Fed Minutes Show Many Officials Said Rate Hikes May Be Needed

27:00So the question now for treasuries, not just the U.S. treasury, but treasuries and treasury departments, the equivalents thereof in the U.K., in Germany, in Japan, and everywhere else, is to try their best to try to manage that movement higher in yields so that it's not overly destructive. So this is just the start. You're going to see more of this. What about one of the things that really we came back over the weekend on Monday and just the impact of the AI spend and build and your hyperscalers, your big tech companies, you know, continuing to, and they're still going in terms of tapping the debt markets and how that's crowding out treasuries.

27:41I think, I can't remember who we spoke to said, We're not necessarily seeing a lot of selling, certainly here in the U.S. by institutional investors, but they're not buying. Yeah, Carol, that's a fantastic question, and I'm glad you brought that up. And you mentioned the magic word, which is crowding out, right? We have to think about that concept. So what we know about the hyperscalers right now is that they are tapping the debt markets in massive size, right? They are issuing a lot of debt. So it's somewhere, if you just look over the last 12 months, they have doubled their run rate, right? There's projections that the debt is going to be like$1.7 trillion overall in the next 12.

28:18I mean, these are insane amounts of debt being raised. Does that put pressure on long-term bond yields moving higher? You betcha it does. And that's what's going on. So if you're the Treasury, right? And this is the way the Treasury thinks about this. It's a zero-sum game. If the duration of Treasury bonds are longer, they're going to compete for capital raises with the private sector, with the more productive private sector, which is AI, CapEx, data centers, and all that other stuff. So that crowding out effect is what exactly what you brought up, which is exactly what the Treasury and I think the government, the Trump administration is trying to figure out and say, look, the government, which tends to issue a lot of debt, is less productive than the private sector.

29:04So why should we compete with the, you know, AI hyperscale arrays? Why don't we pull back a little bit? Right. Let these companies go out there and issue debt and raise the GDP and employ people and do all kinds of things on the private sector side. So more of a supply side push, then have the government do this, right, and compete for those, you know, compete for those long term bond yields. So I think this is a really important nuanced point that I haven't really heard spoken about enough in terms of how this is a positive, I think, for the markets. Ah, a positive for the markets. I find that really fascinating.

29:40And even as we continue to see issuance, we've got 30 seconds, we're going to come back. That doesn't worry you, that it gets too crowded, certainly for treasuries. The thing, you know, it doesn't worry me in terms of the debt markets. What worries me is if there's a sharp slowdown and all that debt becomes somewhat burdensome going forward, but we're not there yet. We're not there yet. We were talking about AI, and it does seem like everyone, we talk with our Mandeep Singh of Bloomberg Intelligence, the investments, looking at the balance sheets, looking at the fundamentals, the spend is still there, the backlog is still there, Jim.

30:15How do you guys, what do you think is the smart conversation to have around AI right now? So the way that we parse this out is we try to find areas in the markets where technology, technological innovation, potentially use of AI is actually unlocking a lot of free cash flow and a lot of operating leverage. And that's what we screen for. And we end up creating baskets of equities to express these views. So, look, today you went through a run rate of some health care sector related companies that are doing super well. Right. So it's no surprise that in the earnings reports for many of these companies this past quarter, that they're using a lot of AI to unlock a lot of operating leverage in their companies.

31:01So we think that there is so much of that, whether it's from the small caps and the mid-cap sectors, where many of these segments of the markets can get a significant advantage just from adding higher levels of productivity very cheaply just by using AI. So, you know, if it's a demand question, because demand right now is outstripping supply and this, that's what keeps the positive momentum going. I don't see this demand falling away anytime soon. We talk a lot. So don't fight the trade. Don't fight it. Okay. No, I mean, that's kind of what I wanted to ask because I feel like all earnings season, the big question was like, when are we going to see the revenue?

31:40Like there's just been so much spending. I mean, I'm really focused on credit, but even on the equity side, like, Like, where are we in that cycle? Are you demanding as an investor that we see that profit? Yeah, so we are at the infancy, right? So if we record this conversation, come back and look at it a year from now, two years from now, three years from now, we'll be going like, oh my gosh, what did we miss, right? So right now, I think there's what we call a productivity gap. So if you ask individual people working at a company, do you use AI? Absolutely. Are you more productive? Yes, I'm 25 % more productive.

