By Jamie McGeever
ORLANDO, Florida (Reuters) -U.S. stocks and bond yields rose on Wednesday on surprisingly strong job growth and service sector data, which suggests the economy is in decent shape and calls into question how much lower the Federal Reserve needs to cut interest rates.
I didn’t write a column today, but don’t worry – here is a link to Monday’s, where I highlight the growing doubts around whether U.S. Big Tech’s astronomical investments in AI will ultimately deliver the returns investors are banking on.
If you have more time to read, here are a few articles I recommend to help you make sense of what happened in markets today.
Today’s Key Market Moves
Today’s Talking Points
* U.S. economic resilience
With the U.S. government shutdown now officially the longest on record, there has been hardly any economic data for investors or policymakers to chew on over the past month. But if the latest figures on Wednesday are anything to go by, underlying growth might be stronger than many thought.
Private sector payrolls growth rebounded sharply in October, and services sector activity rose to its strongest in eight months. Market probabilities of a Fed rate cut next month duly fell back to around 65%, and stocks jumped. Let’s see if these are backed up by other numbers in the weeks ahead.
* AI “bubble” debate rages
It’s been a strange – and potentially pivotal – week in the world of AI. Most U.S. “Big Tech” firms have reported strong earnings, and apart from Meta and Microsoft, their share prices have held up despite some froth coming off the market.
But there are warning signs, certainly regarding valuations if not the technology. CEOs of big U.S. banks are urging caution at these levels, Palantir is trading around 240 times forward earnings, and doubts are gnawing around the huge sums of AI capex. Is it up to Nvidia once again to deliver bumper earnings and soothe everyone’s nerves?
* Japanese FX intervention?
Dollar/yen is trading at 154.50, its highest since February, above levels that have previously prompted Tokyo to intervene (around 152.00 in 2022), and appears to have upward momentum. The dollar is on a roll, while the prospect of fiscal easing from Japan’s new government is weighing on the yen.
Will Tokyo intervene soon? Based on dollar/yen and momentum, perhaps. It intervened last year in the 158.00-162.00 area, so 160.00 might be a “line in the sand”. But domestic and relative U.S.-Japanese fundamentals, and capital flows, would have to align for it to be successful. Assuming dollar/yen doesn’t leap higher in the coming weeks, let’s see what the BOJ does and signals on December 19.
Big Tech, big spend. But big returns?
The reaction of most “Magnificent Seven” tech giants’ shares to their latest earnings suggests the artificial intelligence boom is far from over. Yet doubts about the future returns from these firms’ astronomical AI expenditures are gnawing deeper.
The third-quarter earnings season has seen these tech behemoths continue to rake in huge profits and offer sunny guidance. Some investors may baulk at the Mag 7’s lofty valuations, but today’s tech leaders – unlike the superstar firms of the 1990s dotcom bubble – appear to have sustainable business models. Federal Reserve Chair Jerome Powell reiterated as much last week, saying that their AI investments are a major source of U.S. economic growth.
Just four “hyperscalers” alone – Microsoft, Amazon, Meta and Alphabet – are expected to spend a combined $350 billion this year, and Goldman Sachs estimates global AI-related infrastructure spending could reach $4 trillion by 2030.
The more these firms splurge on data centers, cloud computing capabilities, and the gamut of AI technologies, the loftier investors’ expectations will get. At some point, they will be impossible to meet.
The financial benefits and cost savings for society resulting from that are one thing; which companies actually profit is another. It is important, therefore, to distinguish between “value creation” and “value capture”.
“The value creation is certainly there,” says Daniel Keum, associate professor of management at Columbia Business School. “But will that value flow back to the companies that are making these AI investments right now? For me, the clear answer is no.”
DO THE MATH
It’s early days in the AI supercycle, but Big Tech’s AI outlays are already eating into hyperscalers’ cash flows.
Torsten Slok, chief economist at Apollo Global Management, estimates that aggregate capex at Amazon, Google, Microsoft, Meta and Oracle as a share of their operating cash flow is now a record 60% – and rising.
Amazon reported strong earnings last week, and its stock surged double digits to hit a new high on Friday. But buried in the report was a slide showing that trailing-12-month free cash flow has fallen almost 70% over the last year.
Ross Hendricks, analyst at independent research firm Porter & Co, estimates that hyperscalers’ free cash flow in the first quarter of next year will be down more than 40% from the same period this year.
“The whole sector faces the same basic problem,” says Bob Elliott, co-founder of Unlimited Funds. “The math is pretty simple, unless there is a surge in revenues from these activities, Big Tech is going to pump nearly all their free cash flow into capex in just a few years.”
This creates several potential problems. It intensifies the pressure to generate high returns on these investments, but until those materialize, non-AI-related activities are also under pressure to produce significant returns. And this leaves hyperscalers vulnerable in the event of a sharp economic or market downturn.
HIGHER BAR
The fate of these megacaps will, of course, have a significant impact on the broader economy, not only because these companies’ capex is helping to drive growth but also because almost everyone with a retirement fund is exposed to them. Nvidia’s share of the total S&P 500 market cap is a stunning 8%, while that of the “Mag 7” is a record 37%.
Investors are well aware of how much these shares have appreciated. The Philadelphia Semiconductor Index has more than doubled from its April low. But expensive markets can always get more expensive.
It will take a brave fund manager to tell clients that they’re reducing exposure to what have effectively become cash-printing machines. Of course, whether these companies can continue printing money as fast as they’re spending it is the big question.
For example, Meta’s announced capex this year is around $70 billion, but Unlimited Funds’ Elliott notes that the company’s income is only $3 billion to $5 billion higher, based on underlying trends, than it was before they started spending all this cash. That’s a pretty “mediocre” return on investment.
Of course, CEO Mark Zuckerberg might argue that this is long-term investment and that not spending now could be more costly down the line if the AI revolution lives up to the hype. But it is unclear how much patience investors will have.
Smaller businesses overall seem to be faring better. A Wharton Business School study published last month found that 74% of businesses say generative AI investment is already producing positive returns, especially smaller enterprises in digital-based sectors like tech and finance.
“Confidence remains strong … but future gains must now be justified by clear performance outcomes,” the authors said.
The bar for Big Tech giants with market caps of trillions of dollars and capex budgets of hundreds of billions is higher though. Much higher.
What could move markets tomorrow?
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Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias.
(By Jamie McGeever; Editing by Nia Williams)
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