AI and bond yields

The two big stories of the week have been AI and the less eye catching but perhaps more impactful move in bond yields.

AI: Existential threat or economic miracle?

AI has been topic du jour as the leaders of frontier models in the US have called for a change of pace. Sam Altman (Open AI), Elon Musk (CEO of SpaceX – Grok) and Dario Amodei (CEO of Anthropic) have all come out and asked for a slowdown in development of AI models on grounds of security and lack of oversight that could ultimately lead to doomsday scenarios for the human race. As dystopian as this sounds, there have been several high-profile incidents of rouge AI agents hacking their way into places they shouldn’t in recent months.

As everyone is aware the AI hyperscalers (Alphabet, Amazon, Meta, Microsoft, Oracle etc.) are spending an enormous amount of money building out the infrastructure required to support the demands of the rapid growth in AI adoption. This has been powering the global economy over the past few years and is one of the reasons that until recently markets have shrugged off the ramifications of the conflict in the Gulf. The spend has led to very strong earnings growth both in the US and abroad, in addition to mounting piles of debt being issued by the hyperscalers to support the expansion.

What we know now

The strength of the growth is so large that the outlook for equities, particularly US equities is well supported by earnings for this and next year. In addition Anthropic, the makers of Claude, currently considered the leader in AI - this week have said that it is profitable for the second quarter in a row and that their top line revenue growth is 14 times what it was a year ago. This is what is giving markets the confidence to believe that the infrastructure spend is justified.

What could happen

The looming threats for AI, apart from the existential doomsday scenario above, is that a cheaper more efficient model comes out undermining the huge expenditure and debt piles. Or that the companies which use AI start to rein in the budget that they have for usage as token costs spiral. While those are costs that currently companies are prepared to pay, if it doesn’t lead to gains then budgets will be cut.

There is also the threat of regulation that while Trump is unlikely to introduce should the Democrats take both the House of Representatives and Senate at the mid-term elections in November then it could start to happen as it is high on their agenda, which in turn could lead to a hit in share prices.

What is our exposure like and what have we done

Given that it is the largest companies in the world which are most heavily involved in AI then anyone investing broadly in equity markets today is exposed to AI. Not only that but the impact from this spend is being felt across industries from manufacturing to energy as well as technology stocks. Estimates put around half of the global market capitalisation of companies as directly involved in the AI complex, be they first or second order beneficiaries, not to mention the knock-on effects to growth elsewhere. The truth is it’s the only game in town. So, hiding from it is unrealistic.

Our portfolios are well diversified across asset classes which protects portfolios against concentration risks. In our Prima funds we took profits and completely exited our allocation to the iShares Edge MSCI USA Value Factor ETF, our best performing position, in the summer to dial down exposure to some of the more speculative names in the space.

While in our models we have been reducing the allocation to the L&G Pacific Index trust at recent rebalances due to its big positions in the chip and memory names found in Taiwan and South Korea. We remain vigilant and should the earnings picture or regulatory environment deteriorate then we are prepared to act.

Bond Yields

There is an expectation that the Federal Reserve will raise rates this week on Wednesday, with the market currently pricing in a 92% chance of a 25bp move and four rate rises are priced in over the next twelve months. The impetus for this is that rising oil prices, combined with a US economy that is flush with money and running hot necessitates this move.

While this will be much to President Donald Trump’s chagrin, the bond market is already forcing the new Fed Chair Kevin Warsh's hand. Trump has learned in the past not to take on debt markets and as the yield on the US 10 year debt has risen to levels not seen since before the credit crisis, they are somewhat out of options. With yields at more than 5%, this is nearing the point at which things start to strain and the cost of capital hits areas of the economy that rely on lose monetary policy. It also impacts consumers willingness to spend, due to rising costs of personal debt and mortgages.

We are positioned short of the market in terms of duration with large positions in high yield and global short duration bonds, both of which are significantly shorter than the duration of government debt. These allocations have enabled us to remain less impacted by rising yields.

We are well aware of other sources of risks given the uncertainty this causes, and the knock-on consequences to other parts of the portfolio. As always, we will be taking action to protect portfolios if the situation worsens and yields continue to climb at this rate.