32:16Just put a number on it. The CEO says, but I'm not 25 % more profitable. So how do we convert this new technology? And by new, I mean like this year, like several months ago, into higher margins. And companies, corporations are figuring this out, but they have a lot of legacy systems, right? So you just can't like unplug one thing and plug something else in and expect it to work. But I can tell you that every day, every week, every month, we're incorporating more and more of this technology. And it is becoming a large source of higher productivity for us. So where does it end? How far does it go?

32:55When do we start to see the return on investment? It's going to be lumpy. And I think some of the bigger spenders that are out there that are really investing, their whole goal is just fear of missing out. They don't want to miss the wave. But the beneficiaries of that is the broader economy. So what you're seeing is this broadening in markets that's taking place, which I think is super healthy. You know, one of the things on this, you know, and I was thinking about Alphabet did an issuance, the Australian, its first Australian bond offering. And it resulted in the company's highest ever yield on a note.

33:30I think they paid just under 7%. It just continues. But we had a great story on the Bloomberg buyer, Sebastian Boyd. And he said the rising cost of capital to fund the AI race is making U.S. equity valuations increasingly untenable. The biggest risk, though, isn't higher borrowing costs. The industry's relatively low debt means companies are more vulnerable to equity funding costs that are set to rise along with financing needs. How does that factor in? It's debt capital markets, right? So this is the issue. Is your equity cost of capital more expensive than your debt cost of capital? If it is, then you issue bonds, right?

34:03So if many of these companies have strong balance sheets, and they can issue a lot more without risking a credit downgrade, this is your space, this is what we look at with these strong balance sheets, which means that their debt cost of capital raise is a lot more cost effective for them. So guess what? That's exactly what they're doing. This is what you're supposed to be doing. At some point, it balances out. We're just, again, we just started this. This debt surge has just started in the last several months. And I don't think we're at the tipping point. These balance sheets are big and there's lots of cash on them.

34:40But people talk about exposure limits, particularly when it's not just Alphabet coming and issuing corporate bonds. It's like them doing that and then Alphabet also maybe backstopping some other private credit deal with AI. There's a lot of exposure in a portfolio to a single name. when do you hit those limits? I mean, is that something that does exist at Morgan Stanley, where eventually you do have to say, hey, we already have this much exposure to this company. They want to issue more. We can't participate. Exactly. So how you count the debt really matters. And I think, Emily, you're bringing up a really good point in terms of there's a lot of other debt outside of just the traditional public markets.

35:23There's private market debt. There's a lot of things that are out there that are, you know, weighing on this. And, you know, this is what we do as investment managers. We look at this and we try to understand, is the, you know, is the level of debt relative to the return, is the risk right? Do we want, am I getting paid enough to take this risk? So, you know, it's a market like anything else, but, you know, what's the point, like, what's the level? That's really hard to say. I'd say that the biggest risk for in any cycle, it's not just particular, it's not specific to this particular thing with AI and hyperscalers or anything, is a sudden sharp stop in economic activity.

36:03That's usually what brings these things down. It could be an oil event. It could be a geopolitical event. It could be, you know. But we've had that oil event. Yes. We've had those, you know, but, you know, it could be, it could be a currency, you know, who knows what it is. I mean, is there's always something lurking that's out there that can create this sudden stop and can make people revalue this debt. One of the things that always seems to come up, and we've had this with various CEOs and folks who talk with the C-suite pretty regularly, is that they need certainty from the White House and the continued involvement.

36:40Even today, the president, of course, meeting with folks in the crypto industry, but he said, next week, we're going to meet with the AI people. The AI industry's top people will attend the meeting. We want to regulate, but we want to have regulation where they can continue to lead. It's early. We'll see what happens. But we've seen a global pushback when it comes to social media and the platforms. We've seen it in France. We've seen it in Europe. We've got Meta on trial. We'll see how this one plays out. And people think that there's going to be more to come. And even the possibility that these types of companies, the way they do business, is what's being now at risk.

