I realize that for the last couple of months I have warned of a possible contraction in the markets. I have given statistical data as what might be expected, why it has happened before, and what we could see coming out the other side of the pause to refresh. Does this mean that this pause to refresh is fun? Of course not! Actually, quite the opposite. When markets are in a correction within an overall uptrend investors often throw in the towel because the fear of loss or the fleeting trust in what they believe to be true about companies, industries, and the overall markets. This past week was one such time. It was capped on Wednesday by the melt down of the hedge fund, Situational Awareness. This was an unwinding 3X1 leverage of a portfolio that was unwound. Read about it. Quite interesting story.
One underlying factor that I keep coming back to is that of debt. Debt is personal, business, and national / global. In analyzing it, I first of all look for why it could get worse (more expensive). I am referring to higher interest rates. To have this happen it tends to be from two major places: inflation due to growth of economics, and too much debt (overleverage) and therefore the credit rating declines and the safety of owning forces interest rates up due to lack of trust in the ability to be repaid. So, let’s look at these points.
Inflation in broad economy: CPI- consumer prices are going up slower than the expectations and on a trend to be less inflationary. PPI- producer prices are flat and not showing an inflationary bias. Wages and labor- both growing but not exhibiting an inflationary bias.
That brings us to what I feel is more important; credit quality and market sentiment of debt default preoccupation. I will begin by starting biggest /global. For the US, which is where our most localized sensitivity lies, we are sitting with $38 Trillion in debt. This is a monster number yet not unmanageable given the overall size of our domestic GDP. To put it in perspective, here is our debt compared to China, Germany, and the UK. Notice that it has grown since 2019 (pre-COVID).
At the same time, Governments are levering up at what appears to be maximum velocity, while as can be seen below, consumers and corporations are decreasing leverage at a record pace. This is really interesting I think. People and companies are becoming more conservatively structured, and Governments of the world are subsidizing social welfare at increasing rates. Eventually, this will need to be dealt with. There are really only two levers; more conservative spending (President Trump attempted this with DOGE) and increased taxation. As the old saying goes, “You get more of what you subsidize and less of what you tax.” The problem is that government need to decrease their own size which is very hard to do as it will require tough decisions about pet projects and well-known fellow employees. Taxation will need to increasingly focus on the wealthy as they are the most capable of shouldering the increased taxes. Again, not a comfortable action as these are the donors that support politicians political aspirations. So here is the face of debt at the consumer and corporate level. Notice the decline at an accelerating rate:
This is all interesting, but to me the level of the debt is important but not as important as what the market prices in as the cost of more risky debt (BBB rated) to least risky debt (AAA rated). When this spread increases, that is a time to be concerned as this tends to infer a recession or economic downturn is being prepared for. Markets aren’t always perfect, but currency and bond traders tend to lead the action in the equity markets. Currently the chart up above is helping them feel more comfortable, and as such spreads are at multi-decade lows. Notice the spike up when the world basically shut down during COVID:
To take this one step further, here are the amount of loan loss reserves the major money center banks are holding. Again, you will notice the spike during the Great Financial Crisis and COVID and the utter quiet in place today. I believe that this is further validation of the outright economic strength existent in the US today.
The next point is that of the pullback in prices of recent market leaders. They have hit a clear pothole in the road and even though earnings continue to be stellar, the prices are clearly on the defensive. As far as an answer, aside from interest rates rising and possible debt rating declines, the war in Iran is really the only other major issue that I believe is weighing on the minds of investors.
Last week we had our August Fed meeting. This is where the Fed Chairman discusses the state of the economy and more specifically the course of interest rates to make sure that inflation is where it is supposed to be for the economy to function properly and grow but not be over exuberant. His stated mandate is 2% inflation. He stated that this has been the problem for 67 months. This basically means that we are having a very tough time reigning it in. What is more important is that since this is a new Fed Chairman that has only been in office for 43 days (as of the meeting), the markets don’t like new Fed Chairs and virtually every time take a breather under the new Fed Chair. This one is appearing to be same as the others. Here is a chart of this phenomenon:
There are many other points that could be discussed to add to the “reason why” the pullback that we are experiencing is occurring. To me, I believe that it is a function of a combination of things; seasonal issues, midterm year issues, midterm election year issues, the amount of advance that has occurred in the momentum / growth stocks, and the current level of interest rates. The interest rates are currently at high points not seen in some time. Since high interest rate historically are the nemesis of equities in general, this could have been one of the biggest straws to break the back (short-term) of the market.
