Weekly: October 4th, 2024

Stocks that may benefit from the AI craze; market recap (macro and policy)

TL;DR

In section 1, my focus is on AI, energy, and related infrastructure. I give some themes and relevant stocks that may benefit from the AI infrastructure buildout.

Sector Theme: AI, Data Centers, and Nuclear Energy

• Global data center investments reached $215B in 2023, driven by AI's increased computational demands

• AI chips consume 3-4x more power than traditional CPUs, stimulating growth in infrastructure and energy sectors

• Nuclear energy sector revitalized by ADVANCE Act and IRA legislation

• Tech companies (MSFT) securing long-term nuclear power agreements; Constellation Energy emerges as a significant player

In section 2, I give an update on the markets and the business cycle. Themes covered include valuations, growth, inflation, labor, and fiscal / monetary policy.

US Macro Update

• Market metrics: Forward P/E at 21.5x, bulls-bear spread at 18.2% - elevated but not at historical extremes

• U.S. economy demonstrates resilience: 3% GDP growth, 35% YoY increase in stock market as of October 3, 2024

• Inflation outlook: Moderating trend, with potential upward pressures from wage growth and housing costs

• Labor market strength: Employment growth exceeds forecasts (+254K vs 140K), wages increase 4% YoY

• Monetary policy: Continued easing expected, though market projections have shifted dramatically (probability of 50bps cut in November at 5% vs. 65% yesterday)

• Fiscal policy: remains expansionary, potentially constraining the Fed's monetary policy options

Sector Theme: AI

AI has dominated recent headlines. OpenAI secured $6.6 billion in funding, marking the largest venture capital deal to date and valuing the company at $157 billion.

Another significant AI development was Microsoft's deal with Constellation Energy to purchase power from Three Mile Island, enabling the restart of an 835 megawatt (MW) nuclear facility in the area. The location of the plant is notorious - it was the site of the worst-ever nuclear accident on US soil when a partial meltdown of one of its reactors occurred in 1979.

This highlights a secondary benefit of the AI boom - increased demand for data center infrastructure and energy nationwide. Let’s dig in.

BofA Global Research. “Who Makes the Data Center” (09 September, 2024)

Chips & Data Centers

AI growth fuels demand for data center infrastructure

Global data center investment reached $215 billion in 2023, of which data center infrastructure was $55 billion (remainder was for servers / networking / storage)

• Relevant Stocks: Data center servers, networking, engineering & construction

  • Servers ($25.0mn/MW)

    • Dell Technologies (DELL)

      • Provides a wide range of IT solutions, including servers.

    • Hewlett Packard Enterprise (HPE)

      • Offers enterprise-level servers and IT solutions.

  • Networking ($3.6mn/MW)

    • Cisco Systems (CSCO)

      • Global leader in networking and IT infrastructure.

    • Arista Networks (ANET)

      • Provides cloud networking solutions for data centers.

    • Juniper Networks (JNPR)

      • Develops networking products for service providers and enterprises.

  • Engineering ($0.4mn/MW)

    • Jacobs Solutions (J)

      • Provides technical, professional, and construction services.

    • WSP Global (WSP.TO, trades on Toronto Stock Exchange)

      • Provides management and consultancy services to the built and natural environment.

  • Construction ($0.9mn/MW)

    • Turner Construction (Subsidiary of HOCHTIEF, traded as HOT.DE)

      • One of the largest construction management companies in the US

Bank of America projects the AI chip market will reach $200 billion by 2027, up from $44 billion in 2023, representing a 46% CAGR.

• Relevant Stocks: AI Chips

  • NVIDIA Corporation (NVDA)

    • NVIDIA is a leader in AI chip production, particularly GPUs used in data centers for AI applications.

Data center capacity grew at an 18% CAGR over 2018-2023, indicating robust demand for data processing capabilities (Bank of America).

• Relevant Stocks: Data center REITs (Real Estate Investment Trusts)

  • Equinix, Inc. (EQIX)

    • As a global data center REIT, Equinix is well-positioned to benefit from the expanding data center capacity.

  • Digital Realty Trust, Inc. (DLR)

    • Second-largest data center REIT

  • CyrusOne Inc. (CONE)

    • Operates data centers for hyperscalers and enterprise customers

Power and Related Infrastructure

AI chips consume 3-4x more electrical power than traditional CPUs, necessitating more cooling and power management resources (Bank of America). Jigar Shah, head of the Loan Programs Office at the Department of Energy, estimates that data centers will require approximately 25,000 megawatts of new electricity load by the end of the decade.

