Markets Wrap: Trouble Ahead For The AI Money Machine?

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1:14Welcome to the Merrin Talks Money Market Wrap where we talk about the biggest moves in markets this week and what's been driving them I'm John Stevick, Senior Reporter and author of the Money Distilled Newsletter and then joining me in the studio today is Bloomberg's private companies managing editor Neil Callanan. Neil covers hedge funds, asset management and real estate in EMEA. So in today's show I basically wanted to talk about the AI industry. I wanted to give a structure of what it's actually about, lay it out so that you can understand it better, who's producing the chips and who's producing the models and then wanted to look at how that's funded and why there are some concerns about perhaps the circularity of some of the deals in the industry and Neil has written a lot about that Thanks very much for being with us today Neil, it was great to have you on the show.

2:07Thanks for having me John Not at all So we're recording this on Wednesday and probably the biggest story so far this week has been the route in the South Korean KOSPI index and basically this is driven by the fact that the cost be is half of it is comprised of two stocks that are related to the ai boom and that's sk hynix and samsung and also there is an element of retail investors getting in over their heads because they've been able to buy all these leveraged etfs and so the cost we went up a lot and then down a lot i mean one of the stats that really jumped out at me is that it's actually still up 35 % on the year but in the last month it's fallen 34 % and so yeah okay that's a proper roller coaster moment um but does this tell us or what does this suggest is about the the overarching AI story because it's not just about Korean leverage there's other stuff going on too isn't there absolutely and Korea in a way is a special case because Korea has almost gamified the finance industry and the stock market.

3:23And you mentioned the leverage ETS, but they've been big on crypto and Tether and things like that, stable coins for a long time. And a lot of those investors in retail have grown up very accepting of those levels of risk. And in many cases, it has paid off. So as you said, the KUSPI is still up this year, despite the route in recent weeks. But what is driving a lot of the change at the moment is the fear that China is catching up. And China's emergence in AI, which was always going to happen, but perhaps faster than people thought, is really concentrating minds at the moment. And we have seen in the past when Deepsea came out of nowhere and released its models, the market disruption that that caused.

4:05And now we're going through a kind of second belt of that, where in the space of just over a week, you've seen massive progress in terms of memory chips, in terms of language models. And so China is definitely emerging and one of the things around all the spending that we're seeing in ai is the assumption is that people are willing to pay for it yeah and we pay a lot for it going forward and then suddenly if you have these cheaper models coming out of china and people start switching to that then what happens with the names we're all familiar like with like um open ai and anthropic um and and so you know there's definitely fears in the market about that at the moment and i think people are definitely taking pause globally as a result of that at the same time a lot of this money is going to be spent there is an investment case for it and it's whether it's getting ahead of itself at the moment and certainly in terms of valuations it did seem to be getting steamy at one point this year yeah i mean i thought we'd just kind of lay out roughly the the ai industry and the business model because i think a lot of the time you know we sort of talk about ai and it's quite an amorphous kind of blob and a lot of time we're thinking about chat gpt i mean no nvidia is in there somewhere and all the rest of these things but so i was kind of looking at it um and actually i was talking to to ai about it um and getting a sense of what the the kind of value chain is so you've got your you've got the machines that make the so you've got the companies that make the machines that make the chips and that's like your asml um that makes the kind of lithography machines and then you get the chip foundries themselves and that's like the taiwanese company tsmc you've got chip designers and that's nvidia so they're they're the ones that basically do the kind of value add element isn't it it's like they are they're making the brains for these things and then all of these chips go into big ai hotels the kind of data centers and they're run by the same people that run what we used to call internet hotels the kind of data servers like the amazons and not the rest of this world.

6:13And then you've got the people who actually make the AI models and the AI models, the brains of the AI live on the data centers. And that's like your open AI. And then they're selling them to companies, either big enterprise providers who kind of like garnish their existing offerings with AI or end users like me and you or smaller companies. Is that about the size of it? Does that kind of sound about right in terms of what the AI value chain is and who all the companies are involved in this? 100%, but this is so massive now that it encompasses everything else as well. So they need energy. And so we're seeing a massive boom in energy.

6:57And people are talking about needing up to 300 gigawatts of additional energy power by 2030. That's enough to power 225 million homes for a year. That's just for data. centers. Now, those things have to be built as well. You have to get people to build the data centers and build the energy infrastructure, et cetera. So construction firms are taking off as well. And so, you know, in the US in particular, it's driving a lot of the economic growth and any slowdown in this kind of spending will be negative for growth, not necessarily turn recessionary or anything, but it would be negative for growth in the US.

7:31But this goes back, your point about in the end, it comes back to the end users, goes back to my point about China in a way, which is that we need people at the end to be paying for these services in order to justify these investments. And when you look at the amount of money that are being spent by some of the hyperscalers in particular, which are these internet hotels originally, as you described them, if you look at Alphabet's recent filing, its forward spending commitments rose$500 billion, essentially, in three months. Now, future revenue grew, but not by anything close to that. And that goes back to the fears people have about this entire ecosystem that is sucking up so much money and so much capital at the moment that people are kind of going, well, I don't know whether I want to have as much exposure as I could have to this.