The last major point I wanted to touch on is the comparison that is being discussed between the AI boom of today as compared to the Dot Com Bubble of 2000. The differences I feel are most glaring are as follows:
Dot Com debt vs. AI Boom debt
The data indicates that the internet buildout was heavily supported by debt-financed investment, leaving some members of the group vulnerable to the deterioration in fundamentals and tighter financing conditions that soon followed. Conversely, hyperscalers are funding the record levels of capital spending from a position of greater financial strength. Microsoft, Alphabet, Amazon, and Meta all maintain net debt-to-EBITDA ratios well below the median S&P 500 stock. While the data is for Q1, Alphabet maintained a net cash position after reporting Q2 earnings despite taking on more debt in the quarter. Also, when they announced earnings last week their cloud revenues had increased 82% year over year. This is an acceleration of increase.
In looking at the amount of debt for the internet buildout, this is what we saw:
Now, compare this to the biggest Hyperscalers and how they are using debt. Most of the biggest companies that are building out the datacenters are financing these needs off of free cash flow. The only exception is Oracle as can be seen on the far right:
The next point is the length of time that this capital expenditure to build out the AI infrastructure could continue to exist and expand. Since many of the companies that provide compute (semiconductor and memory) and energy companies (that need to increase the amount of electricity drawn to do the compute) require huge amounts of this investment shown above, the question logically is how big could it get and how long could it continue to grow. Unlike the late 1990s, when the capex-to-sales ratios were mostly stable, capex intensity among the hyperscalers has trended higher and consensus expectations imply another step-up in spending in 2027 and beyond. The sustained magnitude of the spending and the expectation of further increases suggest the AI infrastructure buildout remains in an expansion phase rather than approaching a peak.
In the late 1990’s most internet infrastructure companies financed the fiber buildout almost entirely through debt, as seen above, while generating zero revenues. Nearly all internet startups also lacked revenue. This is the reason for the popping of the bubble back in 2000. It isn’t to say that they weren’t really great companies with really great business models, but rather that the world had just not got there yet! In a stark contrast, AI-related companies are already generating massive amounts of revenue from AI. The problem that I find with this is that there is not a breakout in corporate commentaries on the exact measured financial effect of AI. The period between ChatGPT’s commercial launch in November 2022 and OpenAI reaching $10 billion in sales is believed to represent one of the fastest tech revenue ramps (3 years) in history. Anthropic (which is still a private company) is estimated to have generated more than $10 billion in sales in Q2 alone.
AI as we know it prior to the vast processing going on was measured by the amount of usage of the Cloud from the three big cloud providers. As can be seen in the chart below, Cloud profits has been consistently rising, not at a parabolic rate, but at a consistent increase since early 2024. What is interesting is the dotted line that shows that as AI processing has been overlayed on the Cloud profit growth has really expanded. This just really started to be visible in the last quarter of 2025 and is why it is believed that we are very early on in this expansion:
By the early 2000s, there was so much dark fiber optic cable laid that it would take almost a decade before it reached a 100% utilization rate. The over-building in the late 1990s helped ensure tech spending as a percent of GDP would peak in late 2000 and fall for another five years before bottoming in late 2005. We do not believe this will be the case with the current AI data center buildout. First, JLL reports that vacancy rates for North American data centers reached only 1% at the end of 2024 and has remained there since. We have no tangible signs of excess capacity at this point and still accelerating demand.
The market decline that we experienced since the Mid-May highs has been downright painful, no doubt! But in looking at the fundamentals of the leading industries and companies it remains clear that the growth of earnings, the economy, and the AI buildout has not missed a beat. Often times company prices of publicly traded companies don’t reflect the progressions of the business. This is what we believe we are seeing. This week’s report is somewhat different than the norm, but I believe addresses the important issues that should be paid attention to at this point. Please call should you have any individual questions.
-Ken South, Tower 68 Financial Advisors, Newport Beach
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