Sundar: We’re moving from infrastructure to the application layer

Here's a summary of the YouTube video transcript, maintaining the original language and technical precision:

Key Concepts

• AI Value Chain: The entire ecosystem of companies involved in artificial intelligence, from infrastructure providers to application developers.
• Valuations: The perceived worth of a company, often determined by market sentiment, earnings growth, and future potential.
• Fundamentals: The underlying financial health and performance of a company, including earnings, revenue, and profitability.
• Earnings Growth: The increase in a company's profits over a specific period.
• Private Markets vs. Public Markets: Private markets involve investments in companies not listed on stock exchanges, while public markets involve publicly traded companies.
• Infrastructure Stage: The foundational elements of a technological evolution, such as semiconductors and cloud computing.
• Application Layer: The stage where technology is used to build specific products and services.
• Software as a Service (SaaS): A software distribution model where a third-party provider hosts applications and makes them available to customers over the Internet.
• Services as Software: A potential shift where services are delivered and managed in a way analogous to software.
• AI Trade/Buildout: The current investment and development activity surrounding artificial intelligence technologies.
• GDP (Gross Domestic Product): A monetary measure of the market value of all the finished goods and services produced in a specific time period.
• Capacity Buildout: The expansion of production or service capabilities.
• Overcapacity: A situation where the supply of goods or services exceeds demand.
• Excess Leverage: The use of borrowed money to finance investments, which can amplify both gains and losses.
• Compute Constrained/Power Constrained Economy: An economy where the availability of computing power and electricity limits growth.
• Data Center Vacancy Rates: The percentage of available space in data centers that is not occupied.
• Inflation: A general increase in prices and a fall in the purchasing value of money.
• Fed Rate Cut: A reduction in the target interest rate set by the U.S. Federal Reserve.
• Sticky Inflation: Inflation that remains persistently high and resistant to decline.
• Moderating Economic Growth: A slowdown in the rate of economic expansion.
• Inflation Protection: Investment strategies or assets designed to preserve purchasing power during periods of rising prices.
• Post-GFC (Global Financial Crisis) to Pre-2022 Timeframe: The economic period following the 2008 financial crisis up until the beginning of 2022.

Valuations in the AI Value Chain: Public vs. Private Markets

Sundar, Head of Investment Strategy at JP Morgan Private Bank, addresses the surging valuations in the artificial intelligence (AI) value chain, a key concern for both public and private market investors. The primary metric for assessing these valuations is their support by fundamentals and earnings growth.

• Public Markets: Valuations for hyperscalers and areas that have seen significant returns in the past three years have actually contracted. This is because their earnings growth has more than doubled, outpacing valuation increases.
• Private Markets: A "tale of two cities" is unfolding. There are pockets of isolated froth in certain parts of the early-stage private markets. This suggests a need for selectivity, even though the public markets are also facing similar calls for selectivity.

The discussion highlights the importance of an investor's position within the AI value chain. Historically, value has accrued to the infrastructure stage (semiconductors, hyperscalers, power infrastructure). However, there's a belief that the market is on the precipice of a shift towards the application layer, moving from Software as a Service (SaaS) to what is termed Services as Software. This shift presents meaningful opportunities within private companies, but the presence of froth necessitates a selective approach.

The AI Trade: Bubble or Sustainable Growth?

A new report by JP Morgan Private Bank examines the "AI trade," which many perceive as a bubble. The report argues that the AI buildout is not going anywhere and has significant room for growth.

• AI's GDP Contribution: Currently, the AI trade represents approximately 1% of GDP. This is significantly lower than previous technological revolutions like railroads and electricity, which accounted for 2% to 5% of GDP during their buildout phases.
• Framework for Assessing Bubbles: The report uses a four-part framework to determine if AI is in a bubble:
  1. Excess Capacity/Overcapacity: Is there too much supply being built?
  2. Valuations: Do valuations align with fundamentals?
  3. Fundamentals Justification: Are earnings and growth supporting current valuations?
  4. Excess Leverage: Is there too much debt in the ecosystem?

Findings:

• Currently, there are no signs of excess capacity being built.
• Valuations appear to be justified by fundamentals.
• There are no signs of excess leverage.

Capacity Constraints: The most significant point is that the economy is currently compute constrained and power constrained. This is a stark contrast to the late 1990s/early 2000s, where there was underutilized fiber optic cable capacity. Current data center vacancy rates are at multi-year lows, and demand continues to far outstrip supply. This suggests that the AI investment cycle has years to go.

Inflation and the Macroeconomic Environment

The conversation shifts to inflation and its importance to investors, especially in the context of an expected Fed rate cut. Despite inflation being above the 2% target, it hasn't stopped the bull market or new record highs. The focus is on valuations, not inflation, as the primary market driver currently.

• Changed Macroeconomic Landscape: The current macroeconomic environment is significantly different from the post-GFC to pre-2022 timeframe.
• Inflation Outlook: Inflation is likely to peak sometime mid-next year and then taper off. However, it is expected to remain above the Fed's target.
• Interest Rate Outlook: Consequently, rates are likely to stay higher for longer than historically observed. They will come down but will persist at elevated levels.
• Implications for Portfolios: This scenario of higher-for-longer rates and potentially stickier inflation, coupled with moderating economic growth, necessitates a shift in portfolio building blocks to ensure durable returns.
• Need for Inflation Protection: This is primarily because, during periods of elevated rates and inflation, bonds do not offer the same level of protection. The transcript notes that there have been periods where bonds have not performed as expected in such environments.

Synthesis/Conclusion

The AI trade is characterized by robust growth potential, driven by fundamental demand and a lack of overcapacity, despite some isolated froth in early-stage private markets. The current AI buildout is still in its nascent stages relative to historical technological revolutions, with significant runway ahead due to compute and power constraints. Investors need to be selective, particularly in private markets, and focus on the application layer of the AI value chain. Concurrently, the macroeconomic environment is shifting towards higher-for-longer interest rates and persistent inflation, necessitating a strategic re-evaluation of investment portfolios to include inflation protection and ensure the durability of returns.