Capital Flows and Asset Markets

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Most hedge fund strategies are b******t. I see reports of how it was a banner year for hedge funds - but most of them made less that the S&P 500. No denying that hedge fund managers are incentivised to pretend that is a good result - and at the end of the day, everyone has to eat. But if you are really just going to be a long investor in disguise, why not just go the way of Warren Buffett or Bill Ackman and set up a permanent capital vehicle, or go into private equity. Maybe overly harsh - but generally true.

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I like risk. Not stupid risks - but calculated risks. Over the last couple of weeks, I have been moving the pieces to get a fund of some sort up and running. And I am getting down to signing pieces of papers, and spending some money end of this process. And, it is at this moment, as with all the big decisions in life, I ask myself - should I do this? I have a pretty good life as it - is this a good idea? I looked again at all the different angles and they all come back as yes.

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The last big successful short trade before I gave back money was shorting Chinese tech. It was a trade made solely on the observation that Chinese regulators had stated exactly what they wanted to do with tech companies - that is break down silos, only allow the use of data for the express purpose it was allowed, and to not favour portfolio companies in search results. All seems sensible, pro-consumer, pro-SME reforms to me - but obviously reduced the pricing power of big tech. At the time, everyone was all in on Alibaba, and other tech names - so was a great short.

In addition the war in Ukraine added another risk - that sanctions would turn you into a forced seller. Owners of the London listed Gazprom took a bath as sanctions were implemented. If China invaded Taiwan, would you become a forced seller?

War and regulators drove Chinese tech lower, but as can be seen from above, Chinese tech equities have had a nice move off lows - and famous investors like Dave Tepper have declared themselves all in on China. There are three catalysts I can see for this move.

The US tech sector - particularly the mega caps - are the only sector in the world you “HAVE” to have a view on. When I look at US tech, I see the following (please feel free to abuse me in the comments). Most of the tech space is exactly as you would imagine it to be - volatile and competitive. However big tech - Microsoft, Meta, Google, Apple and Amazon have managed to carve out profitable areas (I will come to Nvidia later). Microsoft has managed to become the “go to” corporate software name. A huge installed base, and large switching costs, allows it to generate significant cash flow. The shift to cloud has helped to reduce sales on original software, and expansion into other areas. While growth is good, it has had to invest to grow.

Google has a dominant position in search. This has allowed it to generate huge growth in cashflow with far less capex than Microsoft until recently.

Meta another advertising giant has been able to growth cashflow with little resort to Capex.

Apple barely bothers with Capex at all.

And then there is Amazon, who basically spends everything its makes to grow.

Each has a monopoly in various area - Google in search, Meta in social media, Apple in handsets, Microsoft in corporate software, and Amazon in online retail. By far the best business is search (social media is good too - but as Tiktok shows, can be either disrupted, or banned). Its such a good market, Google paid Apple USD 20bn a year just not to launch their own search engine. The arrival of AI - Open AI and now DeepSeek - has thrown open the search market. Rather than just asking Google - asking your selected AI program is the default. For Google this is an existential threat, and hence Google is investing USD 75bn. Microsoft, Meta and Amazon are not far behind leading to a USD265bn capex in total on AI. For me, the amount of spending is not just to defend existing market positions, but also to discourage start ups from entering the space entirely. If you set AI bar at USD 50bn to compete - then most of your competition disappears. One way to do that is to bid up the value of Nvidia GPUs - and Nvidia has surged due to this tactic.

In simple terms, Google is trying to defend its position in search, and everyone is else is trying to get in. With limited number of Nvidia chips available, this makes perfect sense. This is why DeepSeek is such a problem - as it seems to imply this tactic is broken. That a competitive AI model can be built much more cheaply, and without cutting edge chips. The question is whether the big tech companies decide that spending on AI makes sense or not. Assuming AI will be a advertising led model (DeepSeek makes that more likely), we can estimate profitability. We can see at how much Meta makes per subscriber. In the most recent quarter than was USD 14.25 on its 3.35bn subscribers or about USD 50 per sub a year.

With USD 265bn Capex from the big 4, and lets assume that they get USD 50 per sub - would mean 5.3bn users (i.e the whole internet connected world) just to get the capex back in sales - and that is ignoring running costs - which are substantial. ChatGPT obviously thinks it can charge directly - it wants USD 20 a month from average punters, and USD 200 a month from corporates. A month ago, I was prepared to pay this - no longer.

