Trump’s man is a threat to spark a Wall Street meltdown
Blame Kevin Warsh for the slump in tech-related stocks over the past few trading days, which has wiped nearly US$1 trillion ($1.45 trillion) off the value of Elon Musk’s SpaceX.
It’s no coincidence that the sell-off in technology stocks (particularly semiconductor manufacturers, but more generally anything related to artificial intelligence) began on Thursday.
This was the day that the first meeting of the Open Market Committee of the U.S. Federal Reserve Board, chaired by Warsh, concluded.
The rate-setting committee has sent a clear message – backed by a “hawkish” tone from Warsh himself – that the Fed is more likely to raise US interest rates rather than lower them by the end of the year.
In fact, everything that came out of that meeting and Warsh’s announcement of five task forces that would review the way the Fed communicates and operates pointed to a more conservative, smaller, less interventionist central bank in the future.
There was something serendipitous about the timing of the Fed meeting, with long-serving former Fed chairman Alan Greenspan dying this week.
Warsh’s plan for a smaller Fed balance sheet with fewer bank reserves would transfer much of the responsibility and risk of providing liquidity to markets.
Rather than the “Greenspan sell,” a belief that stemmed from the way the Fed intervened to put a floor under financial markets during the Asian financial crisis, the Long Term Capital Management collapse, the burst of the dot-com bubble, and the stock market crash of 1987, markets would have to price risk based on asset prices.
Greenspan’s tenure as president was characterized by a desire to rescue financial markets, loose monetary policy, and financial deregulation. If Warsh sticks to his stated conviction, the Fed will be very different (and a huge disappointment to Donald Trump).
Tech stocks, especially AI-related stocks — and especially SpaceX, with its stratospheric valuation that capitalizes on a vision rather than prospective revenues or gains — are vulnerable to even the slightest rate hike, and even more vulnerable if investors believe the safety nets they’ve relied on for decades could soon be pulled away.
This is partly a function of the mathematics of the market, and partly because the way the AI revolution is being financed is complex and vulnerable. Mathematics is traditional; financing certainly not.
Traditionally, investors value companies by discounting their estimated future cash flows at a risk-free rate, usually the yield on 10-year government bonds. The higher this return, the lower the net present value of future cash flows.
The US 10-year bond yield had been rising since Donald Trump was re-elected as president last year, but until last week there was no expectation that the Fed itself would target higher interest rates.
Yields rose a few basis points again following the Fed meeting, and more importantly, futures markets have priced in a rate hike of at least 25 basis points before the end of the year.
Bank of America economists, who predicted that there would be no interest rate movement this year before the meeting, now say there may be three interest rate movements.
This may be extreme, but it shows how suddenly moods and expectations change.
For big tech companies that trade at abnormally high multiples of their revenues and earnings — in SpaceX’s case, when its public market cap peaked at nearly $3 trillion last week, it was trading at 160 times last year’s revenues — even a modest shift in interest rate expectations has a magnified impact on their valuations.
The worst-hit sector of the market has been semiconductor stocks, with the Philadelphia Semiconductor Index losing almost 8 percent this week. The tech-heavy Nasdaq index has fallen 3.5 percent since the Fed meeting, and the S&P 500 index is down just under 2 percent.
The “Magnificent Seven” stocks that account for more than a third of the US market’s capitalization and have driven the market this decade, accelerating as the AI story gains traction and momentum – Alphabet (Google’s parent company), Amazon, Meta (Facebook), Microsoft, Nvidia and Tesla (currently rounded out in the top seven by SpaceX) have fallen an average of 4 percent over the past few days.
SpaceX, which launched last week with a market cap of $2 trillion, reached $2.99 trillion in value and is now back at $2 trillion.
Market math and a broader post-SpaceX reassessment of how much excitement has been generated in its and other AI companies’ valuations may explain why tech stocks are reacting to the Fed’s changing rate outlook, while share prices of major tech companies began pulling back from record highs late last month.
This appears to be driven by the realization that the forces driving the market—massive investments in AI models and the infrastructure needed to train them, and demand for semiconductors outstripping supply—emphasize a different equation.
Any crack in investors’ confidence in all things AI, and the idea that AI valuations can only rise, poses a threat to the sector and the market more broadly.
Estimated by a handful of hyperscalers to be around $750 billion this year and more than $1 trillion next year and beyond, AI investment is accelerating and growing at a faster rate than the AI-related revenues generated by the investments, even as the revenues of the leading AI heroes are growing exponentially.
That’s the kind of capital demand that SpaceX listed and raised US$85.7 billion, and immediately fell into the debt market for US$25 billion.
In recent days, Amazon has given $80 billion in new debt and Nvidia has given $25 billion in new debt, while Alphabet has raised $80 billion in equity capital. These are companies that generate large amounts of cash flow from their traditional operations and are accustomed to announcing stock buybacks rather than bond issues.
Anthropic and OpenAI, two leading pure AI start-ups, have also filed prospectuses for their own trillion-dollar-plus stock listings and capital raises; but they will now be watching the current market with concern, worried that they may have missed the boat.
The gap between AI spending growth and revenue growth and losses from AI investments is unsustainable.
Either the already impressive revenue growth by companies like Anthropic (annual revenue of $14 billion in February jumped to more than $47 billion last month) will need to grow even faster, or the rate of growth in investments will need to be cut.
So far, equity, mostly private, and increasingly debt have filled the widening gap between income and spending.
If markets become nervous about the sustainability of AI financing, that capital will either become more expensive, less available, or possibly both.
SpaceX’s debt raise was notable because intense demand was for short-term, less risky debt. Yield on debt was higher than companies with similar ratings. Investors appear to be a bit more aware of AI risks than they were earlier in the year, when there was uncritical and open-ended investor financial support for all things AI.
The financing structure of artificial intelligence sectors has an incestuous structure; There is a lot of cross-stake among key players and back-to-back deals for equity capital, chips and data center capacity. It is defined as “circular finance”.
There is a risk that the entire industry will collapse if AI companies lose access to stock markets. Non-AI heavyweights with large cash flows will survive with lots of expensive scarring, but slices of the industry will disappear.
That probably won’t happen, at least for now, and the broader stock market may be experiencing only a modest correction after a massive rally. Any crack in investors’ confidence in all things AI, and the idea that AI valuations can only rise, poses a threat to the sector and the market more broadly.
Warsh and the “reformed” Fed he envisions could provide that threat.
The Market Summary newsletter is a summary of the day’s transactions. Let’s each take ittoday afternoon.
