Capital Flows and Asset Markets

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If AI is a “strategic” asset, and it is hard not to see it as such, then China is probably going to have to invest even more money into data centre builds. One knock on feature of this AI race is that the market has recognised that electricity generation which has been stagnant in the developed world is going to have to increase.

I was sceptical about this, as DeepSeek showed there were other ways to do things that were less energy hungry, but the mantra for both the hyperscalers and government is not about efficiency, but about domination. One big bottleneck in the US is generating the electricity needed.

The market has already rerated much of the sector to recognise this changed dynamic. Vertiv in the US is indicative. It now trades on 6 times EV/sales and 37 times forward P/E - reassuringly expensive.

Back when I was running an emerging market fund in 2006, one of my biggest positions was a Korean company called Doosan Infracore, now renamed to Doosan Enerbility. I liked it because it specialised in renovating existing nuclear power pants to extend their life. Back then I sold it at the peak in 2007 after making 500% in it. Owning any Doosan company is a always a trade - never an investment. On an EV/Sales basis it is already above 2007 peak.

But then I started to think about China.

As mentioned in previous posts, I have a small coffee problem. Two or three espressos a day is common for me. So once a year, normally in the summer, I take a break from coffee. The first week tends to be hell, with bad headaches and a need for long naps in the afternoon. But for me this is just my body realising how fatigued it is without stimulant effect of coffee. After a week, I adjust, and start to sleep really well. And after two weeks I feel my ability to concentrate increase. It is in this second week I had a revelation about Net International Investment Position (NIIP) and the US.

NIIP is the sum of the value of your assets invested overseas less foreigner investments into your country. A negative number mean foreigners own more of your assets than you own of theirs. I had found previously that at levels of around a negative USD 2 trillion NIIP, you should expect problems. China got to a negative USD 2 trillion private sector NIIP in 2015, just before currency devaluation fears took over. There are plenty of posts on this in my substack. Around 2017, the US also got to the USD 2 trillion level, so I started to expect dollar weakness, or stock market weakness but we have had nothing of the sort. US NIIP just keeps blowing out.

There is a very big problem with this analysis however. NIIP should sum to zero globally. A US asset, should be someone else’s liability and the converse as well. At the very least we should see a surge in a positive NIIP from Europe. We do not see this. I originally thought this could be accounted for by multinationals hiding money way in Ireland and other tax havens. I called this the “Missing Trillions”.

I am not going to lie, NIIP analysis made me a lot of money in getting bearish China when everyone else was bullish. And when something or someone is good to me, then I try and stay loyal to it. But when something is not working, I will puzzle over it for a long period of time. I want to learn from why it does not work anymore, and then make a decision.

During my recent period of coffee abstinence, and after a particular deep sleep, I had a revelation. Lets take a look at the US NIIP data. The US provides the longest data set for NIIP, and I have adjusted it in two ways. One is by GDP, to “normalise it” and the second is to split between private sector, and public sector (read foreign reserves) holdings. We are obviously more interested in private sector flows. So in the dot com boom, the private sector went negative for a while, and then dollar weakness and an emerging market boom took is positive. Since 2010, we have just seen private sector NIIP blow out.

Just looking at the blue line, I was reminded of a chart I have on Bloomberg - MSCI Value/MSCI Growth. As you would expect, a similar dip in 2000, followed by a huge move lower since 2010.

The implication here is that US NIIP is NOT driven by capital flows - but purely driven by valuation. Valuation is a slippery concept. But most transparent is dividend yield on the S&P 500. We can see that in the late 1980s it was around 3% before falling to 1.2% in the Dot Com boom. And again from 2017 to 2015 we have fallen from 2.5% to 1.2% again. There are plenty of other people who can provide long term graphs of the valuation of the S&P 500 that will match up with below.

So markets are “expensive” again, and US NIIP is very negative. Is the dot com bust and dollar weakness about to happen again? Well one big difference is that even with high valuations, US corporates do not really sell much equity. Shares outstanding on the S&P 500 has flatlined in recent years - in stark contrast to the dot com days.

