00:00of this data, be it the trade balance or durable goods orders, reflects an economy that continues
00:05to be powered by AI. All you need to also do is look at Caterpillar earnings, which were so strong
00:10because of AI. Do you worry about concentration in this overall market? Yes, we're hitting all-time
00:15highs. Yes, earnings are really strong, but just so much of that is underpinned by AI spend.
00:20So I think it's a very interesting dichotomy that in one sense there is concentration of the theme
00:25that AI is becoming so important. And I almost like to say that we are in the midst of, you
00:29know, we had the industrial revolution, we had the internet revolution, and we are possibly on the
00:33verge of something very, very different world. But the broadening out in terms of the number of
00:40names that are benefiting from the AI theme, that's actually diversifying, which is one reason why you
00:47are seeing the small cap rally, why you are seeing the Russell 2000 have such a good year over the
00:52large cap. It's because there's a broadening out of the AI theme. More and more companies,
00:57it's not just the large chip makers, it's now the small companies that are helping out in the AI
01:03built out, that are, you know, giving the inputs into the chip makers, the testing, or the network
01:10connectivity to the data center, that broadening out of the theme. And because there's such a need
01:15for demand, for capex, there's such a need for capital, that's why you are seeing the banks doing
01:21well. And even everything going on in the Middle East, I would like to point out the US is an
01:25energy
01:25exporter today. So it is benefiting from the energy prices. So you are seeing that distinct benefit
01:31across technology, industrials, materials, all these kind of things. And that is one very important
01:38reason there's broadening out and why the small cap rally that we have been seeing.
01:43It almost seems like this is the start of a new cycle, in a sense, because what they always look
01:48for at the beginning of a cycle is small caps doing really well, and they've joined the party now.
01:53Exactly. So this tailwinds to this broadening out and the small cap rally possibly has much more
01:59to go. However, one thing that I would point out is we are in the midst of higher inflation and
02:05higher
02:05rates and higher volatility. And what is important for equity markets today is the linkage between
02:12rates, volatility and equities have gone up because there is so much capex. We have gone into a situation
02:19where the hyperscalers have gone from massive positive free cash flow to zero or negative free
02:26cash flow margin. That increase for capex, actually capex and capital needs increases the linkage between
02:34what's happening on the rates front, rates, volatility and equity markets.
02:38I think that is so interesting because already these were high duration companies because all of it
02:42that you cared about was their future cash flow. Now you have to discount that even more.
02:45And because they're infrastructure companies that start to see some of their various assets devalue
02:50more rapidly. So what does that mean at the very moment that we stand in where 10-year yields,
02:56yes, they've come down, but they're still at 4.6. Like when do the warning signs start flashing that,
03:01yes, higher rates are going to become more of a headache for this equity market?
03:05So I think it's kind of important to point out that higher rates, it's always a question of what is
03:10what is expected and what's actually happening. And what is interesting is we are in a world where
03:15both market participants and policymakers are ready for a world of higher rates. And why do I say that?
03:22I don't just look at the short-term rates market and what's happening, but if you see what's the
03:27terminal rate for the federal funds that's expected, both the median and the lower end of the range of
03:34terminal rate, U.S. equilibrium policy rates has distinctly gone up in the last year, six months,
03:40and things like that. And similarly, markets expectation over the Fed funds future rate,
03:45the implied Fed funds rate has gone up. So both market participants and policymakers are actually
03:51prepared for a world of higher rates. So to some extent, it's kind of built into expectation.
03:57However, the path can be much more volatile because if you look at how much inflation expectations
04:04have come down since April, if you look at the inflation swap market, markets are pricing in
04:10inflation of just around two percentage points. And I would argue that sticky inflation is pretty high.
04:16Most actual inflation rates coming in at closer to 3%. So that disconnect between inflation expectations
04:24and actual inflation can cause much more of the rates volatility. And increasingly, in a world where
04:30the players of the AI, the beneficiaries are broadening out into the small cap, the Russell 2000,
04:36particularly the growth segment of Russell 2000, these are newer companies. They are earlier in
04:41their stage, so to say. So the extent of pricing volatility as any new information comes in,
04:47that tends to become a little more volatile simply because they are newer, earlier stage companies.
04:51So we should be prepared for a world of higher rates volatility and higher actual equity volatility.
04:57What about the rest of the market? And by that, I mean the consumer facing side of the market,
05:01because we saw McDonald's today come in weak. Is there concern that that side of the market isn't
05:07going to be able to keep up now? You know, that's a very interesting question. By a lot of indicators,
05:12the consumer, the average consumer, the lower end consumer, they are under stress. There is no doubt
05:18about that. But there is a strange disconnect there where most of the consumption in the United States
05:23is driven by the top 10 percent. And actually, it's not even the top 10 percent. It's really the higher
05:28end, the top five and the two percentage points. So in that sense, there is a disconnect where most of
05:34the
05:34consumption is coming from wealth and the higher end consumer. So the stress that you see in the lower end
05:41consumer
05:41tends to not get reflected in the headline GDP numbers and the headline equity return numbers.
05:48So there is that little bit of disconnect in inherently how the U.S. economy has transformed over time.
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