• Relevant Stocks: Electrical Equipment

  • Schneider Electric (SBGSY, ADR) - 24% market share

    • Their power management systems are crucial for handling the increased power demands of AI chips in data centers.

  • Vertiv (VRT) - 16% market share

    • Their power distribution units (PDUs) and uninterruptible power supplies (UPS) are crucial for managing the increased power loads in data centers.

  • Eaton Corporation (ETN) - 14% market share

    • Power management company offering electrical products.

  • ABB Ltd (ABB) - 11% market share

    • Offers electrification, robotics, and motion solutions.

Average rack density in data centers has more than doubled since 2017, from less than 6kW to approximately 12kW in 2023 (Bank of America). The thermal management market for data centers was worth approximately $6.2 billion in 2023, with liquid cooling solutions gaining traction (Bank of America).

• Relevant Stocks: Thermal Equipment

  • Vertiv (VRT) - 24% market share

    • Offers both air and liquid cooling solutions for data centers

  • Johnson Controls (JCI) - 15% market share

    • Their cooling systems are crucial for maintaining optimal temperatures in high-density data centers.

  • Stulz (Private) - 11% market share

    • Specializes in mission-critical air conditioning systems.

  • Trane Technologies (TT) - 7% market share

    • Their advanced cooling technologies help manage the increased heat output from denser server racks.

  • Carrier Global (CARR) - 7% market share

    • Their cooling solutions are important for addressing the thermal management needs of high-density data centers.

  • SPX Technologies (SPXC)

    • Provides cooling tower solutions for managing the heat generated by higher density racks.

Nuclear Energy

A combination of economic incentives, favorable policies, and strategic investments has sparked a nuclear energy renaissance in the United States.

• President Biden signed the bipartisan ADVANCE (Accelerating Deployment of Versatile, Advanced Nuclear for Clean Energy) Act into law in 2024

  • The Act will incentivize and support nuclear energy deployment in the US

• The Inflation Reduction Act (IRA) and associated programs provide significant financial support for nuclear projects.

  • The IRA offers technology-neutral tax credits of up to 3 cents per kilowatt-hour for clean energy production. There is also a separate option for 30% investment tax credits, with additional bonuses for domestic content and energy community involvement.

• The Department of Energy's Loan Programs Office expanded lending capacity from $40 billion to over $200 billion.

  • The Palisades nuclear plant in Michigan, which was shut down in May 2022, has now announced a reactivation date by late 2025 with a $1.5 billion loan from the Biden Administration.

  • Major banks are also pledging financial support for nuclear projects

    • Relevant Stocks: Banks

      • Bank of America, Barclays, PNP Paribas, Citi, Morgan Stanley and Goldman Sachs are expected to support the COP28 goal of tripling global nuclear power capacity by 2050.

• Tech giants such as Microsoft and Meta are securing round-the-clock clean power through nuclear energy agreements.

  • Long-term power purchase agreements with technology giants like Microsoft provide reliable financial foundations for nuclear investment. The use of contracts for differences (CFDs) help manage market price risks and ensure stable returns.

  • Relevant Stocks:

    • Constellation Energy (CEG)

      • Constellation Energy's stock price rallied on news that they signed a 20-year power purchase agreement with Microsoft.

US Market Update

Valuations

While valuations (21.5x forward P/E) and positioning (18.2% bulls-bear spread) are high, they have not reached extreme levels

• S&P 500 Valuation: As of October 3rd, 2024, the S&P 500 index closed at 5,700, marking a 35% year-over-year increase (Syz Group). The index has a forward P/E ratio of 21.5x—significantly above the 30-year average but not at an extreme. The U.S. stock market's valuation is almost 2x GDP (Syz Group).

• EPS Growth: S&P 500 companies are projected to achieve EPS of $241 in 2024 (9.4% growth), with profit margins at historical highs of 12.9%.

Key risks include:

• Concentration Risk: Market gains are largely driven by a small number of large-cap technology stocks. The top 10 stocks account for 35.8% of the S&P 500's market capitalization, trading at a higher P/E ratio of 30.5x.

• Inflation Risk: Rising input costs (PCE inflation at 2.2% YoY) and wage inflation (4% YoY) may constrain future earnings.

• Labor Market Strength: U.S. job growth accelerated (+254K) and unemployment rate decreased to 4.1%, signaling a strong labor market. Furthermore, wage growth remains elevated (4% YoY vs. consensus forecast of 3.8%). This may reduce the likelihood of a 50bps Fed rate cut in November.

• Potential Rotation to Value: Value stocks currently trade at a forward P/E of 16.7x compared to 28.6x for Growth stocks. Historical patterns suggest value stocks may outperform in rising interest rate environments (JPMorgan Guide to the Markets for Q4 2024).

