Inflation's Collapse | AI Dominates Markets | State of Private Equity

Inflation is collapsing, passive investing has a hidden risk, and private equity is flashing warning signs.

In this episode of Off the Charts, Andrew Sarna and Vanessa Hui break down why June's surprise CPI drop may be too good to be true, why passive investing has quietly become a concentrated bet on AI, and why now is not the time to rush into new private equity allocations.

WHAT TO LISTEN FOR

:28 What does June's surprise CPI drop mean for markets and the rate outlook?

3:08 How concentrated is the S&P 500 in AI — and what are the risks for passive investors?

6:50 Where is Forthlane finding genuine diversification away from the AI theme?

8:55 Is now the right time to increase private equity allocations?

CONNECT WITH ANDREW SARNA

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CONNECT WITH VANESSA HUI

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This podcast is for informational purposes only and does not constitute investment advice. Views expressed are those of the speakers and should not be relied upon for investment decisions.

Transcript

Andrew Sarna (00:04):

Welcome back to Forthlane's Off the Charts podcast where every two weeks we cover three market headlines that matter. I'm Andrew Sarna, portfolio manager.

Vanessa Hui (00:11):

And I'm Vanessa Hui, senior client advisor.

Andrew Sarna (00:15):

It's been a bit slow on the macro front. It feels like we're in the dog days this summer, but the three big things we're going to cover this week, inflation's collapse, the singular theme driving markets and the state of private equity.

Vanessa Hui (00:28):

All right Andrew, let's start with inflation. June CPI came in well below expectations and core inflation also surprised to the downside. And month over month CPI recorded its biggest decline since May 2020. What was your reaction to these numbers and how do you think this changes the outlook for markets?

Andrew Sarna (00:49):

Yeah, long duration assets rejoice. So June CPI headline came in at 3.5% below the 3.8% the market was expecting. Core CPI was 0.2% below market expectations. And then when you look at CPI on a month over month basis, it was down 0.4%. The biggest monthly drop since May 2020. Not a single analyst really saw this coming. And I'll be honest, I'm equally as surprised. The drop was driven largely by core prices and transportation services, communication services and lodging, which tend to be pretty volatile categories. So I wouldn't say we should read too much into this, but from a market perspective, the market has fully removed the odds of a hike in July, which had been priced in. There's still a hik priced in till later this year, but that would be it for 2026, which at one point there was two hikes being priced in.

(01:52):

This is a boon for long duration assets such as speculative tech, things like biotech, venture capital, and then things without cashflows like gold and crypto. My gut reaction though is honestly, it's too good to be true, not to get into the conspiracies, but it honestly wouldn't surprise me if some of these numbers were made up. It certainly feels that way. I totally though the lags from spiking energy prices would be flowing through to these numbers over the past couple months because when we think about CPI, these numbers are almost baked into the cake months in advance, essentially spiking energy prices flow through supply chains on a lag. And so I'm a bit surprised even though we saw energy prices come down, that this number is down so much. I was a bit worried that the reigniting conflict in the Middle East was going to be concerned for further inflation and we would sort of be back to where we started.

(02:48):

But I mean, these numbers sort of point to the fact that inflation might be peaking. So I guess it's a good thing for long duration assets. And if you look at the price action today as we record this on Tuesday morning, risk assets are rallying. So risk on, I guess.

Vanessa Hui (03:08):

Now for our second topic, AI and the stock market. The nine largest companies in the US now make up roughly 37% of the S&P 500 and nearly all of them are tied to AI in some way. Andrew, it feels like AI has become the dominant force driving markets today. What should investors make of that?

