Talk Your Book: Will AI Debt Cause a Recession?

Oracle

Across the shows: 5 speakers in other episodes, 0 bullish and 4 bearish calls, past 30 days

• Bill Eigen · J.P. Morgan Asset ManagementBearish

  Oracle's negative cash flow and capex consuming all revenue is unsustainable; force majeure signals payment worry.

  Oracle has negative cash flow and is spending 100% of its revenue on capex, which Bill calls not sustainable. Its operating cash flow has crumpled, and like the other hyperscalers it has taken on large off-balance-sheet obligations. He points to Oracle invoking force majeure last week as a sign it is already worried it may not be able to pay the bills down the road for some of this data center spending.

  “And in the case of Oracle, it's obviously, you had negative cash flow numbers coming out of them and also spending 100% of the revenue on CapEx. That's just not sustainable.”at 23:41

US Treasuries & yields

• Bill Eigen · J.P. Morgan Asset Management

  Government ignores the long end; deficits make long Treasuries unattractive, and only a recession would help duration.

  Bill says the government has shown it doesn't care about the long end of the yield curve. Debt is about $40 trillion, the deficit is about $2 trillion and getting worse, and debt-to-GDP is 125% versus about 50% fifteen years ago. Revenue is falling because of tax cuts, while entitlement and defense costs and interest on the debt are rising sharply. Countries including China, Japan and European nations are divesting some Treasuries, which hurts technical flows. Even at 5.5% on the 30-year he finds the long end unattractive, and he thinks the only way to make money there is a nasty recession that takes rates down. He prefers cash at about 4% and high-grade floating-rate notes over 10-to-30-year duration, while the two-year at around 5% is worth owning.

  “the thing I've been saying lately is this government has shown me that they don't care about the long end of the yield curve, so why should I, right?”at 11:28

• Bill Eigen · J.P. Morgan Asset Management

  TIPS are not attractive yet; the spread to nominals is too thin, though they will beat Treasuries.

  TIPS reset off the unadjusted CPI, which is running in the threes, so the current yields look like about 6% total. Bill would like TIPS much better if the CPI they reset off used the formula from the 1970s and 80s, which would mean inflation two to three times the current level and tremendous value. Right now the spread between TIPS and nominal Treasuries is not wide enough to get him interested. He thinks TIPS will outperform traditional Treasuries but still carry duration, so they would be hit if rates keep rising, as in 2022.

  “I'd like them a lot better if the CPI that tips reset off of was the same formula they used to use in the 70s and 80s”at 14:42

US rates & the Fed

• Bill Eigen · J.P. Morgan Asset Management

  Fed can't tighten much further; two-year near 5% prices too much tightening and risks recession.

  Bill thinks the two-year Treasury at around 5% is pricing in too much Fed tightening. The economy is being held up by a narrow set of factors, mainly hyperscaler AI capex, and the Fed can only tighten so far before it tips the economy into recession. He says AI capex is already slowing at the second derivative, which would pull a leg out from under the economy if it reverses, and the Fed is now partly reversing easing it should never have done. He does not think the Fed gets to 5%; he expects one or two more hikes at most, and then a nasty recession would bring rates down.

  “I think two year treasuries at around five are pricing [in] too much Fed tightening now because the Fed can only tighten so far before they're gonna tip us into recession”at 8:51

US inflation

• Bill Eigen · J.P. Morgan Asset Management

  Inflation is not slowing and is getting worse, with input costs and $6.50 diesel pushing prices up.

  Bill argues inflation is the single biggest problem and it is getting worse, not slowing. Manufacturing inputs such as copper, aluminum and rebar have become ridiculously expensive, and food costs are rising for consumers. Diesel at $6.50 a gallon affects construction equipment, 18-wheelers and nearly everything else, so it will be a problem for some time. He argues the Fed never should have eased as much as it did, since inflation never got near its 2% target and is now moving the other way.

  “Inflation is not slowing down. In fact, it's getting worse. ... whether it's copper, aluminum, rebar ... diesel's $6.50 a gallon... So that's gonna be a problem for some time.”at 10:15

Private credit

• Bill Eigen · J.P. Morgan Asset Management

  Private credit is cracking: BDC discounts widening, bad PIK paper rising, redemptions and gates spreading.

  Bill sees private credit as the first warning sign of the credit cycle. BDC average discounts are widening and the amount of bad payment-in-kind paper is rising sharply. Redemptions are running at a very high pace, and there are more gates on private credit funds than during the COVID lockdown, as investors find out that something they thought was liquid is not. Much private credit sits in affiliated insurance companies owned by private equity firms, where average allocations are 40%-plus private credit. Those general accounts should be duration-matched and liquid, so an annuity run at one of these insurers would be a big problem.

