentrated market phenomenon, with names like Nvidia coming back down to earth in isolation, or whether it will impact the broader market, with a lower Nasdaq, a weaker US dollar and stronger US treasuries.
In recent weeks, I have been showing the chart below to illustrate what an odd bull market US growth stocks have been enjoying. The outperformance of US growth stocks started in 2007, at a time when valuations had been thoroughly rinsed out. This bull market initially had two important drivers: the launch of the first Apple smartphone and the US shale revolution, which meant that the US suddenly had a cheaper cost of energy than almost everyone else and was set to record an improvement in its trade balance.
By 2015, investors realized that returns from investments in US energy would most likely disappoint, and the markets suffered a bit of a hiccup. But the combination of the “Shanghai agreement” with the promise of deregulation and Trump’s first-term tax cuts got things going again.
By 2020, the market had entered a typical “blow-off phase,” characterized by sheer silliness: the GameStop saga, the AMC stock surges, exercise bikes with iPads trading at a market cap of US$49bn, Metaverse spending etc.
Then, in 2022, the air came out of a lot of the flimsiest ideas and the more egregious Ponzi schemes, and the market rolled over. So far, the bull market was thoroughly “text book”: 10 years of solid outperformance, a couple of years of exuberance, then the implosion.
What was not textbook was the back-to-back very strong years in 2023 and 2024. These two years of impressive returns led by a handful of mega-cap stocks left the broad market indexes more concentrated than at any time in history. And the catalyst for this rebound? The release of ChatGPT and the sudden excitement over all things AI-related.
In truth, not much was textbook since 2008. Remember Bernanke’s ZIRP, helicopter money, the financial repression, COVID-19 and the mega handouts, core CPI surging from 1.2% to 6.6% and 10Y Ts at 1.5% while inflation was 3.2%.
And, BTW, a 50% jump in S&P 500 earnings between 2019 and 2024.
Also true: the increase in the trailing P/E from 19.8 in December 2019 to 25.1x currently.
Louis Gave continues (my emphasis):
All of which brings me back to the release of DeepSeek, and the following questions.
1.
Has AI reached a dot-com moment? At the end of the 1990s, hundreds of e-commerce platforms were funded by eager VCs. When Pets.com and others started to fail in 2000, and dot-com companies started to run out of money, companies like Lucent and Sun Microsystems that had extended credit to fast-growing customers suddenly found themselves in deep trouble on two fronts. First, their former clients were fire-selling their new equipment for cents on the dollar. Second, the clients stopped making the payments they owed. Balance sheets and income statements came under assault at the same time. Could history repeat, but this time with failing VC-funded AI companies selling the high-priced chips they were rushing to buy just months before on the fear of shortages?2.
If the AI bull market stalls, what will take over? There are plenty of other exciting stories today: the rise of autonomous driving, Chinese stimulus, US deregulation, the impact of steeper yield curves on financials. Some of these themes center on the US. Others less so.3.
If the next “new new thing” is not in the US, what will it mean for the US dollar? Last week the US dollar gave back some of its recent gains. Arguably, the US dollar’s rollover was linked to Trump’s softening stance on tariffs. But given the news on DeepSeek, it may not be all that surprising. If China can develop a more efficient AI at very low cost, it calls into question a lot of the recent rhetoric about the need for very high-end chips, one key US comparative advantage. Whatever the reason, the fact remains that over the past year, the US dollar and US growth stock relative performance have been heavily correlated. So if, as seems likely, the Nasdaq now starts to underperform on the back of the DeepSeek news, then given recent trends, the US dollar will most likely follow.
In closing, I would like to highlight that one of the odd things about the AI bull market has been its capital intensity. Up until a couple of years ago, one of the main attractions of tech companies (along with strong growth) was the “capital-light” nature of their business models. But AI turned this on its head. All of a sudden, the market seemed keen to buy semiconductor companies on triple-digit multiples, based on the premise that the tech world would now have a capital intensity higher than a steel plant or an oil refiner.
On the positive side, DeepSeek seems to bring things back to what tech should be: open-source and capital-light. This is ironic since it is coming out of China, where the popular perception is that growth is always capital-intensive and policy is anything but open-source!
Perhaps most importantly, DeepSeek destroys the idea that although having a few tech titans controlling the broader tech ecosystem might be socially pernicious, at least it makes for technological progress and ensures that the US remains technologically dominant. In this latest Sputnik moment, the tech war between China and the US, between open-source and closed-system, and between capital-light and capital-intensive models has just taken a very interesting turn.