Andrew Sarna (03:30):

Vanessa, you're totally right. Nine companies make up 30% of the S&P 500, the home to billions and billions of dollars of passive flows. And if you look at those nine companies, they're effectively all AI related. So I'm looking at the list now, Nvidia, Apple, Microsoft, Amazon, Alphabet, Broadcom, Meta, Tesla, Micron. For the most part, these are all AI related companies. So when you are investing in the S&P 500 and just buying a plain ETF, it's not as much as we talk about it being a passive index. It's increasingly being concentrated in one theme and that theme is AI. And then we can look back at Q1 earnings. There was an extraordinary bump driven by other income between Outfit, Nvidia and Amazon. This bump was driven by markups in SpaceX, Anthropic and OpenAI, all AI related once again, pretty much. And this represented 12% of the total index earnings.

(04:36):

So we look at the companies and earnings, they're all being driven by AI. Then if you look at earnings growth across the rest of the index, well, all the non-consensus earnings growth thus far has come from that AI complex. If you look at the biggest IPO of the year, SpaceX, again, they own XAI and they plan to launch data centers in space. So again, AI related. So what do investors do? Maybe we look globally. Well, 26% of the ACWI is again, concentrated in 10 companies and there's really one big addition versus the S&P 500, and that's TSMC. Again, AI related. So maybe we look at emerging markets. Historically, emerging markets indices have been dominated by banks and commodity producers. Well, 30% of the MSEI EM index is concentrated in three companies, Taiwan Semiconductor, Samsung Electronics, and SK Hynix. So all AI supply chain companies. So regardless of where you ultimately look across equity markets, you are sort of investing in this AI theme.

(05:48):

So maybe we can look at alts. Well, looking at venture capital in Q1 2026, 80% of all venture funding was AI related according to Crunchbase. Then we can look at things like private credit. If we think back a couple of quarters and to some of the problems happening within the private credit complex, well, investors were worried Blue Owl was getting over their skis funding data center expansions. Again, AI related. Okay, what about investment grade debt markets? Well, the hyperscalers are increasingly tapping and looking to investment grade markets to continue to fund the build out of these data centers. So regardless of really where you look across the investment universe, if you're taking a broad-based approach, you're getting exposure to this AI theme. And that's all the same. Investors better hope that this works out because if it doesn't, investors are very heavily exposed to a theme you wouldn't want to go sideways.

(06:50):

At fourthline, the things that we're looking at is you really have to get more granular if you want to find diversification. So we're looking at within our absolute return fund, we have some sector specialist managers. We have managers focus on isolating specific inefficiencies like Chinese convertible bond arbitrage that should have very limited exposure to this AI buildup because they're more nichey. Again, if you look on the active management side within our credit portfolio, if you're actively managing in some of these areas, you can avoid some of the AI exposures. And then another area that we're looking at is real assets where multiples remain attractive. And again, you should be a little bit more insulated from this AI build-out. So again, I think from a portfolio construction perspective, we're really just looking at ways to diversify and remove the dependence on one single theme working to drive the portfolio.

(07:55):

From an average investor perspective, I think the easiest thing maybe to look at would be equally weighted S&P 500 exposure, which again, taking this approach, you get more exposure to different companies rather than the top heavy index. Albeit the one dynamic that I think is worth noting is hyperscalers may actually be a nice hedge to some of these AI infrastructure plays because it's ultimately the hyperscalers that are funding the AI infrastructure. So if they pull back, there is a world where the mag seven is rewarded for pulling back on CapEx and that might happen sooner rather than later. There was a headline that just hit the tape today on Tuesday. New York State actually put a moratorium on data center build-out. So it's all to say I think investors need to be a little bit more thoughtful in terms of the bets they're taking because this passive bet of just owning the market is increasingly turning into one big bet on AI.

Vanessa Hui (08:55):

Okay, let's finish with private equity. One question we're hearing from clients is whether now is the right time to increase private equity allocations. Andrew, how are you thinking about the state of private equity today?