37:17Yeah. So let's combine the last question with this right here, because this is critically important. So let's think about data centers. Let's think about energy. Let's think about all of these various things, all of the policy factors. And we know that there's some pushback against data centers and everything else. If we just think mathematically through a textbook and say linearly, okay, look, this is a really good technology. We should use it. We should invest in it. And it's great. The real world answer is like, but my utility costs are going higher. Voters are getting mad. Politicians are reacting to that.

37:50They're responding. So when we start to think about the valuation of debt, whether it's in the private markets or it's in the public markets, we always have to put in a factor for what's the political risk. What if somebody else gets elected or what if there's a new policy change? How do we factor that in? And it's almost impossible to do that because you can't anticipate policy changes very easily. But you could put something in and say, well, how much of a cushion do I have if that were to happen? Let me look at the longer-term contracts. How do the cash flows get negotiated over time? If it's utilities, it could be utility raises.

38:28Is that scheduled over a period of time? And those are things that we have to incorporate. So to the extent that there's volatility around policy on this, I think that's going to stay with us. but we have to build it into the price and it just means that it's a higher risk premium for us to factor in. There's no real really other way to answer that because there's no specific numbers around it. Right. But we have to build that in. You have to say this could happen and things could be changing. Aside from policy pushback, what are the other kind of key risks with just the AI trade? Is it that there's too many names and like, Or is it like the technology might not prove to be as reliable as we expect right now?

39:14I have to say, the enthusiasm and the coziness, and we talk about the circular finance, it just makes me a little nervous, right? Yeah. So I'd say the concentration risk is something that we hear quite a bit, right? There's a lot of money funneling into a very, very narrow sector, and that usually doesn't end well, right, historically. But part of this, too, is that there are going to be winners and losers in this, right? So there are companies that are making a massive spend, and they might not get the return on investment, the ROI, that they were hoping to get. Now, the question is, is this a small company that's very narrowly focused, and if they lose this, they lose everything?

39:54Or is this like a very large, multi-franchise company that says, well, if I lose that, I can write that off. It's not going to be a great year for my stocks, but I can recover from it. Right. So the answer to a lot of this is how these companies are diversifying their risk. But as time goes on, what history would suggest is that people get more and more and more concentrated. And then there's a sudden break. There's a sudden stop. And something changes. And, yeah, there's going to be fallout from this. There's no question, right? Timing that is going to be really hard. Is that 10 % from now? Is that 20 % from now?

40:29Is that tomorrow? We don't know what that is. So, you know, as investors, we just have to make sure that we understand the risk and that we're being compensated for the risk as best we can. And that's where the investment selection, you know, the quantitative analysis, the optimization of portfolios, the correlation risk, all these things matter quite a bit in terms of how you construct your portfolio. Yeah, and time will tell. I mean, I think it's hard not to feel sometimes it's a little bit of a FOMO feel, right, of just chasing this as the build continues. I do feel like earnings are getting a little bit more discerning when it comes to that.

41:07And certainly when we have some really big-name IPOs, whether it's Anthropic or OpenAI, we are increasingly getting a window into their financials. So we're not going to let you go yet. And I want to kind of look forward. We still have a few months left in the year. I feel like there's going to potentially be a lot coming at us. whether it's politics, whether it's more out of the White House, others earning cycles. And I am really curious about kind of what the Fed's going to do. So we're going to continue. Jim Caron's going to stay with us, chief investment officer of Portfolio Solutions at Morgan Stanley Investment Management.

41:40Stay with us. More from Bloomberg Businessweek Daily coming up after this.

41:47Quick one before you jump back in. You're listening for ways to help teams move faster, make sharper decisions, and turn scattered context into work they can use. ChatGPT for Business can help. ChatGPT for Business gives teams a shared workspace with admin controls, permissions, and access to work and codecs in ChatGPT. This means your business can move from question to answer and code to rollout quicker. Join over 10 million business and enterprise users worldwide already using ChatGPT for Work. Download the ChatGPT desktop app or contact sales to learn more. Hi, I'm Tom Keen, inviting you to join me for the Bloomberg Surveillance Podcast.

