More AI Downward Pressure
Another tough week for Mag 7 names as earnings releases put the spotlight on AI revenue growth and accumulated debt. Last week, the Fed kept rates unchanged in a
move largely expected by the market. Warsh indicated that there was "consensus is medicine starting to work" and there's "no firm conclusions now about monetary policy."1 It would appear that he's leaving the door open for flexibility, yet UBS believes the Fed's action and language to be hawkish as it stated, "The US 10-year yield took a few moments to consider the new statement wording, concluding that the guidance was for a December hike. The new wording about accumulating more data appears to nod to Warsh's view that he bases his decisions on trends rather than single data points. If trends continue as they are, then December is on."2 Currently, Fed futures show a 72% probability of a 25 basis point rate hike in December.3 A rate hike could cause overnight financing to rise which could affect rental and power deals between neoclouds, hyperscalers, and AI chipmakers. Even Warsh himself admitted in last week's post-meeting presser, when asked, that rate hikes would affect the "investment surge" in AI.
Last week we noted how intertwined the various companies in the AI space are from an operations and financing standpoint.4 The risk that potentially comes from the intertwined relationship is that real consumer demand could be distorted in favor of
circular financing. It also makes the financials of AI firms, harder to read versus actual sales and expenses. With free cash flow in negative territory for some hyperscalers, as evidenced in the graph, investors have begun to pay more attention to the circular financing of AI-related companies - neoclouds, hyperscalers, hardware, and AI labs. For the first time since late March, Mag 7 stocks were lower by at least 2% last week for the 3rd consecutive week.5
While the prices of AI-related stocks are under pressure, the Wall Street Journal last week brought up concerns about not just what is "on the books", but what is "off the
books" for AI-related companies.6 According to their their analysis, there's some $2.42 trillion in leases not yet started and purchase commitments for some of the largest AI-related companies. It's important to note that "off balance sheet" does not mean improper accounting. This practice is allowed under GAAP. However, it does mean that details about those "off balance sheet" items are not readily available to current and prospective investors. Just last week, S&P Global estimated that the world's biggest tech firms likely have more AI-linked liabilities that is currently known.7 S&P's Global Head for Digital Infrastructure Mark Habib noted that the biggest risk to hyperscalers' credit ratings remained whether expected profits "fail to materialise."7 Corporate earnings may become more important over the next couple of quarters.
Lastly, there ought to be some consideration to the future and where AI might be headed. At some point there could be consolidation in the AI industry if financing
costs and revenues become untenable. There is no way to know exactly when that will occur, but history has given us some perspective. In early 2000, as represented in the graphic, Lucent was one of the first major companies to warn of missing analysts earnings expectations. Equity markets continued to march higher to hit an ultimate peak 3 months later. It wasn't until after the first wave of downward pressure on equities that companies started to miss earnings expectations on a regular basis. The point is that market prices tend to lead fundamentals. Earlier this week, as reported by PANews, citing Bloomberg, a report indicated that the bond giant Pimco had reduced AI debt holdings by up to 50%.8 It is usually a good idea to annually review investment portfolios to make sure risk and time horizons are accurately represented in portfolio holdings.
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