If AI is going to be free - and DeepSeek makes this more likely - then something has to give. My guess is that should a rally in commodity prices, or a sell off in bonds tighten financial conditions - AI budgets will be the first to get cut. For the moment, financial conditions remain benign.

The risk to this view is that DeepSeek is a fraud, or the AI market changes again - but given the Capex numbers we are talking, and the availability of DeepSeek as a free option in the AI space - a cut in AI capex seem inevitable to me.

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Someone asked me about investing personally the other day. I basically told them if you find a company you really like and use, and the shares look cheap, then buy it and hold it forever. As they had never bought shares before, I directed them to Warren Buffett letters to shareholders to get an education in long term investing.

I originally thought Warren Buffett’s bullishness on US stocks in 2008 was misplaced. For me, US treasuries following in the footsteps of JGBs signalled a long term deflationary bust in the US.

Low bond yields in Japan has meant that the Nikkei still below highs in US dollars seen in 1991. China has low bond yields, and a weak equity market. So what makes the US so special? What did Buffett see that I did not?

During the GFC, Berkshire Hathaway, with its heavy focus on the US consumer, had suffered with the rest of the market. At the time, I thought we were heading to a Great Depression outcome, but Warren was very bullish, and started buying aggressively. Berkshire is now a member of the USD 1 trillion market cap crowd. That is, contrary to my expectations, betting on the US being special WAS the right trade - and Buffett has cleaned up. In my defence, I thought he was talking his own book as his stock got punished during the GFC.

Buffett has called this market perfectly. So what should we make of his sale of Apple stock?

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When Deepseek first grabbed the public consciousness - my thoughts were that Nvidia was a short, and it was potentially negative for Microsoft and Google. The market has also seen this as being very good for Meta - as there AI strategy is close to the open source methods of DeepSeek. Market action has followed this analysis.

To be honest, I expected a more violently negative price action from Nvidia, but I suspect the market has been reassured by the capex plans out of Meta, Microsoft and Google, which remain huge. If they are spending that much money, its still has to go somewhere, so Nvidia will be fine - is the thinking I guess. If you want truly violent market action - you have to look elsewhere.

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I know that I and many other “macro” managers have commented that the world no longer trades the way it used to trade. I have spent the last few years trying to find ways to put it together - but to be honest, the models I have needed have always ended up being too complicated to use effectively. I have looked at the idea that there are hidden levels of GDP, as well as the rise of shale oil and gas and EVs have effectively broken the links between the US and the rest of the world. While there is some truth to these, they are not really simple models, and they have no benefit for investing, and no strong “non-consensus views”. But thinking about all these things again, I think I have a model that resolves these issues. It took the market reaction to DeepSeek to resolve things in my mind. Things seem relatively simple to me again. First lets look at the “macro problems”, secondly, how DeepSeek helps resolve them, and then thirdly, how that leads to an aggressive investment strategy that I like the look of.

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The core trade of GLD/TLT continues to do well, hitting a new high during the month.

When I look at the long term graph of this chart, we can see we are still at the foothills of this move.

When I look at previous moves in GLD/TLT in the late 1970s, and 2000s, you wanted to be long oil and gas names. That has not been the case this cycle - and I think, during this wild and crazy January, I have worked out why.

Nvidia has been THE play on the AI revolution. Not only does it have a monopoly on cutting edge GPUs, it has also had a lock on the software needed to develop AI products. This has propelled Nvidia to an over USD3 trillion valuation.

As I understood it, the success of Chat GPT suddenly opened an opportunity for Microsoft to access the search market that has been dominated by Google, as well as strengthen their existing business software franchise. Google needed to invest as well to maintain their position in search - and perhaps to attack Microsoft’s business software market. As the number of very high end chips needed for AI was constrained my manufacturing issues (ie only TSMC could make them) - the business model for Google, OpenAI and Microsoft was to bid up the value of these chips to make it too expensive for other players to follow (that is to follow the Amazon business model of huge start up capital losses to build a moat). In other words, big US tech wanted to corner the market for GPUs. The US government did its part by banning the sales of high end chips to China. Despite surging pricing, wafer shipments from TSMC have stagnated.

