$1 Trillion AI Bet. $10 Billion in Profits | Bob Elliott on the AI Income That Isn’t Coming

Key Concepts

Late Cycle Environment: An economic phase characterized by a strong economy that is beginning to slow down due to factors like high inflation, central bank tightening, and potentially restrictive government policies.
Disconnect between Financial Markets and Real Economy: A situation where stock markets are pricing in strong future outcomes, while actual economic conditions, particularly in the labor market, are weakening.
Income-Driven vs. Debt-Driven Cycles: The distinction between economic expansions fueled by household and business income versus those driven by credit. Income-driven cycles tend to be slower moving.
Tariffs: Taxes imposed on imported goods, which can have an inflationary effect and act as a drag on consumer spending.
Quantitative Tightening (QT): The process by which a central bank reduces the size of its balance sheet by allowing assets to mature without reinvesting the proceeds.
Ample Reserves: A concept in monetary policy where banks hold a sufficient level of reserves to ensure smooth functioning of the financial system.
AI Mania: The current market enthusiasm and investment surge driven by artificial intelligence, which is significantly impacting stock market performance and corporate spending.
Consumer Surplus: The economic benefit consumers receive when they are willing to pay more for a good or service than they actually do. This is not directly beneficial to GDP.
Information Asymmetry: A situation where one party in a transaction has more or better information than the other, creating an advantage. This is a key concern in private markets.
Hedge Fund Replication: The process of using technology to mimic the strategies and returns of hedge funds, often at a lower cost and with greater transparency.

Economic Environment and Market Disconnect

The current economic landscape is described as a "typical late cycle environment." Following a strong post-COVID recovery, high inflation prompted central bank tightening, which has begun to slow economic conditions. This slowdown has been exacerbated by government policies such as curtailing immigration and increasing tariffs, which have negatively impacted growth.

A significant observation is the disconnect between financial markets and the real economy. While equity markets are pricing in strong outcomes, real economy conditions are weakening, most notably in the labor market. This divergence between high expectations and weakening reality is a common characteristic of late-cycle phases. The challenge lies in maintaining agility to adapt to these shifting expectations.

Labor Market and Wage Growth

The labor market is identified as the weakest point. Data, even with the disruption of government shutdowns, indicates that job growth has been near zero, and wage growth has continued to moderate. This suggests that households have limited real spending power, with real spending power growth estimated at 0-1% annually.

Inflation and Tariffs

Inflation, while trending down, remains above the Federal Reserve's 2% target, hovering around 3%. The introduction of tariffs has had an inflationary effect, offsetting some disinflationary pressures like cooling rents. Tariffs are estimated to have a modest inflationary impact, potentially a few tenths of a percent more, and are also acting as a drag on consumer spending by reducing available funds for real spending.

It's noted that companies have absorbed a significant portion of tariff costs, with households bearing approximately 60% and U.S. businesses 40%, while foreigners absorb none. This translates to a roughly 1% drag on consumer spending annually, which is meaningful but not immediately noticeable in any single month.

Federal Reserve Policy and Market Expectations

The recent rally in financial assets was largely driven by the expectation of significant Federal Reserve rate cuts. Fed Chair Powell's Jackson Hole speech signaled a focus on the labor market over inflation, leading to expectations of a substantial cutting cycle.

However, there's a growing indication that the Fed might not cut rates in December, with several Fed speakers reinforcing this message. This potential disappointment could impact markets that have priced in aggressive easing.

The Case for and Against Rate Cuts

There are differing perspectives on the Fed's next move:

Dovish View (e.g., Myron): Argues for rate cuts due to concerns about downside risks, believing elevated inflation is transitory and that the Fed is significantly restrictive. This view emphasizes the need to return to more normal policy levels.
More Hawkish View: Points to elevated measured inflation and a strong labor market (despite some softening) as reasons to maintain current interest rates or even tighten further.

The Fed faces a challenging situation with conflicting data points: elevated inflation, a softening labor market, and a stable unemployment rate influenced by supply-side factors. The speaker expresses sympathy for the view that inflation pressures will peak and fade, and that the labor market and demand are weaker than perceived, suggesting proactive easing might be warranted to avoid a self-reinforcing negative dynamic.

Economic Cycles and AI's Impact

The economy is characterized as being in a slow-moving, income-driven cycle, rather than a debt-driven one. Credit is not the primary driver of the current expansion. Household and business spending is largely financed by income and free cash flow.

The AI investment boom has provided a temporary boost to GDP, but its overall impact is limited as it represents only about 1% of the economy. The sustainability of this spending is questioned, especially as companies begin to borrow.

The AI Mania and Real-World Impact

The current stock market rally is heavily concentrated in a few large-cap tech stocks, driven by "AI mania." While AI spending is boosting corporate profits and contributing to economic growth, the real-world income generation from AI is questioned.

Meta's Example: Meta's advertising revenue has increased by a few billion dollars, but this is a poor return on a $70 billion annual investment in AI capex.
Amazon AWS: A $20 billion annual revenue increase from AWS comes after a $125 billion investment, indicating a poor deal.
OpenAI: Claims a need for $1 trillion in investment over two years while earning $10 billion annually, suggesting an unrealistic economic model without exponential growth.

The core issue is whether AI adoption will lead to increased profitability and GDP growth, or if it will primarily result in job losses and reduced consumer spending. Techno-optimists often fail to address the macroeconomic consequence of job displacement on aggregate demand.

Private Markets and ETFs

The discussion touches on the trend of bringing private market assets (private equity, private credit) into the ETF space.

Concerns with Private Markets

Rich People Aren't Making Money: Data suggests that, net of fees, returns in private alternative assets have been negative relative to public market benchmarks over the last 30 years.
Information Asymmetry: Private markets suffer from significant information asymmetry, where issuers can advantage certain investors by withholding information. This creates opportunities for "grifters" to exploit retail investors.
Fraudulent Practices: An example is given of a venture capital access fund (DXYZ) with a stated management fee of 2.5% but a total fee load of 7.5%, highlighting potential outright fraud.
Conflicts of Interest in Private Credit ETFs: The structure of private credit ETFs, where a third party (e.g., Apollo) provides a bid for illiquid assets, creates potential conflicts of interest. Apollo could sell "crap assets" at elevated prices or offer low bids during redemptions, disadvantaging retail investors.

The Role of ETFs in Private Markets

While ETFs offer liquidity and transparency, bringing illiquid private assets into them is challenging. ETFs must hold primarily liquid assets, meaning that even in a private credit ETF, a significant portion will be in public instruments, diluting the exposure to the intended private asset class.

Unlimited ETFs and New Strategies

Unlimited ETFs aims to provide diversified, low-cost strategies, including hedge fund replications, for all investors. They have launched three new ETF strategies this year:

Equity Long/Short: Targets equity index-like risk for greater cash efficiency.
Global Macro: Aims to generate returns in both positive and negative market environments by tactically positioning long and short.
Managed Futures: Offers exposure to this strategy with equity index-like risk.

These strategies are built using a "third-generation replication" approach, employing Bayesian machine learning to infer hedge fund positions in near real-time, allowing for more tactical alpha capture.

The Vision for Alternative Asset ETFs

Unlimited ETFs is exploring the concept of low-cost indexing for alternative assets like venture capital, aiming to bring these strategies to a broader investor base at a lower cost than traditional hedge funds. The goal is to offer differentiated performance through diversification and fee reduction, which are identified as persistent sources of alpha. The new ETFs aim to reduce overall fee loads by 85-90% compared to typical hedge funds, while also offering advantages like tax efficiency, liquidity, and transparency.