DeepSleep

“Are you a parrothead?” asked a lovely lady after one of three AI presentations I delivered this week in Naples and nearby Marco Island, FL. Referring to a Jimmy Buffet reference during my talk, this original parrothead and her friends saw one of his first concerts at a tiny Bryn Mawr coffee shop in 1972, after which Jimmy joined them on the beach. The otherwise chill (one gentleman sporting his “Success by Trump” cologne) and mostly baby boomer audiences were dubious of AI. “Will we be lazier, less creative?” “Will AI dumb us down?” “Can AI make sure my fridge is stocked with red wine?” I heard about an employer, exasperated by the thousands of “perfect” resumes he received for just two jobs. “I called one of them, and they know nothing! ... I would hire the first person of these thousands that anyone knows!” And from several exasperated parents—“My tech-skilled son applied for many positions, and is hearing crickets!” That’s progress?!! Speaking of which, last Monday morning investors saw sharp selloffs in leading AI stocks with news from DeepSeek, the Chinese AI company that aims to compete with ChatGPT at a fraction of the price. The week before, stocks had moved to all-time highs and leveraged ETFs linked to the Trump and Melania cryptos were under development. The bull market, now entering year three, still had swagger. But on Monday, 14 S&P 500 names lost 10% or more, even as the median stock in the index rose 1.3%. The Nasdaq lost 3%, though the equal-weighted index was flat and the Dow closed higher on the day. Nonplussed, retail investors bought the dip, particularly Tech and Industrials, making it the biggest net buy day for them in nearly three years. And market breadth was remarkable. Advancers led decliners in the S&P 500 by more than two-to-one even though the index fell 1.5%. That sort of showing whereby the bulk of index constituents gained while the index itself staggered has not been seen in many years. And now with 50% of the S&P 500 having reported for Q4, 80% beat on earnings, better than the historical average. The size of the aggregate beat (5.9%) and the beat by the median company (4.1%) are also above their historical averages. These earnings beats have been broad-based across sectors. If companies yet to report beat at the current rate, Q4 earnings growth for the S&P 500 is on track to end at 12.4% y/y, up from 8.7% in Q3. This would be the strongest rate of growth in three years. Earnings growth for the median company is also tracking a three-year high of 10.3%. One could be lulled to sleep.

AI is now a race, irrespective of whether we trust China, the number and type of chips used, or the actual price tag. Importantly, the DeepSeek release was deemed “legit” on the main metric that matters—technical viability—as tech leaders from OpenAI and Nvidia, among other companies, tipped their hats to the Chinese firm’s achievement. While struggling with tech import restrictions and a shrinking working-age population, Beijing is likely to subsidize AI, robotics, and other productivity-enhancing technologies. Piper Sandler sees this as a very clear signal to the Trump 47 administration that China does not see itself on the back foot technologically. Interestingly, it was released as open-source software, for world innovators to explore. The next level of evolution in the AI theme is likely to shift from the infrastructure layer to the application layer. The practical implication is it is radically easier and cheaper now to build models to solve very specific domain purposes. The average company will benefit from cheaper AI tools. If indeed AI is coming faster and cheaper, that’s phenomenal news for productivity. Just what we need! Still…

For his part, Pres. Trump called the release a “wake-up call.” Indeed, China has taken a lead in important areas of technology recently, announcing a 6G phone breakthrough, while its EVs have prompted the US and Europe to set up trade barriers. China’s universities give degrees to more science, technology, engineering and mathematics graduates than the rest of the world combined. The challenge doesn’t only come from China, and it’s not just Big Tech that will need to step up. Banks face a major challenge with the advent of payment stablecoin, an access technology for bank deposits – like bank branches, ATMs, debit cards, bank websites and mobile apps. Pres. Trump’s executive order on digital assets opens the door for banks to use stablecoin, but many of them will struggle to let go of their fee-rich legacy payment systems. They better wake up, lest they become financial dinosaurs. With so much of the S&P 500 concentrated in a handful of tech firms, it’s easy to see how a sustained sell-off would raise concerns about a slowdown in consumer spending due to confidence and wealth effects. Nonetheless, the US consumer’s balance sheet is surprisingly well-positioned, with a robust ratio of liquid household assets to total liabilities and the ratio of equity and mutual fund holdings to total liabilities near record highs. Even a 20% decline would leave this metric strong, suggesting the consumer is not particularly fragile right now. This promises to be a volatile year. Next up, Tariff Man! Hey, wake up!

Positives

• Inflation moderates slowly Core PCE, the Fed’s preferred inflation metric, rose 16 basis points in December and 2.8% y/y, a hair better than expectations. At his FOMC press conference, Powell noted a particular interest in y/y figures due to seasonal fuzziness. Fortunately, the next four months have favorable comparables from last year. The labor market does not appear to be an inflation threat, with the Employment Cost Index rising 0.9% for Q4. That indicates a 3.8% 2024 increase, in-line with expectations and down from 4.3% the year before.
• US macro environment Manufacturing surveys from the Dallas, Philadelphia and Richmond Feds all showed gains. Q4 GDP rose at a 2.3% annual rate, a bit below expectations, but real consumer spending gained 4.2%, rising faster than incomes. The FOMC kept rates unchanged, preferring to wait and see how inflation—and tariffs—proceed. Chair Powell maintained that current rates are restrictive and announced a five-year review, noting, however, that this review would not explore raising the 2% target rate.
• Housing’s mixed bag New home sales rose 3.6% m/m in December, beating consensus. New single-family completed homes rose on the month to their highest level since 2009. However, pending home sales declined as did sales of new homes that were not yet started. FHFA home prices rose 0.3% m/m in November while the S&P CoreLogic Case Shiller 20-City index gained 0.4%.

Negatives

• Worried about jobs The Conference Board’s Consumer Confidence Index fell in January to its lowest rate since September; perhaps the LA fires and the cold snap were factors. Unfortunately, the labor differential, which measures those saying jobs were “plentiful” versus those who say they were “hard to get” fell in January, undoing three months of progress. This labor metric is a leading indicator of recessions.
• Durable goods and tariffs Durable goods orders fell 2.2% m/m in December, disappointing expectations they would increase 0.6%. On an ex-transportation basis, however, orders rose as expected. These ex-transportation increases may be tariff related, as they increased just before Trump’s first term tariffs were imposed. Are these orders just pulling activity forward or do they indicate bullishness?
• Eurostagnation Germany’s Ifo business climate survey ticked higher, but the expectations component fell to its lowest level in a year. The drop in expectations may reflect expectations that tariffs will hamper demand. European growth came to a standstill in Q4, but there were divergences, with France and Germany quite weak while Spain showed brisk growth.

What Else

AI could follow the “Jevons paradox” In the 1860s, British economist William Stanley Jevons observed that improved efficiency in the use and burning of coal led, paradoxically, to more consumption of coal rather than less. For Jevons, the paradox meant trouble as he expected it to hasten the exhaustion of England’s finite coal supply. Fun fact: his father-in-law started the Guardian newspaper.

Leverage is a two-way street Some 90% of US imports of barley, oats and potatoes come from Canada. Over 90% of household goods imported to the US are from China. And 83% of US imports of beer made from malt come from Mexico.

WAKE UP! Did DeepSeek simply piggyback upon work that OpenAI and others had previously done? Does it even matter? We have more data center capacity in Virginia alone than exists in all of Europe or China. But we only produce 18% of global AI talent, whereas China produces nearly half.