8:22And you're starting to see that in the credit markets as well, where people are becoming much more discriminating about the deals they invest in and the price they're willing to pay. And they're also hedging a bit more. So this week, CoreWeave's CDS, which is a form of hedging against default risk, that's risen to almost a record. CoreWeave is one of these companies that is like a WeWork of the GPU world, which is the chips. And they basically rent out to other people what they're doing. And, you know, people have become much more cynical in the last few weeks about deals, partly because they know so much of this stuff is coming to the credit markets that they don't have to buy everything.

9:01and the question is whether people in the AI industry as a wider thing have become too complacent about the idea that the credit markets will be there and be supportive of them and that's not necessarily always going to be the case. Well I mean I think that this is it's fascinating from that point of view in that there really has been a deluge bond issue and I mean we're talking about what was by some measures now the hyperscalers are the biggest issuers of corporate investment grade debt and it you're used to being the banks and the other point about hyperscalers is that before all this they were they were basically running on their own cash generation they were deemed as being essentially impregnable balance sheets um and while it's not negative that they've started you know raising or not started they've now got a lot of debt um and for example at alphabet its latest quarter was its first negative free cash flow quarter ever since it listed um it's just a sort of saying that how much is out there um and how these these businesses are kind of fundamentally being changed by this and then you throw in china maybe turning around and doing it all much much cheaper and suddenly you're kind of oh wait a minute your earnings are going to be crushed or sorry the earnings that that we're hoping that you get might get crushed by this and and one thing i thought was really interesting going back to the debt point is you were involved in putting together this very complicated and now famous in a sort of local way uh chart um about how this is all being financed and one of the the big things that's i think slightly worrying people as well is that a lot of the money seems to be coming from the people who you know raise the money in first place so like almost like a form of vendor financing where you've got companies that kind of make the chips paying the people who buy the chips or who are going to rent the data centers that use the chips can you talk to us a bit more about about that and how that's kind of panning out yeah what happened late last year was um i was sitting there reading story after story about these deals where companies were doing deals with other companies in the AI universe.

11:23NVIDIA has always been at the center of this, but the likes of Google, Ananthropic and OpenAI were doing all these as well. And I literally couldn't keep up. And so we just had the idea that maybe we need to do a visual here and kind of show the levels of circular deals that are happening. And this became something of a bad word in the 1990s with fiber optic, when there was a big rollout of that and lots of spending and there was vendor financing and there was capacity sharing and various other things and then a lot of those companies went bust when the demand wasn't there at the end having invested in all that money now of course the irony of course is that uh long term the economy benefited massively from that level of spending it's just the companies involved but no way so many of them ended up going bankrupt well that's the that's the infrastructure story isn't it you know you the railways are still here and we still have trains but a lot of companies about them went biased and same with dot com and that happens with most new technologies and again that goes back to why investors are being somewhat skeptical at the moment about that but these circular deals they can create misaligned incentives um around things like are you making the decision for the in the best interest of the company are you making it in the best interest of the company that invested in you and is one of your biggest customers etc and does that mean you're not devoting resources to something else when perhaps you should be it also raises the question of whether there might be misaligned values so yeah the deal is being done at let's just say seven billion valuation but if that was with somebody else might have been a four billion deal yeah you're also creating customers for you who are beholden by those um contracts and then you that like essentially creates regulatory risk as well but regulators may come along go actually we don't like that and we're not sure whether that's the best deal for the consumer and so you know all these risks are emerging that perhaps we didn't have before but the biggest one probably of all is that these circular deals can create a false impression of demand and you may think that all these companies are generating massive revenues but if it's all just moving around and sloshing around then if something falls out of bed then there could be wider implications and that could become systemic.

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15:55The other thing I thought was interesting this week is that although Cosby's fallen out of bed the Nasdaq took a bit of a bump but not a big one it so far seems to be restricted largely to the AI and the tech sector and actually plenty of other stocks are doing fine the equal weighted S &P is doing fine as it is and that's the S &P that's not wholly invested in the tech sector. And also the FTSE 100 is almost back at a record high, the kind of laggard of the global stock markets. But is this issue of how much does this spread or could it spread beyond the tech sector? Who else is involved in lending to these companies?

