Hyperscaler Selloff | The Taco Index | Fed on Hold

AI Capex is rattling markets, Trump has a new policy trigger, and the Fed's new chair faces his first big test.

In this episode of Off the Charts, Andrew Sarna and Vanessa Hui break down why hyperscalers spending $700 billion on AI infrastructure is spooking investors, why Trump's decision to return to the negotiation table with Iran is best understood through a four-variable "taco index," and why new Fed Chair Kevin Warsh is almost certain to hold rates, even as hike odds climb.

WHAT TO LISTEN FOR

:32 Why is the market punishing hyperscalers for their AI CapEx spending?

1:42 Are the Mag Seven turning into the next commodity producers? 2:48 What is the taco index and how does it predict Trump's next move?

5:38 What should investors expect from new Fed Chair Kevin Warsh this week?

7:37 How is AI reshaping the real economy and what does it mean for rate hikes?

CONNECT WITH ANDREW SARNA

Website | LinkedIn

Off the Charts Newsletter  

CONNECT WITH VANESSA HUI

Website | LinkedIn 

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 (00:14):

Three big things to cover this week, AI CapEx, Trump's taco line, and Warsh's decision this week.

Vanessa Hui (00:21):

All right, Andrew, let's get started. So last week, Google announced they were once again increasing CapEx during last week's earnings call. The market did not like it. What is going on?

Andrew Sarna (00:32):

The moment this was mentioned on Alphabet's earnings call last week, the stock plummeted. The following day, the entire basket of hyperscalers plummeted as well. The Mag seven finished the week down 5.7%. We have another wave of hyperscaler earnings this week that we'll see what happens given there was a slight rerating last week, but the market is ultimately concerned that these companies are overspending on the data center build-out and won't be able to generate an acceptable return from all their investment in building out this infrastructure. And it's really hard to tell. The scale of the build-out is enormous. It's nearing $700 billion for 2026, and that is almost equivalent to the entire defense budget of the US. And their business models are also transforming. They're transforming from asset-like businesses into asset-heavy businesses. And that raises the question, will they command lower multiples? They used to be these amazing asset-light businesses that they could sell an incremental unit and there was no incremental cost associated with it.

(01:42):

And now they're almost turning into commodity producers. I'm almost thinking of these hyperscalers as they're turning into the next ExxonMobil. So as long as the world remains short and computer scarce, they can generate an acceptable return on this CapEx. But the moment the market becomes oversupplied, it's going to get really ugly. And as a commodity investor, you see this time and time again. High prices drive this investment cycle, and oftentimes overinvestment is occurring. And then on top of that, when we think about broader US equity markets, 10 companies represent almost 40% of the index. So this single dynamic is going to dictate the entire direction of US equity markets.

Vanessa Hui (02:35):

And onto our second topic, the US once again announced over the weekend that they were close to a deal with Iran causing oil prices and yields to fall on Monday. Andrew, why are we hearing this news all of a sudden?

Andrew Sarna (02:48):

We're hearing this news because there's a new taco index. The first aspect of the new index is oil prices. Why does this matter? Number one, you have prices at the pump into midterm, so general consumer happiness as we approach the time to vote. And then secondly, you have oil prices impacting broader inflation, which flows through the entire economy. So Trump really needs inflation to be lower. The second element of the index when we're trying to figure out if Trump is going to taco is the US 10 year. If we remember back to 2022, one of the reasons that caused the selloff was rising interest rates. And there is a level where if rates rise too far, it's going to cause financial market dysfunction and the market will begin to sell equities. So as you know, one of Trump's barometers for success is the equity market.

(03:46):

And then secondly, it impacts US borrowing costs. So the deficit is already over 5% a year. And as the 10 year rises, it costs more for the US to borrow. Third element of the index is the inverse S&P 500. So as the market falls, Trump is going to get closer to tackling. People are just happier when they are feeling rich, and this matters as we approach midterms. And then lastly, the last element is the US dollar. This one is a little less relevant, but Trump and Bessent, they want a weaker USD because it makes US industry more competitive. And one of Trump's objectives is to re-industrialize the US. So what happened over the weekend to drive this piece of deal, and I'll say piece in quotation marks, oil went from 70 to $100 in the past month, and the US 10-year went from 435 to 4.7 in the past month, hitting new 2026 highs, surpassing the peak in May.

(04:55):

So Trump, and I wouldn't be surprised if Bassent also had input into this, but they were feeling antsy and they made the decision that is too close to midterms. And regardless of the reality on the ground, it was not time to escalate. So back to the negotiating table we go, and I'd expect this sort of muddle along into midterms, and Trump will try not to escalate any further before votes are cast.

Vanessa Hui (05:28):

Finally, the market's attention will shift to the Fed meeting later this week. Andrew, what do you expect out of the relatively new chair of the Federal Reserve, Kevin Warsh?

Andrew Sarna (05:38):

Yeah, Kevin Warsh was appointed by the current administration. And while the Fed is independent, I really don't expect him to go off script. I mean, the market always expected an insider to be nominated and appointed as the Fed chairman. So I don't think we're going to see an overly hawkish Warsh trying to make him the center of attention. That would just be crazy. I do think we are in a world though where there is much more coordination between fiscal and monetary policy. You know what? Budgets are just in a place where this is almost a requirement. And the reality is there's certainly a line of communication between Scott Bessent and Kevin Warsh. With that being said, nine of 18 Fed officials at the last meeting projected a hike this year. Forward guidance has been eliminated, meaning we have less information to go off to figure out what the Fed's intentions are.

(06:40):

Really one of the last signals is Fed speak where the governors are going to make statements and it's left to us to interpret it. So PolyMarket has about a 25% odds that there will be a hike at the July meeting. For 2026, there's a 72% chance that we get a hike by the end of the year, according to PolyMarket. Now, market implied odds are a little bit higher than this. They're closer to 40% for a hike this meeting. But the reality is there's a reason Trump tacoed over the weekend. He didn't want to give Warsh another reason to potentially hike. I think it's pretty clear that Warsh isn't going to make himself the star of the show. And he's probably going to go pencils down on this one and there's going to be no movement on the Fed funds rate. It's also not even clear how strong the real economy is anyways.

(07:37):

A material amount of GDP is being driven by AI. And outside of that, the lower end consumer continues to struggle. The job market is still dominated by government jobs, and you still have this overhang that AI could disrupt the job market further. I'm not even sure a hike would accomplish anything because it's not like a lot of the interest rate sensitive parts of the market are humming along at too fast of a speed and hiking interest rates isn't going to lower oil prices anyways.

Vanessa Hui (08:09):

So to summarize, one, the market has been selling off because investors are questioning whether hyperscalers can really generate adequate returns on their massive AI CapEx spending. Two, high oil prices and a rising US 10 year has forced the US back to the negotiating table with Iran. And three, we're not expecting a hike at the Fed meeting later this week.

Andrew Sarna (08:37):

That's it for this week's Off the Charts. Thank you for listening. Thanks for your time. Let me know your thoughts on the pod. Should be an email, subscribe to the newsletter, leave a rating or review, and please share it with somebody who you think would appreciate it. I