Andrew Sarna (09:08):

Yeah, it's a great question. And we're still sort of waiting on private equity to turn the corner from the bubble in 2021. I feel like every quarter we're waiting on exits to increase. But again, the market's sort of concentrated in this AI theme. And while that is getting rewarded, the broader market hasn't really been rewarded and the exit window hasn't really opened up for these companies. Fundraising activity looks fine. Exit activity looks fine and steady. Again, below the bubble years of 2021, but stable. But stable isn't really enough. The challenge that the market is facing that assets under management have increased, but distributions have not increased proportionately. And the problem that some of these mature plans are having is that they're being forced to outlay more cash than they're receiving. So capital calls are coming in faster than distributions are being made. So it ends up being a capital suck, which a lot of these institutions never really plan for.

(10:18):

We're also seeing the largest firms continuing to attract more capital. There's a saying in the industry, nobody really gets fired for hiring Blackstone. And I mean, you're seeing this through. I think a problem that I see is that a lot of allocators don't really question these things from first principles perspectives. It's just like private equity outperformed for 10 years, so let's add more private equity. And I think we really need to be asking ourselves why should we be investing in private equity? And that dovetails into one of the themes that we're seeing is that the market remains so expensive. You really have two sides of the equation. You have multiples, which as more capital has flown into private equity, multiples have steadily increased and that's going to be a major driver of returns. We look back at the past decade, about half returns were driven by multiples increasing, which we can't really count on that moving forward.

(11:16):

And then the other side of the equation is cost of fundraising and we need the Fed funds rate to fall if we want to see this market get more attractive from a financing perspective. Until then, I think returns aren't going to be overly exciting. Again, thinking about from a first principles perspective, why am I buying this? Well, there was a time when private equity firms were buying companies at four to six times earnings and now it's in the double digits. So you just have less of a margin of safety. Another major theme in the space is software. I mean, this is the same theme that is hitting the private credit world and the private credit world is panicking over it. And I mean really I think private equity should be more worried about it because if the credit is being impaired, definitionally speaking, it almost means that the equity is going to zero.

(12:11):

So there's private equity franchises like Vista and Thoma Bravo that are likely sweating profusely on portfolios of software companies that could be getting disrupted by AI. And so they are going to be very challenged moving forward. And one of the last themes we look at are where are companies exiting relative to where they are held on their books? And if you look back five years, it was common for companies to get a pop when they exited relative to their bookmarks. That's not really happening anymore and companies are exiting at prices near where they are held on the books. And that again, just means there's pricing pressure, which means again, worried about prices coming under pressure rather than companies being able to exit at very attractive valuations. And then the last thing as an investor I'd be thinking about is just what are the fees I'm paying?

(13:16):

Two in 20 is sort of a mountain to climb out from under. I remember looking at an investment that displayed 14% gross returns in a 2021 vintage, which is a challenging vintage. But to the end investor, that was a net 9%. So when I just think of things, if you're paying 5% in fees, that just means the private equity firm ultimately needs to deliver over 5% of alpha over that public market equivalent. And we'll say that is the Russell or the S&P 500, and you're going to be paying anywhere between 0.02 to 20 basis points for that exposure. So the private equity firm, yes, they might be adding value, but you have to make up for that 5% of fee drag, which is a lot. So certainly not banging the table. I think when I think about it from a first principles perspective, it's wait and see.

(14:18):

I'm certainly not rushing to allocate to private equity right now.

Vanessa Hui (14:22):

So to summarize some investor takeaways, number one, markets are rejoicing to low CPI numbers. We'll have to see whether that lasts. Number two, passive investors should really evaluate their portfolios to review how much exposure to AI they're comfortable with. And finally, given elevated multiples and private equity's exposure to a challenged software sector and high fees within the private equity space, we're not rushing to increase client exposure to private equity.

Andrew Sarna (14:54):

That's a wrap for this week's episode of Off the Charts. Thank you for listening. Thanks for your time. Let me know your thoughts on the pod. Shoot me an email. Leave a rating, a review on your favorite podcast listening app, and please share it with somebody. I