Also likely to help:
- continued strong economic growth, particularly in the U.S.;
- +11.6% growth in earnings of S&P 500 companies ex-Tech and Comm. Services, per the current consensus, critically important in the current environment;
- lower personal and corporate tax rates in the U.S.;
Potentially offsetting: tariffs, higher deficits and a volatile U.S. president.
Louis’ point on private company debt gets support from this S&P Global’s chart showing deteriorating coverage ratios:
Bloomberg had this on January 11:
The International Monetary Fund is planning a deep dive on the growing prevalence of payment-in-kind debt that allows companies to defer interest payments, amid wider fears the tool could undermine financial stability by obscuring stress.
The watchdog plans to look at how often the expensive debt used to keep struggling companies alive is in fact merely delaying an inevitable insolvency, according to a person with knowledge of the matter. The IMF also plans to look at interconnections between banks and private credit after a series of lending partnerships were announced this year, the person added, asking not to be identified as they weren’t authorized to speak publicly.
Watchdogs across the world are concerned about the risk of bubbles in private markets against a backdrop of inflated asset values, high interest rates, and a rush-for-cash among firms battling to build scale. PIK has become an increasing area of focus, sweeping to prominence as private equity firms sought ways to manage higher-than-expected interest payments amid a prolonged period of higher rates.
The IMF work comes amid rising concerns about potential systemic risk from private credit’s growth. Of particular interest to the watchdog, the person said, is understanding the different layers of leverage in the financial ecosystem. Investors might borrow to help fund their allocations to private credit funds, which in turn might have leverage on their portfolios. And ultimately the money is flowing to companies getting loans from these funds. (…)
This is happening while valuations are
Unanimously Expensive: And here’s another angle on it, this one shows what looks to be the average historical percentile ranking across 8 different valuation metrics, and the signal is unanimous: the US stockmarket has reached new heights of valuation extremes. You can kind of explain away some of this with datapoints of how valuations don’t matter in the short-run, or that it’s expensive for good reason, etc, but I think it’s quite dangerous to try and argue that valuations don’t matter when we’re at this stage of the cycle (and it might even be outright irresponsible). (Callum Thomas)
Source: @joosteninvestor via DailyShot
- “Consumers’ stock market bullishness remained near a record high in January according to the CCI survey. From a contrarian perspective, this is bearish. The “stock prices higher in 12 months” series is correlated with the S&P 500’s forward P/E, which is historically high. Nevertheless, we believe that better-than-expected earnings will drive the market higher, not rising valuations.” (Ed Yardeni)
BTW:
The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the fourth quarter of 2024 is 3.2 percent on January 28, up from 3.0 percent on January 17. After recent releases from the US Census Bureau and the National Association of Realtors, the nowcast of fourth-quarter real gross private domestic investment growth increased from -0.9 percent to 0.1 percent.
As I wrote previously, there is more than DeepSeek:
Alibaba Touts New AI Model Superior to DeepSeek’s and Meta’s
Alibaba Group Holding Ltd. published benchmark scores and touted what it called world-leading performance with its new artificial intelligence model release.
The upgraded Qwen 2.5 Max edition scored better than Meta Platforms Inc.’s Llama and DeepSeek’s V3 model in various tests, according to figures in Alibaba Cloud’s announcement on WeChat. Alongside Tencent Holdings Ltd. and Baidu Inc., Alibaba has poured significant resources into its cloud services segment and is engaged in a hot contest to recruit China’s AI developers to use its tools. (…)
Cloud service providers like Alibaba and Tencent have slashed their pricing in recent months in the effort to win over more users. DeepSeek has already contributed to that price war, alongside a half dozen other promising AI startups in China that have secured funding at unicorn valuations.
US Core Business Equipment Orders Increase by More Than Forecast Bookings for core capital goods ex-aircraft, defense rise 0.5%
Core capital goods orders, a proxy for investment in equipment that excludes often-volatile aircraft and military hardware bookings, increased 0.5% last month after an upwardly revised 0.9% increase in November.
Core capital goods shipments, a figure that excludes often-volatile sales of military equipment and commercial aircraft, increased 0.6% in December — the most in nearly a year. The latest figures will help economists fine-tune their business equipment spending estimates for fourth-quarter gross domestic product. Those figures will be reported on Thursday.
Including aircraft, shipments of nondefense capital goods jumped 3.5%. (…)
- “November’s surge in capital expenditures continued last month, with the 3-month moving average rising at the fastest pace in over two years, marking a 28-month high.” (Interactive Brokers)
Why the gap between new orders and production?
Imports?
- “All of January’s business surveys conducted by five of the 12 regional Federal Reserve Banks are now available. They strongly suggest that the month’s M-PMI was solidly above 50.0 for the first time since early 2022.” (Ed Yardeni)