42:27It's about making you smarter every business day. I'm Paul Sweeney. We bring you complete coverage of stocks, bonds, commodities, even crypto. All the information you need to excel in the markets. And I'm Alexis Christophorus. Listen to us for essential conversations with the smartest names in economics, finance, investment, and international relations. That's the Bloomberg Surveillance Podcast. Subscribe today on Apple, Spotify, or anywhere you listen. You're listening to the Bloomberg Business Week Daily Podcast. Catch us live weekday afternoons from 2 to 5 Eastern. Listen on Apple CarPlay and Android Auto with the Bloomberg Business App.

43:04Or watch us live on YouTube. I want to get back to Jim Caron, Chief Investment Officer of Portfolio Solutions at Morgan Stanley Investment Management. We were just saying that we like when we can just kind of slow down and talk about some bigger stories. Jim, I am curious, like, what you find interesting in this market cycle. Like, I'll take a look at the most read stories in the Bloomberg right now. And you have SpaceX attempting to acquire an AI coding startup. And there's a story about that. There's the Besson story about the dead buybacks, FedMinutes, Moderna. You have stuff about what's going on in the Middle East.

43:40I do wonder when you look at this, there's a lot that we always say is coming at everybody. What do you find interesting, though, right now? The most interesting thing going on right now is a change in the interest rate cycle. So we are leaving a regime where we've gone down steadily in rates. I highlight the period 1981 to 2021. To now, it's pretty much ingrained that we're probably not going to resume that. What that catalyzes is higher nominal growth. We are in a higher nominal GDP world, right? So nominal GDP is real GDP plus inflation, right? And where we were for many, many years, we had about 1.8 % growth and about 1.8 % inflation.

44:23We can never get above two. So nominal GDP was like 3.5 % to 4%. Nominal GDP right now as of second quarter is 6.5%. That's a whopping number. What that does, when you have higher nominal growth, it's good for cash flows, it's good for earnings, and it's good for earnings growth rates. So what are we seeing this year? We're seeing an earnings boom that's taking place. It's not an accident. You have higher nominal GDP. That's what you're going to get. So what we're effectively doing now is when we think about balancing a portfolio is we're thinking about what role, how do I manage my fixed income risk relative to my equity risk?

45:04Equities in a higher nominal growth world, that's a tailwind. In a higher nominal growth world for bonds, it's a headwind, right? Because inflation and interest rates are going up in that environment. So if we think about the level of yields today in 10-year treasuries, it's about 4.64 % right now as we speak. Typically, historically, nominal GDP is the speed limit for 10-year yields, meaning that 10-year yields and nominal GDP historically tend to sit right on top of each other. Now, I'm not suggesting that 10-year treasury yields are going to 6.5%. What I am suggesting is that a 4.6%, 4.7 % 10-year yield is not something that's going to contract the economy.

45:45Ten-year yields can gradually move higher as long as it's slow and as long as it's managed. They can move higher without hurting the markets. The number one question we get is, at what level in the 10-year yield does it derail everything? You can't answer that question. You have to know where nominal growth is. In a 6.5 % nominal world, it's a higher number. In a 4 % nominal world, it's a lower number. So then the question is, though, what is out there to derail growth? And I think that's what we have to ask. And I think this is some of what we're trying to figure out. I understand AI making us more productive, but if it puts people out of work, what's the economic impact of that?

46:23So what do you see as the risks to growth that are out there? So whenever we get to these points where there becomes a lot of overinvestment in certain areas, and if there's a lot of hiring in certain segments of the markets, that could cause the unemployment rate to spike quite a bit. That to me is something, because consumption is 70 % of GDP. If you lose the consumer, if you lose consumption. So could that happen if there's an inflation shock, if there's an energy shock, people save their money instead of spending their money? Those things are much more geopolitical at this point. From an economic fundamental standpoint, there's not much out there.

