The S&P 500 closed June down 1.1%, a muted end to a strong quarter. Concerns on the sustainability of the AI boom offset positive developments in the Iran conflict. A fragile ceasefire between the U.S. and Iran and some increased shipping traffic through the Strait of Hormuz led to a large decline in oil prices. Early in June, investors showed signs of increasing concerns about the AI trade. Considering the substantial AI concentration in the S&P 500, any investor concern can lead to large market swings. By our research, almost half of the value of the S&P 500 is comprised of AI-related stocks. The S&P 500 has become more of a concentrated bet on AI rather than a diversified basket of companies.
A leading concern to investors in June was the inflationary risk and potential interest rate increases posed by the massive and rapid AI infrastructure buildout. Several major bottlenecks in the buildout have caused input prices to increase significantly. These bottlenecks include severe power constraints and low memory chip supply. Hyperscalers have struggled to find available power for new data centers as the available capacity may not be able to meet demand. New natural gas generators now have multi-year backlogs. Additionally, memory prices have quadrupled over the last twelve months according to a recent report by the Wall Street Journal. So far, much of the elevated cost has been borne by the hyperscalers, who have seen capital expenditures increase much faster than their earnings. This has been a growing drag on free cash flow for some of the largest U.S. companies. Without a substantial increase in operating cash flow, this could ultimately lead to moderating capex growth in the future. Recent price hikes by consumer tech companies like Apple, which is increasing the price of MacBooks and iPads double digits, have highlighted how the AI buildout may start contributing to higher inflation. This could naturally force the Federal Reserve to increase interest rates, which could lead to lower valuations for growth stocks due to increased investor opportunity costs and higher financing hurdles. If this scenario plays out, it’s possible the AI buildout will be forced to slow down as investors reassess the value of the trade in a higher interest rate environment.
We remain committed to prudent investing, staying diversified, and prioritizing downside protection within your portfolio. Have a happy Fourth celebrating our nation’s 250th birthday!
– Levi I. Gates