US Dollar & the AI capex cycle

0:00Patrick Coffey:Welcome back to the Barclays Brief Podcast. Last week on the show, we had a really interesting conversation between Andrew and Roddy talking about massive numbers around AI CapEx spend from the hyperscalers, how they were going to finance that from the credit perspective and the impact it was having on the equity markets. We want to carry on that conversation today, thinking about AI CapEx, but we want to think about it from a different lens and a really interesting one. So we're going to be talking much more about macro and FX today. And there's no one better at Barclays in our research business to talk about that than Themos, who's our global head of FX and EM macro strategy.

0:37Patrick Coffey:Themos, thanks so much for joining me here today. Thanks for having me. And indeed, it has been interesting in how the FX market has been slow or even numb in responding to what has been, as you say, earth shattering numbers. Earth shattering numbers, numb. There are some big words that we can use around this trend. Now, what you wrote in your note that's just been published, the note is called an AI revolution for the dollar, is you said that the FX market is operating in a parallel universe to the equity market. What did you mean by that? Sure. I mean, you have major and highly successful private sector US companies pledging what is a number that could be more than$3 trillion over the next five years.

1:23And the FX market is doing nothing. A few months back only, when Germany announced about a sixth of that spend in terms of infrastructure, spending and investment, spent or spread over twice the time, the FX market was moving a few percentage points. So there's a pretty big disparity in how the market is addressing the two different market reactions to it.

1:47Patrick Coffey:You're talking about huge numbers here again, and yet the FX market seems kind of numb to it. We've obviously done lots of work on prior investment booms. In the note, you talk about the 50s and 60s when we had the durable goods boom. We have talked about the investment in the internet in the 90s. So what are the key lessons from history and what normally happens to the dollar when you have these massive investment booms? So in this note, when we took a look back into previous investment cycles, it was very interesting that some of the lessons held true across a very wide cross-section of cases, whether you looked at technologically driven booms or just simple investment booms for other reasons, whether you looked at the US, other G10 economies, or emerging markets, some things held true across the board.

2:41You had a higher GDP growth rate than average as a result of that. You had a very large, unusually large investment contribution to GDP. But contrary to what you would have expected from standard identities in economics, the external balances and even the current account improved, which is a statement of the fact that the economy just operated a higher equilibrium. And that just drove the currency stronger by a few percentage points per year for an average and across these economies.

3:14Patrick Coffey:Okay, so how does that history that you've done all this work on resonate with what you're seeing and observing with the US tech sector and the dollar in the market at the moment? It's not too dissimilar. The cloud revolution, if I can use the same word, has been a crucial element of dollar strength for the last decade, let's just say. You've had a pretty big increase in profit share of income for the US. You've had a pretty big accumulation of profits in a few companies that are dominant in the sector and they have absorbed revenue from outside the US. And the combination of a bigger revenue from outside the US and capital invested in those profitable companies has been a key driver for dollar strength.

3:56Now, as we can draw a parallel from that, you can definitely think a few things. First of all, when you look at the actual spending, you can get a sense that the US has been spending more and more in services that are vulnerable to AI and could be reshored. And some economies such as the UK, Sweden, but also in emerging markets, India or the Philippines could stand to lose from that shift. But also geopolitically, given that AI is a very big part of defense, national security, information, data sovereignty, you could be creating strategic dependencies, even for big countries like Europe or Japan, that have less capacity or less instinct to invest as fast in what is becoming a bifurcated world where only the US and China are engaging in this very fast, very aggressive arms race in AI.

4:45And that obviously benefits the US relative to a number of other economies, other currencies.

4:53Patrick Coffey:Right. So in the interest of keeping it simple, you're basically saying it's a two horse race between the US and China. Is that fair? That's fair. OK. Right. But that makes sense. But what doesn't make sense is this lack of movement in the dollar right now, given these massive investments across AI in terms of capex. So what's going on here? Because if the dollar isn't moving, there must be some risks to that fairly simple narrative. And if so, what are those risks? The first one is a fairly straightforward one. We're going through a period of indigestion. The amount of issuance is enormous. And there are some questions on whether the market will allow, in terms of spread or other kind of opportunities, will allow that kind of enormous financing.