16:42And if something did break down there, where are the contagion vectors? The demand means that the AI industry has had to go to pretty much every corner of the credit market and hand out the ball and kind of say, give us a few quid on what we need going forward. And so you're seeing everything from direct lending, which is a private credit usually for infrastructure. So like just to build a data center, you're seeing investment grade. you're also seeing these neo clouds like core weave who i mentioned who are sub investment grade sometimes not not all of them but some of them are sub investment grade so that's the high yield market the junk bonds that people might know um they're in the structured credit markets so they're uh you know these are basically taking bond payments that are due and slicing them up by risk and selling them off to people yeah that reminds me but hey it didn't something like that had in the mortgage market uh what is it 20 years ago we haven't got to kind of the cdo level or cdo squared level but like where i would be concerned around that lending in particular is around what in real estate is called speculative lending which means something else to many people but in real estate it's basically building the stuff before you have a tenant yes and if you can get finance from that from a bank or from a private credit lender that says something about bubble territory because they are taking a complete risk that you are building this thing over the course of five years and you will find somebody to occupy and if not or if the industry moves on and technology moves on you can end up with a very expensive elephant uh at the end which may not have much residual value for people yeah if you build it they will come it only works in the field of dreams doesn't it yeah i mean there can be a first mover thing where you can get away with it but if you're spending five billion credits building a data center i certainly would want to be more certain of that but we are beginning to see elements of that and we're also beginning to see uh terms being pushed within those deals for lending that maybe are too generous to the hyperscalers that is the point of view of the credit markets so you're starting to hear things like after a certain amount of time if the project is delayed then the hyperscaler come back out now if you've invested five years and spent as i say five billion dollars in building a data center and it gets a bit delayed because let's just say something got stuck in the straits of her moves at the moment that's a very big risk and so again that's part of what's happening with the credit markets and the pullback um they're kind of reconsidering some of the levels of risk that they're accepting at the moment i mean from that point of view this arguably as long as it's not already going too far may be a good thing as in maybe it gets everything to rain in their horns a bit before it does go properly pear-shaped yeah and i think it was always going to happen um and to be fair like you look at something like the cosby and it's still up you know many of the companies in are still up over 100 percent here today in some cases where ai adjacent companies are up 300 % for the year.

20:00So, you know, there was a natural moment for a pause anyway. And what we are seeing in terms of the Chinese evolution is that that was always going to happen as well. And China's big advantage is it has cheap electricity. So the tokenization is cheaper. So if you're a company that's also been spending loads of money on AI and your staff, it turns out, are using it to convert Excel files into PDFs rather than actually, you know, using a much cheaper technology for that. You're going to be scouting around for cheaper prices. And so, you know, China and the Chinese LLMs become a natural kind of success story from that.

20:43And, you know, that was all to be expected, I think, for a certain reason. And it's just all happened very quickly and all at once, as it does these days in markets. And there's a bit of panic in certain areas, particularly when it comes to retail money. you and I have spent years writing about retail money being hot money and how people can panic and to be fair if I had leveraged several times I would be looking at that and kind of going oh my god so it's understandable in a way but you know if people are sensible about how they invest there's still major opportunities there Yeah I mean yeah my heart goes out to the various kind of rookie retail investors in South Korea who are now looking at you know some really nasty losses I'm hoping that they were all young enough to bounce back from it thanks very much for this Neil it's really helpful, the one other thing I was asking about is on the debt side, so we've flood the debt market if you like, and we have also seen a bit of equity issuance and I suppose the other thing I'm wondering about is how much can the market take whenever we've had decades of de-equitisation so companies buying back all their shares or getting bought off the market.

21:57And now we're going to get quite unusually kind of net equity issuance quite possibly this year. I mean, what does that say to you about what might happen regarding the tightness of my overall, as in there's just not going to be enough to go around for all the hungry mouths? I think investors will be discerning. I mean, you can tell an equity story that people will follow. uh i mean just think within ai how many of these companies we had heard of three years ago very few of any um and yeah you know that they may not have very much revenue but people are willing to bet on a deal but um there's also a thing of like it can go wrong quite quickly and spacex is probably a good example of that not let's say it went wrong but there was so much hype and now it's obviously down since its ipo price which was ambitious in the first place I looked recently and the short interest on the stock was at near 40%.

22:55So people are being very bearish on the future front. And that's probably the big question for investors at the moment, SpaceX being partially an AI story with data centers in space, etc. Is has that and what happened to that stock closed the IPO window for a while? And in that sense, then the focus would shift back to the equity markets. I'm sorry, to the credit markets and the credit markets. Sculptor, I think it was, put an investor letter out recently and they said they talked about how credit capacity is needed at its greatest extent, just as people are pulling back. And that's something you have to be a bit fearful of, I think.

23:39Now, often we have thought these things and two weeks later, it's the market has said, oh, oversold and it's all right back up and often exceeding the previous size, obviously. but at the moment it's definitely a moment it's just the length that that moment takes Great, well Luke thanks a lot Neil, I think that was really helpful I hope the main point here was to try and explain to people what's going on and I think you've done that excellently and obviously the market can remain excitable for longer than anyone can remain solvent especially if you're invested in a leveraged ETF so just be careful out there thanks again Neil Thank you

24:25Thanks for listening to this week's Merrin Talks Money Markets Wrap If you like our show, rate, review and subscribe wherever you listen to podcasts and also be sure to follow me on X or Twitter at join underscore stepic This episode was produced by Summer Sadie and Moses Andam Questions and comments on the show are always welcome Our show email is merrinmoney at bloomberg.net Special thanks to Neil Callen.

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