As my last two posts on AI reflect, sure I can see problems with AI, but I don’t think I can see reasons why investment will get cut, unless there is a recession. What does this mean? I started using NIIP as it seemed like a short cut to calculating capital flow data that I used to get from BIS. Ireland NIIP and BIS data both showed problems in 2007. In the BIS data for Ireland below you can see the red line, representing flow from abroad into Ireland, had surged above the blue line, which was Irish investment abroad. As this pushed up Irish valuations, this was also reflected in NIIP data.

More than the gap between the two lines, I found that when financial flows surge, trouble is brewing. Japan in the 1980s saw a similar surge.

But when we look at US data, while NIIP data showed problem from 2016 onwards, BIS data only shows potential flows from 2020 onwards, but the scale is lower than what we saw in 2007.

One of the problems with BIS is that they keep changing the way they report the data, so I find that I keep having to make adjustments. When I saw that NIIP data worked just as well, I focused on that. And it worked well with emerging markets, Europe and Japan. But not the US. Sadly, with the US over 50% of equity market capitalisation, that is not an exception I can live with.

What does it all mean? I don’t think NIIP and BIS data work that well with the US. As a equity and credit based market, it operates without restraint, while Europe, Japan and Emerging Markets have bank based systems. All NIIP data tells us is that growth based investing is killing value based investing. But we knew that anyway. With the US, I will rely purely on industry analysis, but will use BIS and NIIP data for the rest of the world.

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After I published a note yesterday, I got a long email basically saying, “No it is a bubble”. As I read the note, I found that I agreed with most of the points. In simple terms it made the following points:

* OPEN AI and Anthropic are burning cash

* Corporate take up is lower than expected

* No one is willing to pay for it

* Many of the key customers seem to have a vendor financing relationship - meaning the whole thing is a house of cards.

The really wild thing is that I agree with all of these points! Which is why I thought when DeepSeek came along, the whole thing was going to fall apart, but it obviously has not.

So the question to ask is why has it not fallen apart? What is different about today than back in 2000? I see three big differences. First of all, back in 2000 the dot com investment binge was fed by IPOs and share sales. The shares outstanding of the S&P 500 grew rapidly in that era, as new companies with no cash flow desperately raised capital. This always raises the risk of dilution, and eventually scares off buyers of shares - which is one reason the dot com bubble topped out in my view. Share sales are not surging today.

The other big difference between today and 2000, is that most of the hyperscalers are investing out of cashflow. This changes the dynamics greatly. Back then, the Zuckerbergs, Bezos and Sons of the world had to convince sceptical finance types to back them. These days, they have the cash flow and the corporate control to do whatever they want. And as they often built businesses before there was an established business model, I think it very likely that they look at the current unprofitability of AI and look through that. The limit on investing is not the profitability or non-profitability of AI. The limit is the profitability of their own businesses. So if we have a recession, then AI is in trouble, but then so is everything else.

I have also learnt the hard way, is that you should never short a dream. I read many many bearish notes on Tesla, how it would never make money, and was a scam of sorts. And for years it had the highest short interest in the market (see middle chart). But when the dream came true - the short sellers were taken out back and shot.

What is even more incredible about Tesla is that now that its a reality, it earnings are poor, and the stock still holds up. Usually stocks follow earnings, but not with Tesla anymore. The bulls will tell you that Robotaxi and self driving cars will be the next leg of the bull market in Tesla. Could be. Buy my rule of never shorting dreams still holds true. And in the case of AI, or AGI - this a dream I do not want to short.

The final point I am going to make about AI, is that it has become a strategic industry in the competition between China and the USA. The space race was the defining competition between USSR and the USA. This led to huge uneconomic investments in sending astronauts to the moon. The Apollo program cost USD 300bn in today’s money. And when money became tight in 1970s, the program was cut. On balance, the US government see AI as a new space race in my view. That means questions of economics and returns are unlikely to be asked in the foreseeable future.

In short, I agree that the financials are indeed a bubble. But I don’t see how or why any of the major players cut their investments as yet. All of them have been involved with loss making visionary businesses - and the strategic value of AI will make it unlikely that they back away from their investments, even if they are loss making for the foreseeable future.

I have only had one period of success in shorting technology stocks - which is when the Chinese government told me to short their technology stocks in 2021.

Back in 2000, the US government sued Microsoft over antitrust, which was a good reason to short. Bit like the experience of China in 2021. But outside of these special cases, it never works to short expensive tech. One lesson I have always had to teach new hires about short selling, which they really struggle with, is that you will make far more money shorting stocks with low PEs than stocks with high PEs. The problem with shorting AI is that these are high PE’s stocks - and unfortunately, that is a bit like Stella Artois - reassuringly expensive.

