The bonds that bind the markets
Dear Friends,
For the markets, it has been an unusually eventful summer.
The biggest news in equity markets this quarter was that both Anthropic and OpenAI have delayed their long awaited IPOs. We will return to this later. In our view the moves in the bond markets are more significant and should be the primary focus of investors. Both the US 10 year (5.35%) and the 30Y Treasury (5.6%) are now trading at yields not seen since the early 2000s. The US has effectively had a Zero Interest Rate policy for most of this century. Initially instituted in the aftermath of the Tech wreck, briefly relaxed in the mid 2000s, and then quickly brought back in the face of the Global Financial Crisis and the Covid pandemic. This summer may be remembered as the moment when US policymakers returned to a pre-ZIRP world and the catalyst was inflation.
Inflation readings have remained stubbornly above the Fed’s stated target of 2%. By August, the President’s demand for lower rates heading into the midterm election had brought the new chair Kevin Warsh’s independence into question. The board eventually voted to increase the short term rates target by 25 basis points and reiterated a commitment to bring inflation down to the target. The persistently high inflation readings are explained by rising fuel prices and the large scale infrastructure investment being made in data centers to host AI companies. Together these factors are raising the price of goods and services across the US and are the largest risks (apart from high valuations) haunting markets.
Despite many announcements of victory or an impending peace agreement, the war begun by the US and its allies against Iran shows no sign of coming to a definitive negotiated conclusion. After the closure of the Strait of Hormuz, which took offline most natural gas and oil shipments from Gulf states, Saudi Arabia continued to export about half its production via an oil pipeline to the Red Sea. In September, the Ansar Allah (aka Houthi) army in Yemen took over several islands and coastal redoubts along the Red Sea. They have closed the crucial Bab-al-Mandap strait to all Saudi shipping and severely damaged crucial infrastructure in Saudi Arabia. This effectively means no country in the middle-east is now exporting oil in significant quantities and 15-20% of global supply is offline. If the war were to end tomorrow, it would still take months to bring production back to pre-war levels.After being attacked twice during the course of negotiations, Iran’s administration are understandably skeptical of US assurances. Iranian diplomats are well versed in domestic US politics and have indicated they would drag out the closure of these key waterways till the mid-terms, when they expect Washington to have a divided government.
Even if the Democrats take the House and the Senate, we do not see this conflict reaching a definitive conclusion. Despite murmurs of dissent, the current Democratic Congressional leadership is tacitly supportive of the war on Iran, quibbling only with the administration’s tactics. A strong majority of both party’s leadership eagerly supports the continuation of the Russian-Ukranian war. Various representatives and US policy-makers have publicly said they see that conflict as a way to undermine Russian power in the region at virtually no cost in American lives. Ukraine bears almost all of those costs; its population has been cut almost in half, its economy destroyed and hundreds of thousands of Ukrainians killed or maimed. Unlike the US, where we have held elections during the Civil War and both World Wars, Ukraine’s leadership suspended the last election, and it is unclear when, or even whether, Ukraine will ever have an election.
With production and transport of petroleum products from the Middle-East partly offline, limited Russian production, and oil reserves depleted, the energy markets are in uncharted territory. It is hard to dismiss Iranian claims that they are engineering something akin to the oil crisis of the 1970s. If successful, that would be a remarkable mirror image of the US threats to harm the Iranian economy that accompanied the beginning of the war.
Meanwhile, in the bond markets, investors are increasingly concerned that inflation will erode their long bond portfolios. That is half the explanation for the sharp drop in treasury prices which has been driving yields upwards. The other half is concern about the ballooning US deficit and its impact on the US’s creditworthiness. US federal government debt exceeds 40 Trillion dollars. Increasing rates means the amount of interest paid to service this debt is increasing. Treasury has taken to refinancing long dated debt as it matures, into short dated notes. Several observers had compared this to paying the mortgage with a credit card. In Treasury’s defense, short dated treasuries carry very low interest rates, and they are buying long dated bonds which are underwater, so reducing the size of outstanding nominal debt by doing so. However, this makes the US’s interest burden much more unpredictable. That is, however, likely to be a different administration’s problem.
Further downward pressure on treasury prices comes from the expectation that the Saudi, Japanese and other governments will soon be forced to start selling. Mr. Bessent (nicknamed “The House” by most financial commenters) has created unorthodox programs to support the Japanese Yen. The Saudi Rial may be next since the Kingdom runs enormous fiscal deficits financed through sales of oil which can no longer be delivered.
The administration’s big bet is that all the borrowing and deficits will be immaterial if the US can grow its way out of this mess. These growth expectations increasingly rely on the fortunes of a single industry, the AI complex to deliver profits and productivity gains. Instead, the AI sector has become the source of immense drama this quarter. SpaceX IPO’d in June and shortly thereafter, the stock was trading below its IPO price. OpenAI (ChatGPT) and Anthropic (Claude) had their bankers pitch their IPOs to investors. As part of the disclosure process, both companies reported that their AI models had hacked into the systems of several other companies during training runs. This would of course, create enormous liability, if for instance, the models were hack into a bank. The major AI labs have now banded together and demanded that government regulate them and slow down their activities. To our knowledge this is a first for a fast-growing industry. We suspect that as part of this deal, they are seeking a liability shield from the government.
After absorbing feedback from investors and the market, both OpenAI and Anthropic chose to delay their IPOs to 2027. The primary reasons appear to be slowing revenue growth, competition from lower cost open-source models, the lack of long-term customer commitment, the apparent ease with which customers can move between models. Assorted risks exist, which in Anthropic’s case include “outcomes involving large-scale loss of life, severe and irreversible harm to global economic or social systems, or civilizational-scale disruption”. It is easy to see why under these circumstances investors might have had second thoughts about paying 30x trailing revenues.
As professional investors reviewed the AI labs’ company financials, they also delved into their capital investment plans. Both OpenAI and Anthropic intend to spend 400-500 billion building or leasing data centers in a rush to provide capacity for customer growth. A big chunk of this expenditure is the cost of purchasing Nvidia GPUs. Researchers have said that as many as half the GPUs Nvidia has sold in the past year may be idling in warehouses, waiting to be installed in data centers that have not been built. As rates rise, the cost of financing this latent capacity is increasing.
There is no guarantee that customers will materialize for the additional GPU capacity either. Both Anthropic and OpenAI have reported a slow down in revenue growth as customers figure out how useful this technology is and what limits to place on their employees’ use of it. Nvidia, for its part has been helping its customers find ever more baroque ways to finance the purchase of its GPUs. This week it was reported that Nvidia had approached insurers to underwrite loans to its customers with its chip as collateral. These arrangements have drawn comparisons to circular financing deals that have led to scandals in other parts of the technology hardware market.
The current highs in the US Equity market rely on a near perfect outcome for the AI complex. The past month has shown a series of cracks in the story. The equity market has shrugged off most of the news, but we are reminded of advice we received early in our investment careers to pay attention to rates because they underpin everything. When we look at the rates market, we see AI and technology companies that have to deliver much higher rates of growth than they did even three months ago. They are now competing for investment dollars that could be placed in a 10 year bond yielding 5 1/4%.
Our advice to investors is to maintain a defensive allocation. We believe rates have the ability to go higher. A short duration portfolio will protect principal and provide the ability to invest at higher nominal yields in the near future. Equity prices continue to be very elevated and past history is suggested that evaluations at these levels eventually suffer dramatic falls.
Regards,
Louis Berger
Subir Grewal, CFA, CFP