5:35So we need to go through that period of indigestion, make sure that this cap expense will be financed and will take place. To some degree, the market could be going through some kind of delayed response because of backward narratives that have been troublesome so far, like Fed independence, you know, shutdown, government shutdown risk, data quality, etc. Again, that's something that we could transition out of at some point. What I think is also contributing here is that for the best part of the past few months, we have been discussing de-dollarization. And that theme still lingers in the heads of a number of investors as a big risk to the greenback.

6:16Patrick Coffey:It's interesting, isn't it? Because if we rewind a year, the market was expecting a dollar rally as President Trump took office. Then the narrative changed to widespread concern in this narrative around de-dollarization as the tariffs were announced. So where are we now in that debate? I would say that it's a smaller or more marginal debate than people imagined it to be in the beginning of the year. It is basically, we haven't seen the capital outflow that will be associated with investors abandoning their dollar assets. In fact, we have seen rapid inflow in the last few quarters. We also have not seen the reserves from officials, the official sector being wound down very aggressively from the dollar.

6:56And the infamous hedge ratios, they have stopped increasing. So people haven't been hedging their dollar risk in a more aggressive way at this point. However, what we have seen is that there is some diversification flow that has benefited smaller assets. It's not that big to have an impact on something as big as the dollar, but it's definitely meaningful for a place like gold, which you touched upon in your great podcast with RJ, or even some emerging markets that are beneficiaries of that diversification trend.

7:26Patrick Coffey:Let's just dig into that for a moment. You talk about gold and RJ has talked and argued that the surge in the gold price was about a distrust in fair regimes. Reading at the moment about China buying up more gold than perhaps others thought. So what's going on there? And is that purely related to de-dollarization in your view? I would say that the gold price has definitely benefited from central bank purchases. We have monitored that in our research, together with a delayed response of gold to accumulated inflation. I would say that there are some dollar pairs that are benefiting from that outright.

8:02And what I find the most interesting, because some of them could be benefiting for tactical reasons, what I find more interesting is that in some of those currency pairs in emerging markets, you could see some strength against the dollar and definitely against other currencies, virtue of the fact that they themselves will be beneficiaries of the big AI trend. Namely, the AI capex cycle will need a lot of metals, rare earth metals, copper, aluminium. And those can be found in a concentrated way in a number of emerging economies and some smaller G10 economies, places like Chile, Peru, Australia, Indonesia.

8:35They all stand to benefit from that. Andrei Kiguel, my colleague, has written an excellent part of our outlook around what could be a potential capex cycle related to metals, related to the AI investment cycle in these economies. And the early innings of those cycles tend to be very beneficial for those currencies.

8:53Patrick Coffey:Okay, so I think we'd need a whole new podcast to talk about that investment in metals. We've got a huge amount of interest in the gold price, lots of discussion about distrust of fair regimes. We've got a mini or maybe massive rise in super cycling metals like copper. We've got huge amounts of dollar investment in AI capex. And still FX markets were a little bit stale. So what happens next? What's changing in the narrative? And what do you think the kind of key question or debate will be for you next year? Maybe it's the Greek in me speaking, not being too enthusiastic about what's going on in the US, what's going on in Europe in response to that.

9:34But I do think that the disparities are going to be widening up. And I do think that the dollar will be strengthening, not everywhere, not against those metals, investment destinations, etc. perhaps not against China where all this spend is there, but definitely relative to major currencies such as the euro. And this is part of the story that underlies an upgrade to our dollar views, which we have done in our recent outlook, just published.

10:00Patrick Coffey:Perfect way to finish, Semos. Thanks so much for joining me today. Thanks for having me. Okay, so as I walk out of the room today, I think the key takeaway for me is that if the US tech company's AI CapEx plans do materialize, the impact could be economically and geopolitically completely transformational for the dollar but there are short-term headwinds that the market will have to navigate and we're going to be keeping a very close eye on that here at Barclays. Clients can read more from Themos and all of our analysts on Barclays Live and there's a link in the show notes and don't forget to subscribe to the podcast wherever you're listening.