I understand the bearish arguments - but I don’t see who is the investor who is going to suddenly pull out. Or governments suddenly not being supportive. What is more likely is that there is a technological breakthrough that upends the AI race - I thought DeepSeek was it - but it looks like I was wrong. Time to be patient I think.

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Old men and women are always obsessed with the past. When I first started working in finance in 2000, the oldies in my office would go on about the 1970s. There was a lady working in the cash management department who had started with the company in 1960s as a secretary, and kept telling me about 1974 crash. She said it was like a light switch was turned off. The managing partners came in and basically looked at the office and said everyone sitting to the left of the central aisle is fired and that was it. At the time, I thought, well that was 25 years ago when people thought flares were a good idea, nothing to do with me. Of course, within 6 months, the dot com bubble burst, and once again half the office was fired.

So here we are 25 years later, and an oldie is talking about a bubble bursting 25 years ago, and if you are in your 20s, you are probably thinking why is he talking about 2000, you guys were going to Blockbuster and thought Nokias were cool. I would calm yourself now, as this particular oldie is not going to talk about AI being a bubble - but I am going to look into other oldies claims that we could be a AI bubble. The FT Alphaville is conjuring up comparisons to the telecommunications bust that was part of the dot com bust.

Most of the note is based of Morgan Stanley research - a tech bullish broker. First of all they forecast USD 2.9 trillion of capex from 2025 to 2028 - which is a very big number in a very short period of time.

A big increase in capex IS a bearish signal. One of my best short were iron ore miners, who massively increased capex in from 2007 to 2011. Vale in Brazil was a poster child for this excess. The peak in capex then led to a 90% fall in the share price.

As both the FT and MS acknowledge, the hyperscalers have the cashflow to fund their investments, so they spend their times looking at the other USD1.4 trillion of investment that is coming from private markets. In my view, if the hyperscalers are spending, then the other markets will deliver the cash as well, so there is no need to think too much about credit markets.

For me, excess capex is a necessary, but not sufficient condition for thinking about a “bubble” (lets take bubble to mean excess investment that leads to collapsing prices and write-downs). Back in the dot com bubble era, there were two separate type of company that got into trouble at the same time. The first were a whole bunch of internet stocks that listed, but had no real path to profitability. If you were to talk about a bubble, this was it. Companies like Web Van or Boo.Com. Once the market turned on them, there was no way back. The modern day equivalent of these would be some SPAC companies and “shitcoins”. Generally speaking, these highly speculative companies got destroyed in the 2022 sell off. And we saw a corresponding sell off in Nvidia at that time.

You might want to argue that OpenAI, or DeepSeek are similar crappy companies, but as I use both their products I find that a stretch. There is obvious real demand for what they do. The other type of company that got in trouble in the dot com bust was telecommunications companies that massive overpaid for 4G licences. Vodafone, which both over paid for Mannesmann and licences is a posterchild for this excess.

It was falling free cash to equity that really did Vodafone in back in 2000.

So could the market punished the hyperscalers like it punished Vodafone? Generally speaking of the “hyperscalers” only Alphabet is potentially running a risk here. But they really have no option but to spend big. Chat GPT is threatening their cash cow search business, and need to spend big.

What I find most interesting is that the market is recognising the threat that AI causes to business built around intellectual property in the software space are coming under threat. Shutterstock with its store of images has seen its share price tank. Adobe with its Photoshop products also suffering, as IT outsourcers with their IT integration business (Accenture, Infosys etc). Rather than being a bubble, the market seems to be implying that legacy IT businesses are heading for decline.

From a market perspective, outside of a recession, the hyperscalers, and the AI spend seem fine. There is one potential cause of a recession from AI I can see. It is putting extreme pressure on the grid, which could cause power prices to spike. Again from MS via the FT, they are forecasting a shortfall of 10% of current US capacity.

When I look at US CPI Electricity is has the type of movement that I would normally associate with a recession. Businesses and consumers hate rising electricity costs.