  “But most importantly, the amount of bad payment in kind paper in the marketplace is hockey sticking higher, right? Redemptions continue at a very high pace.”at 18:31

AI bubble & tech valuations

• Bill Eigen · J.P. Morgan Asset Management

  AI speculation mirrors 1999-2000 tech excess plus 2008 financing problems; this behavior worries him.

  Bill says the current pattern is a combination of the massive tech speculation of 2000 with the financing problems that came out of 2008. He has never seen this type of behavior, not even in 2015-16. Underwriting standards deteriorated until about six months ago, and AI-related borrowers can still get debt deals, just at worse prices. He recalls telecom and fiber executives in 1999 insisting demand was insatiable and calling skeptics dumb, which resembles the reaction he gets now when he questions data center spending.

  “This is more kind of a combination of like the massive tech speculation you saw in 2000 coupled with financing issues that came from 2008”at 21:00

AI infrastructure & data centers

• Bill Eigen · J.P. Morgan Asset Management

  Debt-funded AI data center buildout is a bubble; many data centers won't get built, ROI doubtful.

  Hyperscalers that never took on much debt are now issuing tens of billions at once, on top of roughly $2.3 trillion of off-balance-sheet obligations tied to AI and roughly $2 trillion of RPOs owed to companies like Oracle, Microsoft, Amazon and Meta. The unprofitable AI labs that owe these RPOs can't pay next year's bills without raising an enormous amount of money. Even a data center with a 30% gross margin won't cover its cost, and chips bought now may be obsolete before the data centers are built. Neoclouds depend on the AI labs to fund them. Bill compares data center construction to the 2008 housing bubble and expects that many of these data centers won't get built.

  “I view data center construction is kind of similar in a way to the housing bubble ['08]. Like a lot of these data centers aren't gonna get built.”at 21:22

IPOs, M&A & deal activity

• Bill Eigen · J.P. Morgan Asset Management

  A major IPO repeatedly delayed is a bad sign, echoing 1999 and 2007 speculative peaks.

  One of the biggest IPOs, which was supposed to happen months ago, keeps being postponed and is now pushed into next year. Bill says that is never a good sign. He thinks a good outcome for this market would require much more money flowing in through VC, secondaries and IPOs, and he sees the pattern rhyming with 2007 and 1999 even if it won't repeat exactly.

  “Think it's interesting that one of the biggest IPOs that was supposed to go months ago keeps putting it off, putting it off, putting it off, right? And now it's into next year and that's never a good sign by the way.”at 26:54

Credit markets

• Bill Eigen · J.P. Morgan Asset Management

  High yield spreads near record tights despite CCC blowout; a bigger high-yield selloff and default cycle are coming.

  All-in high yield index spreads are at absolute tights even though CCC spreads have blown out from about 600 to 1,200 over, because double Bs and Bs have tightened beyond record levels to about 150 bps. He has not seen this kind of high yield tightness since 2016 and calls this the longest credit cycle in history, which he expects to end in the shadows, starting in private credit and then spreading to public markets. He thinks that when high yield blows out this time it won't stop at 500 over, because the default cycle will kick in, with payment-in-kind paper, rising defaults and deteriorating coverage ratios. His fund is hedged with credit default swaps on IG and HY indices and some individual names, roughly 0.33 short for every dollar long.

  “When high yield goes this time, I don't think it's gonna stop at 500. ... Got a lot of companies hanging by a thread right now, both in private and public credit.”at 27:53

US growth & recession risk

• Bill Eigen · J.P. Morgan Asset Management

  AI spending could cause at least a minor recession; AI capex accounted for almost half of GDP growth.

  Bill now believes AI could cause at least a minor recession, which he didn't believe a year ago. The reason is the sheer amount of money spent, debt raised and off-balance-sheet obligations incurred. AI capex accounted for almost half of GDP growth last quarter, so if that spending disappears there is a real problem. He expects AI capex to reverse or slow, and says small business owners he talks to describe the economy as fragile.

  “Yes, yes, 100%. And again, if you asked me that question last year this time, I would say no. But now I say yes, just because of the sheer amount of money that's gone”at 29:02

Market sentiment, positioning & volatility

• Bill Eigen · J.P. Morgan Asset Management

  Low VIX and tight spreads mask stress in private credit, CCCs and BDCs underneath.

  Generic market statistics such as the VIX and high yield spreads say everything is perfect, but underneath, private credit, CCCs and BDCs are telling you things are not right. Bill says he has never seen a cycle end where the surface looked fine while things underneath were not, and that this is when you find out who is swimming naked.

  “when you just look at generic market statistics like the VIX or high yield spreads, they would tell you everything's perfect, right? Everything is just perfect.”at 30:25