Nvidia only uses TSMC to make it cutting edge GPUs. So from a business perspective, Nvidia has surged with surging pricing (not surging volume) in my view. In my experience, this tends to be an opportunity to short (pricing is volatile - volume is forever). TSMC surged with chip pricing in 1999 to 2000 dot com bust - and then fell as supply came on line and pricing fell.

One big difference between 1999 and today is that the semiconductor industry is not advancing as quick as it used to. In 1999 and 2000, moving to a new node meant a vast decrease in transistor gate length (read as improved performance), but in recent years productivity improvements have slowed greatly. The Economist has a great chart showing how productivity has slowed.

For me, the semiconductor industry reminds me of the oil industry in the 2000s. Productivity in OECD oil production was declining rapidly, which delivered strong pricing and profits to the OPEC monopoly. But after some time, high prices spurred innovation, and we saw the eventual growth of US shale. This changed US oil production profile, which had been in decline since 1970, and led to lower prices.

Examples of new technology or new processes that destroy the profitability of incumbents and break monopolies is, in my mind, the best part of liberal democracy free market capitalism. The freedom of choice - and the freedom to compete. From this perspective, the emergence of Deepseek and its low cost AI model using older technology should make Nvidia a slam dunk short. The business model for OpenAI has been eviscerated, the large tech companies, that have already starting investing into next generation computing (quantum computing for example) and have been handed blueprint in how to reduce costs to make a AI system, should be ripping up their capex plans. Speculators that have been hoarding Nvidia GPUs should be dumping them into the market before pricing collapses. In a free market - I am sure this would be happening.

To be fair, there has been examples of US tech companies that have faced Chinese competition and continued to thrive. Apple still does well in China, despite low cost Chinese phones, and US cloud companies have also held up well against Chinese cloud companies. Cisco survived the onslaught from Huawei, and Meta seemingly survived the rise of TikTok in the US. So perhaps Nvidia could be the same? The problem I have is that Open AI has a business model built around charging users access - and DeepSeek model gets around that. Also, Nvidia is heavily reliant now on a just a few clients - and Microsoft in particular. Maybe I am wrong, but I don’t see how Microsoft does not look to replicate DeepSeek’s success. The idea of Microsoft deciding it makes sense to invest USD80bn, to then be competing against systems that cost a fraction of that price is not one I comprehend. The big risk to shorting Nvidia is that it gets seen as a national champion and trades higher as Tesla has done since the re-election of Donald Trump.

I can see how tariffs would be good for Tesla, but I don’t see how the average consumer can be banned from using Deepseek or its inevitable copycats. Of course, companies like TSMC, Nvidia and ASML who have all benefited from their monopoly positions would not like to cut prices. Nvidia is not a short if the US government works to maintain its competitive position. But Nvidia’s gain would be at the loss of competitiveness for the US. In EVs, cloud computing, handsets, drones and a range of other industries, the US is already losing competitiveness to China.

In a free market, Nvidia would be a short - but we are not in a free market anymore. That being said, I don’t think it will easy to ban Deepseek and other low cost LLMs. I cannot help but feel this genie is out of the bottle - and GPU pricing is going to fall - which would be bad for Nvidia. Or perhaps, realising that cutting edge is not so advanced as it should be (see Economist chart above) the US government bans any and all Nvidia exports to China to protect US developed AI. China is still a large market for Nvidia - so this would be bad for Nvidia. In almost all cases I can think off -free market, and non-free market Nvidia loses here.

All eyes should be on Microsoft. It was their investment into Open AI and their capex plans that have been instrumental in driving the Nvidia boom. If they decide to go the Deepseek route - or are forced to by their competitors to do so - then Nvidia should collapse, which in this case would be a good thing. If Nvidia does not collapse, then the US has truly lost its way, just as Japan started to do in 1991, and which this market bears much resemblance to.

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit www.russell-clark.com/subscribe

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I was once asked if I felt guilty about short selling. I think they felt that profiting from other people’s loss was morally wrong. To be fair, I could sympathise, but I think I provide a useful service. For big money allocators, it is very hard for them to not be fully invested in the S&P 500 or the Nasdaq - even when it seems overvalued. It is much better to fail together, than to go it alone. However, if you can provide short exposure at the right time, a short fund not only makes money, it greatly mitigates career risk for allocators. I see short selling as buying insurance - most of the time a stupid cost - but when things go wrong, the best thing you can possibly own!