AI is not a bubble, but the demands it is placing on the US economy seem to be mounting. In a different political climate where some Schumpeterian style creative destruction would be seen as a wise choice of action. AI seems real to me, but inflation also seems real to me too. This seems like one of those times when a recession would be good for the US. But as Bureau of Labor Statistics Commissioner Erika McEntarfer discovered anything but awesome is not allowed. Given that rising electricity prices are good for gold, and bad for treasuries, is GLD/TLT working less because the US is a bad credit, and more because politically speaking recessions are no longer allowed?

Strange, I don’t see an AI bubble, but I think a recession would probably be good for the AI hyperscalers long term. They would be able to build out without pushing up costs for everyone else. The rising electricity price also makes Trump’s vision of bringing manufacturing back to the US harder. The current administration will probably focus more heavily on increasing energy supply, as they have done with OPEC and the EPA. But that will take time, and tariffs are going into effect now. My guess is that we are heading to an AI boom, and stagflation for the rest of the USA. Which is what Jerome Powell and Erika McEntarfer were trying to tell Trump. There was a good reason economic decisions were moved away from politicians - looks like we need to learn those reasons all over again.

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July was a volatile month. The core trade of GLD/TLT broke higher during July, to then pull back in the last week to finish near lows.

The other core trade of gold versus S&P 500 had a late month breakdown to approach the 200MDA.

The Dollar Index also saw a late month rally.

With so many core themes reversing in the final week of July, we ended up having a down month. However I did take of the advantage of the strength of the dollar to add to dollar weakness trades. As much as the late month trend reversals disturb me, I can not forget the “correlation break” we saw earlier this year, when treasuries and dollar sold off as equities weakened. The Economist provides a useful graph.

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Hating private equity is easy to do. It often feels like they use debt to drain the life out of a company. The most recent example would be UK beer company, Brewdog. While the company still operates, the value of equity given to employees and private investors has been wiped out by the value that has accrued to the private equity investors. I have friends in private equity and they always claim that they are providing capital and are value creating. Perhaps this true and in this case perhaps the founders of Brewdog were just foolish to agree the deal. But one thing that has always been clear about private equity is that they are hostage to corporate debt markets and the economic cycle. During the GFC, Blackstone lost nearly 90% of its value.

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You are probably wondering why I think its exciting times? The potential bear market set up of the rise of Deepseek and Trump’s tariffs have come and gone, and the S&P 500 is back at new all time highs. Even the announcement of 15% tariffs on Japan and Europe are seen as bullish as the expectation was for more (to balance the budget they would need to be higher).

I won’t lie, a bear market in the US would suit me from a fund raising point of view, but I always considered the possibility of the bull market continuing. I just wanted to construct a portfolio that would allow me to short, but still make me money. Like a put option that instead of paying a premium, you get paid a premium. So far, the portfolio has performed exactly like that. That is exciting. What is most exciting for me is that bearish signals are starting to appear everywhere.

AI is incredible. I have always wanted to make a short film about a story I heard about a fund manger in the early 1990s that went to Korea. Its a funny story, and I thought it would make a good short film. I always wondered how I could do it and low and behold with Google’s VEO I was able to make it. It is on my Tiktok, or you can see it here on substack.

In 2019 when I looked at big tech, and in particular Meta and Google, I tried to get an idea of how large they could get. Basically I looked at total advertising spend (ex-China) back in 2019 which was about USD 600bn. I assumed that digital share of advertising gets to 75% or so, and that Google and Meta take 75% of that. Which gets a total revenue number which gives around USD 340bn. Google was forecast to have revenue around USD 200bn in 2020, and Meta around USD80bn. At this time TikTok was beginning to take off, and Amazon and Microsoft where expanding into advertising so there seemed some downside risk to the market share numbers to me. I also thought the US cycle looked extended, with NIIP data pointing to extremes. Advertising revenue is very cyclical, so I thought big tech looked like dead money. For awhile this analysis seemed on the money for Meta - but after a volatile 2020 to 2023 it has surged to new highs.

This was sort of true for Google as well, but stock is now at new highs. Where did I go wrong? Well first of all, US fiscal spend has moved US GDP much higher in a rapid amount of time. Advertising tends to be fairly stable as a share of GDP, so strong GDP means strong topline for these companies.

The other thing is that Big Tech has been generally able to control costs very well. Meta saw margins dip briefly, before pushing them back to highs.

