Dear Clients,
I felt like I needed to send something out after the big DeepSeek news out of China that affected the AI markets and the big aggregators the past 3 weeks. Additionally, I also have been getting a lot of questions about the various markets because of the Geopolitics across the world, all the tariff talks, especially with overall market valuations at this level.
First, many aspects of the DeepSeek discussion have caused many investors concern, and made many wonder what is real and not real. I wrote a Flash about three weeks ago discussing some of the talking points as to why I felt that while the moat may not be as strong around certain AI companies as it used to be, that I would be given the opportunity to reduce risk a little when given the opportunity, I still felt like the AI story over here in America is still pretty strong, but it might make some sense to not have too much concentrated risk with the narrative change. Well, now that we have gotten through a lot of the AI aggregator reports, I feel even more convicted that AI as a whole and the AI spend still has legs, as that has been backed by several of the U.S. technology hyperscalers such as Amazon, Microsoft, Google and Meta, as each are ramping up their AI-related capital expenditures despite concerns over mounting expenses and the delayed profit payoff. Anxiety around the effect of China’s entrance into AI has only added to the urgency for these companies, which are relying on heightened investment in AI infrastructure — such as data centers and graphics processing units — to lead to more computing power and, ultimately, revenue. Combined spending from the four tech giants is set to exceed $315 billion in their current fiscal year, which is another 39% increase over the incredible spend we just witnessed in 2024! Pretty incredible, especially as Wall Street has been pretty tough as of late, on companies that aren’t showing immediate gains from this type of AI spending.
Morgan Stanley analyst Brian Nowak updated his capex forecast for the four hyperscalers, expecting spending will surge to $367 billion in 2026, which is a 62% spend increase over 2024. While he agrees with the foundation of the Big Tech investments, he acknowledges that questions over the return on invested capital “will remain in focus.
I thought some of these aggregators might insinuate they might spend less, just to try and get some negotiating leverage, but none of them did, which shows how dependent they are on certain AI products right now. UBS equity strategist Sundeep Gantori wrote in a Thursday note to clients, “Contrary to the general perception that low-cost models like DeepSeek will result in near-term cuts to AI capex, we are actually raising our Big 4 capex estimates based on solid big tech guidance during the 4Q24 reporting season and a strong demand outlook for frontier models,” Gantori said. “We believe the recent correction in AI compute stocks is overdone,” Gantori added. Like many strategists coming out as of late, Gantori believes the the recent correction in chipmakers Nvidia and Broadcom was exaggerated, given strong trends in AI adoption and compute spending. After the brief Jan. 27 sell-off in technology stocks, fueled by anxiety over Chinese startup DeepSeek’s low-cost AI model that used less-efficient Nvidia chips to create a chatbot rivaling OpenAI’s ChatGPT, almost all of that selloff has been reversed and the “buy the dip mentality has seemed to return. Not that we are not out of the woods yet, but I do believe this a precursor to some good AI earnings calls and technology will continue to fare pretty well.
I have had multiple discussions also about other aspects of the market also, as tariffs could even add fuel to the fire on the potential for rising rates. While I do think rates could be sticky for a while, especially if we get into a tariff war, I still like the way the fixed income market is shaping up this year for multiple reasons. First, I am fine with rates staying higher for longer, as long as the Fed doesn’t reverse directions and start raising rates again. But I just don’t see that happening any time soon, and likely not at all for at least another year, likely longer. Second, the bond market rarely has multiple poor years in a row and after such a dreadful year in 2022, I think the risk/reward is good in the area of investing.
The bars in the chart below show the total return for the Bloomberg U.S. Aggregate Bond Index each year since 1976, the inception of the index. The red dots show the largest peak to trough decline that occurred that year. History shows that bear markets for bonds are more like koala bears than grizzly bears, given the average intra-year decline is just 3.5% per year vs. an average decline in equities of 14.2%. Further, following bad years of performance, bonds tend to deliver strong returns.
So, this is another area I think we will get good results this year, without a lot of risk. Though the markets as a whole are overvalued in my opinion backed by most valuation models, you can’t fight the tape in the short term as valuation is just not a good short-term indicator. There are many ways I can reduce risk/reward in these markets, with buffer ETFs, intermediate bond duration investments, covered calls/stocks, covered call income funds, and very selective sector investments (with Financials continuing to be my favorite and off to an incredible start in ’25 after a very strong ’24). So, while there are a lot of crosswinds and more politics and geopolitics than many investors are comfortable with right now, there are also more investment options than we have seen for some time. While I believe there will be lots of volatility this year and a full 10% correction at some point, I think looking for risk/reward opportunities with lower Sharpe ratios will be very important in 2025.
I felt like I needed to give some clarity on a couple of issues that are on a lot of investor minds. And the coming weeks could be very telling in multiple economic areas. This week will be chalked full of data as U.S. inflation updates may test investors’ resolve with tariff talk churning. The CPI report will be released on Wednesday, followed by PPI on Thursday. Fed Chair Powell begins his two-day Congressional testimony on Tuesday. Although fed funds futures are still pricing in two rate cuts before year end, Powell’s tone in the hearings could alter that outlook. Friday’s retail sales report will provide a look into consumer spending trends as the new year begins. The rest of the domestic economic calendar includes 10- and 30-year Treasury auctions, small business sentiment, and industrial production figures.
The markets and many investors will have plenty to think about. Hope you have a great week.
Best Regards,
Hunter Hardy CFP®