Market participants are paying up for a future built around AI and shunning low risk, low growth companies. Traditional safe havens like consumer staples and other low volatility stocks are greatly lagging the broader market and tech especially. Last month we discussed the rising interest rate and inflationary environment and how it plays a role in some of these market dynamics. The downstream effects of the buildout behind AI are immense and also play a role, one that is still largely unknown but does tie into interest rates. It’s estimated that by 2035 the energy demand from data centers at the heart of the AI story will total about 194 gigawatts, or 20% of total US consumption, and yet utility stocks are in a downtrend. One can never be sure what exactly is driving the market, but in this case, it looks like the macroeconomic headwinds of higher rates are just too great a force to overcome for a rate sensitive sector even as growth explodes. Nonetheless, this growth explosion has placed the broader market firmly in the grips of the bulls, rallying behind the new technological revolution even if it is nudging rates to new highs.
By November of 2022 stocks had already been trading down for nearly a year as the bear market was getting worse and inflation was raging after massive fiscal stimulus to fight economic collapse due to COVID flooded the economy with cheap cash. Then Open AI released Chat GPT. Since that moment companies have been tripping over each other to implement the new tools that come with large language models (LLMs) and watching their production increase. Here we are nearly four years into this new AI bull market, and it seems like we are still in the early innings despite some stocks already gaining thousands of percent as broad AI adoption is still relatively low. On the bear side, market breadth has recently pulled back, meaning fewer companies are making new highs and participating in the gains demonstrated at the index level. However, that is likely a result of rotation back into the mega-cap growth companies. The MAG 7 were essentially flat since November of last year after posting monster gains the previous three years. This points more towards healthy market rotation than evidence of an impending crash. It is also good to see the leaders leading again. Just like in sports, it’s nice to see role players have big games and occasionally carry your team to victory but it’s much more sustainable to have your superstars dominate on a consistent basis. So, if consumer staples and utilities are losing power to higher growth, higher margin companies for a few months so be it.
The reality is that technological revolutions cost a lot of money and a lot of money takes a lot of borrowing. The likes of railroads, electrical grids, and interstate highways, to name a few, all cost roughly 10% of our GDP to build out, but the growth they deliver has been many, many times that. Lending rates are going up along with capital expenditure as is expected. The more you borrow, the more the bank is going to demand in interest on that loan. Right now, it still makes sense for these companies to borrow and spend hundreds of billions of dollars on microchips because there is a shortage of compute. Furthermore, if these companies aren’t using their compute to make their own AI models better, they can lease it to the highest bidder for massive profits. At some point we will reach equilibrium, but we are nowhere near there yet. Eventually the cost of compute will outweigh the returns generated from using it and at that time we will likely see renewed interest in energy production rather than data center production and other traditionally conservative sectors even if the underlying growth story for those more boring companies never wavered. In short, the new industrial revolution is upon us, AI is working its way into every system, the buildout is real and very large, and rates are deciding which parts of the market get rewarded and which ones get discounted. Right now, the lean is heavily toward growth.