| “The proof is in the pudding”… A popular phrase with origins dating back to medieval times when pudding was not so much a dessert as it was a mixture of savory meats and spices that were boiled in animal intestines. As such, one could only tell if the pudding was well cooked and safe to eat by eating it. Fast forward to today, investors are similarly unwilling to accept at face value that the enormous amounts of AI-related capital spending will produce positive returns on invested capital; instead, they want proof. That proof is still one of the major open questions on the minds of investors as they continue to digest Q2 earnings. Both Alphabet and Intel reported stellar earnings last week. But both companies traded lower after announcing plans to increase already huge amounts of capital expenditure related to AI. Such has been the theme of markets recently, with aggregate AI capex from the largest hyperscalers set to approach approximately $750 billion this year on its way to $1 trillion in the coming years. In the near term, various sectors of the markets have been beneficiaries of the spending, particularly the semiconductor supply chain. But there is still a large open question for investors about whether the massive amount of spending will yield a future profit increase for the companies that continue to spend a majority, if not all, of their free cash flow on AI-related capex. Additionally, with several companies now issuing debt to pay for that capex in an environment where interest rates continue to drift higher, the hurdle for producing a positive future return only gets higher. As a result, investors are growing cautious in the near term and taking profits as companies report earnings. This week, market focus will be split between Q2 earnings and central bank decisions. Apple, Amazon, Meta, and Microsoft all report this week. Also, the Federal Reserve, Bank of England, and Bank of Japan will all convene for interest rate decisions, as interest rates have drifted higher as continuing tensions in Iran have left energy prices elevated. With the Iran conflict still very much unresolved and oil prices back within reach of $100 per barrel, the probability of a Fed rate hike on Wednesday has climbed to almost 40% (see the chart of the week below). With the next data point on U.S. inflation coming after the meeting, the Federal Reserve will be left to decide on interest rates with a backdrop of conflicting data points. Therefore, while the probability of a hike continues to grow, the proof will be in the pudding. |