47:02It's not very high risk at this point. What's the recession call right now. It's a very, very low probability. But could something be triggered with, say, higher energy prices, geopolitical tensions? Could that change things? Absolutely, that could change things. I mean, Russia, Ukraine, all of these various components to me, inflation and potentially the Fed having to hike interest rates in order to combat that, that by design is supposed to slow the cycle down, right? So those things are what I worry about. But these are very big macro macro events but you know sentiment is down and i i think we we do kind of think a lot about like wall street here at bloomberg because this is you know we're talking about wall street here but you do look at social media and people are complaining about higher inflation since covet that now their grocery bill is higher k-shaped economy just not not everybody's feeling great down.

48:01Like how does Wall Street kind of square that in? Yeah, square that with Main Street, right? So I use the hamburger analogy, right? So pre-COVID, I could go to a diner and I can get a great hamburger for 14 bucks. Now it's 20 bucks, right? So how do I make that hamburger, that$20 hamburger,$14 again, right? You're not going to. It's not going to happen. The way that you solve that is by making that$20 hamburger more affordable for everybody. And that means that you have to have higher wages, higher jobs, better jobs. So, you know, President Trump was speaking today about manufacturing, the reindustrialization cycle in the U.S.

48:38These manufacturing jobs are really strong. So when you talk about Wall Street versus Main Street, the strongest part of the jobs market is the trades market, is skilled tradesmen, right, you know, that are coming through. electricians, plumbers, pipe fitters, all of these areas, if there's a data center that's being built in some rural area in the U.S. or something like that, you get a lot of jobs. And if you get manufacturing jobs, the ratio of manufacturing jobs is six to one in terms of services jobs, meaning that for every one manufacturing job you create, you get six service sector jobs that come to support that.

49:16So that broadening, whether it's coming from the one big beautiful bill or the deregulation or the CapEx spend, we're just getting started in this whole thing. So we're going to make that$20 hamburger more affordable and that should change sentiment. But it takes time. As long as those jobs stick around. Yeah. Right. You can build a data center and then you move on. Or if you don't need, right, like those workers have to have a place to go. We were talking about summer vacations when you came in. You're getting ready. Just got about a minute left. Is there a book you take with you? Is it research or do you just say, I'm done?

49:49You know, I'm not taking a book with me for this trip. I think what I tend to do is I tend to read a lot of financial news. I tend to read a lot of research that I can just get caught up on, you know, most of its economic theory, just because I think that we are in a very big changing point right now. And I think that relying too much on historical data today is going to be a mistake. and we have to think about a higher nominal growth world and more of a supply-side dominated world as opposed to a demand-side dominated world. We need to do more of that with you, maybe bring Mike McKee on too, because I think that would be a fun, fun discussion.

50:26I'm just picturing like Aperol spritz with a side of our star and term premium. Yes, exactly. We do do wine segments sometimes on Friday. Maybe we can couple them together. I've said it before, but I really mean it. You're a gem. Thank you for giving us all this time. We love having this opportunity to do this. Jim Caron is Chief Investment Officer, Portfolio Solutions at Morgan Stanley Investment Management. This is the Bloomberg Business Week Daily podcast. Available on Apple, Spotify, and anywhere else you get your podcasts. Listen live weekday afternoons from 2 to 5 p.m. Eastern on Bloomberg.com, the iHeartRadio app, TuneIn, and the Bloomberg Business app.

51:09You can also watch us live every weekday on YouTube and always on the Bloomberg Terminal.

51:22Before you sign off, you tuned in for ways to help teams move faster, make sharper decisions, and turn scattered context into work they can use. ChatGPT for Business can help. Chat GPT for Business gives teams a shared workspace with admin controls, permissions, and access to work and codecs in Chat GPT. This means your business can move from question to answer and code to rollout quicker. Join over 10 million business and enterprise users worldwide already using Chat GPT for Work. Download the Chat GPT desktop app or contact sales to learn more. Hi, I'm Tom Keen, inviting you to join me for the Bloomberg Surveillance Podcast.

52:01It's about making you smarter every business day. I'm Paul Sweeney. We bring you complete coverage of stocks, bonds, commodities, even crypto. All the information you need to excel in the markets. And I'm Alexis Christophorus. Listen to us for essential conversations with the smartest names in economics, finance, investment, and international relations. That's the Bloomberg Surveillance Podcast. Subscribe today on Apple, Spotify, or anywhere you listen.