• Positioning: According to the AAII Sentiment Survey, bullish sentiment is at 45.5% and the bulls-bear spread is at 18.2%. While elevated, this does not fall into an extreme zome (within 1 standard deviation from the LT avg. of 37.7%)

US Macro Update

Growth

The U.S. economy shows robust GDP growth and improving fundamentals

• GDP Growth: Real GDP expanded at an annualized rate of 3.0% in Q2 2024

• Corporate Profits: Corporate profits in the U.S. are near all-time highs as a share of GDP, approaching 15%, indicating strong business performance (Apollo Global Management data).

• Savings & Debt Burden: The saving rate (5.2%) is below the historical average but not at an extreme. However the Debt Service Ratio (DSR) increased to 10.1% in Q3 2024, indicating higher debt burdens.

Inflation

While inflation is expected to continue moderating, potential resurgence risks include wage growth (4% YoY) and rising housing costs (+5% YoY).

• PCE Inflation: On a year-over-year basis, the PCE index climbed 2.2%, close to the Fed's 2.0% long-term inflation target (Bloomberg).

• Moderating Services Prices: Services prices excluding housing and energy rose 0.2% for a second month, suggesting moderating inflation in a key sector (Bloomberg).

• Housing Costs Rising: The S&P CoreLogic Case-Shiller Home Price Index is showing an upward trend (+5% YoY), suggesting potential inflationary pressures in the housing market (Apollo Global Management data).

  • Mortgage rates are declining, dropping from peaks above 7% to around 6%, which could stimulate housing demand and potentially contribute to inflationary pressures (Apollo Global Management data).

Labor

The labor market was incrementally stronger this month

• U.S. job growth accelerated (+254K) and unemployment rate decreased to 4.1%

• Wage Growth: Wage growth remains elevated, with Average Hourly Earnings growing at 4% YoY vs. consensus forecast of 3.8%

  • The Indeed Wage Tracker also shows signs of wage growth rebounding, indicating persistent labor market pressures (Apollo Global Management data).

  • Immigration remains strong, with the working-age immigrant population trending upwards, potentially helping to address labor shortages and moderate wage inflation in certain sectors (Apollo Global Management data).

  • The job finding rate remains strong, hovering around 30-35%, indicating a tight labor market that could sustain wage pressures (Apollo Global Management data).

Monetary and Fiscal Policy

Monetary Policy: While the Fed is expected to continue easing financial conditions, futures markets have shifted dramatically on the magnitude of rate cuts this morning.

• The Fed enacted a 50 basis point rate cut, the first in four years (BlackRock). Historically, the S&P 500 gains an average of 8.5% in the 18 months following the first rate cut (Syz Group).

• Market pricing for another 50 bps rate cut at the Fed's next meeting has dropped from 65% (yesterday) to 5% this morning. This was due to the hot jobs report released today showing employment growth exceeding forecasts (+254K vs 140K).

• Default rates on leveraged loans are declining, potentially giving central banks more room to ease policy without immediate financial stability concerns (Apollo Global Management data).

Fiscal Policy: The U.S.'s ongoing loose fiscal policy may constrain the Fed's ability to cut rates in the future (BlackRock report).

• The federal deficit is projected at $1.9 trillion, with net debt reaching 97.7% of GDP in 2024 and potentially 131.8% by 2034. The U.S. has entered a period where fiscal policy, rather than monetary policy, is increasingly driving economic outcomes. Large structural deficits may make it more difficult to bring CPI down to the 2% target.

• Total federal spending is estimated at $6.8 trillion in 2024.

  • An aging population will elevate Social Security and Medicare costs

    • Medicare & Medicaid: $1.7 trillion (25%)

    • Social Security: $1.5 trillion billion (21%)

  • Interest payments on our debt outpaced defense spending for the first time

    • Defense: $1 trillion (14%)

    • Net Interest Payments: $1.1 trillion

Works Cited

Apollo Global Management. "Quarterly Economic Outlook" 2024.

Bank of America. “The Future of AI Chips”. Bank of America Research, 2024.

BlackRock. “Monetary Policy Update”. BlackRock Investment Institute, 2024.

JPMorgan Chase & Co. "Guide to the Markets - Q4 2024" J.P. Morgan Asset Management, 30 Sep. 2024.

Shah, Jigar. “Three Big Things Driving the Nuclear Energy Revival" Odd Lots, 24 Sept. 2024

Syz Group. “Market Insights and Analysis”. Syz Group Publications, 2024.

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