The conclusion is that these are incredibly well run business that can grow with GDP, and cut costs at will. There are potentially loads of political problems, and regulatory problems like those that affected Chinese tech, but US tech views seems to be well represented at the White House. Probably the best thing about these businesses is that can grow the top line with little additional capex. And here is the problem with AI. AI seems to be offering relatively little new growth for a lot of capex. The big AI spenders are looking to spend USD 1 trillion in the next few years. For comparison, Amazon spent USD 21bn building its cloud business from 2006 -15.

There is nothing wrong with Capex, but its good when it generates additional revenue. And here is the problem. As the video above shows, it should allow big tech to capture more of the advertising creative generation. But this only adds USD 114 bn or 13% to addressable market.

My reading of the AI boom is that ChatGPT is changing the way people search for information. I know that I am as likely to search for things on ChatGPT and Tiktok as I am to search on Google. For me, the investments into AI for big tech is as much about defending market share than growing revenue. For me, this changes the nature of big tech. The risk is that they choose to cut margins for awhile to keep competition out. I thought something might happen when TikTok started to take market share - but whether Meta and Google just out competed, or the political pressure brought them into line I can’t tell.

So my problem with big tech are three fold. One is that a recession is overdue, which should slow top line growth. Secondly, the industry is becoming more competitive with the entrance of new players in the AI space. And thirdly, Capex is exploding to capture only incremental growth. The risk is that GDP growth surges again. But when I look at long term government bond yields, I think that risk is diminishing.

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The blessing and curse of getting older is that you know that everything can change. The blessing and curse of being young is thinking nothing will ever change. I found myself explaining a recession to a 27 year old the other day. He looked at me like a mad man - but maybe I am the crazy one for worrying about them. We have not seen a prolonged period of unemployment in the US for over 10 years.

I saw Japan go through a long struggle with rising unemployment in the 1990s. But again since 2010s, sustained unemployment is a thing of the past.

Perhaps my homeland of Australia is the best example of an end to unemployment. I matured in the 1990s, and thought 2000 was a peak in employment markets to never been seen again. Since 2000, unemployment has been generally lower than the 2000 peak. To quote Harold MacMillan “you have never had it so good”.

This period of low unemployment has coincided with stocks being priced ever more richly. The S&P 500 has gone from 1.6 times sales to 3.2 times sales today.

Only one country I know of has seen unemployment worsen in recent years - and that is China. China would be the only country that has seen defaults rise, but also see government bond yields decline and deflation. It stock market trades much more cheaply as well. You should be able to see where I am going with this.

In my pro-labour view, I saw the ever rising sales for corporates being compromised by rising costs, and rising yields. For example in Japan, stagflation has ended. Food prices have stagnated for decades are now rising rapidly. Low unemployment seems to lead to higher stocks, but also higher inflation. This is standard economic theory.

When we compare to the US, we can see the deflationary 1930s clearly, and then the inflationary 1970s onwards. Recent years have seen a sharp acceleration again.

When do politicians choose inflationary over deflationary policies? Obviously after the oil shock of the 1970s, there was a move to tighter monetary policy and then a move to more “pro-market” policies in 1980s. The inclusion of the former Communist nations into the world trading block, was also a deflationary policy. Obviously, the world has moved away from these deflationary policies, with predictable effects on the long end of the bond market.

One of the obvious things about “pro-labour” inflationary policies, is that voters want the employment without the inflation. Japan is only the latest example of the ruling LDP suffering politically.

All of this is inflationary - and we are seeing yields rise globally. At some points voters tire of inflation, and business tire of higher interest rates costs, and as a society we accept higher unemployment for lower inflation. When is that point? In the US, government yields are rising, but corporate bond yields have stayed contained, so far. That is treasuries are weak, but corporate bonds yields have been contained.

Higher government bonds yields forcing up corporate bond yields would be seismic change in American finance. For 40 years, we have had the opposite, with falling government yields acting as a tail wind. If government policy begins to act against business borrowing costs, I would start to expect some political change. I think this is why gold is attempting to break higher against the S&P 500 - perhaps sensing we are near an inflection point?

At some point voters will tire of inflation, and business will tire of rising yields, and then the politics will turn to deflationary policies again. But right now, higher yields look close to impacting markets again. To borrow from Soros, I think you need to see the price action in bonds affecting markets first before we see any political change.

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