The Market Is Undergoing a Change in Character as AI Splits Into 2 Groups
The hyperscalers pay for AI out of their own cash. The companies that borrow to build it are starting to trade like rate-sensitive stocks.
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The key question as we close out an eventful week is whether Wednesday’s corrective action marks the start of a new market phase that will close the gap in the two-tiered market, or is just a temporary blip we’ll forget as we move into the heart of earnings season.
I believe we are likely experiencing a significant change in market character, because at the center of it are inflation, interest rates and massive capital spending. Those issues don’t just suddenly disappear.
Early Friday, we have mild action as oil softens slightly and bonds hold on to recent gains. Semiconductors and data centers are under pressure again, but Tesla (TSLA) and SpaceX (SPCX) are higher after Elon Musk unveiled a second-generation Tesla Roadster powered by SpaceX thrusters that he says will go from zero to 60 mph in under a second. Production is targeted for 2028.
The Marginal Borrower
The Wall Street Journal has an article this morning on CoreWeave (CRWV) that explains where the pressure is building in the AI sector. CoreWeave rents out computing power for AI, and it borrows heavily to build the data centers that provide it.
CoreWeave stock jumped about 6% on Thursday after Nvidia (NVDA) CEO Jensen Huang said he is optimistic about the company, but at one point this week it was down 28%, and it is still down about 15% for the week. Two other AI cloud providers, Nebius Group (NBIS) and IREN (IREN), are down 15% and 14%, respectively.
Meanwhile, Microsoft (MSFT) and Alphabet (GOOGL) have hardly noticed the jump in rates. As Ali Bendarkawi of AllianceBernstein put it, “the marginal borrower in the AI trade is anyone who’s not a high-quality hyperscaler.” The hyperscalers pay for their AI spending out of enormous cash flow. Companies like CoreWeave pay for it with borrowed money, and every move higher in rates is a substantial tax on them.
Distressed Debt
CoreWeave has at least $35 billion in debt, and CreditSights expects it to burn through about $80 billion in cash over the next three and a half years. The interest rate on a loan it took out in July was above 10%. Its unsecured bonds are trading below 80 cents on the dollar, and its 2031 bond yields more than 10 percentage points above Treasurys. That is what bond investors call distressed territory. The market has serious doubts that it will be paid back in full.
Two Australian data center IPOs were put on hold this week, and Broadcom (AVGO) CEO Hock Tan said AI investors have “no clue what they are investing in.” Yet retail investors bought stocks at a record pace on Wednesday and are eager to set aside these valuation concerns.
Why This Isn’t a Blip
This week tied together several issues I’ve been writing about. The hot CPI report raised the odds of another Fed hike. Taiwan Semiconductor (TSM) beat estimates and fell anyway because of margin pressure and higher capital spending. Anthropic is preparing an offering of up to $100 billion, and SpaceX is reportedly looking to raise $40 billion. All of them come back to the same thing: AI growth costs a huge amount of money, and the competition for capital is intensifying while rates are high.
For most of this year, the AI trade acted as if rates didn’t matter. That has changed. The AI group is now splitting between companies that can fund the buildout themselves and those that have to borrow, and the borrowers are behaving like rate-sensitive stocks. That is a change in character, and it’s another reason the leaders no longer look like a safe haven.
The argument that this is just a blip is that strong hyperscaler earnings could pull money right back into the leaders and widen the gap again. That could happen. But earnings won’t fix CoreWeave’s balance sheet or bring down the cost of capital, and that is why I think we will see robust rotational action.
Game Plan
Friday is monthly options expiration, which can produce some odd intraday action, so I won’t read too much into the moves today. I’m treating this as a change in market character until the market proves otherwise. That means I’m carefully evaluating all positions and looking for new leadership as it emerges.
The AI trade isn’t over, but the names that depend on borrowed money are the most vulnerable if rates turn back up. I’m continuing to add in pieces to beaten-up names, particularly in biotech, where stabilization is giving me logical stop levels.
The most important thing I’m watching is the bond market. If yields keep easing and the laggards keep acting well, I’ll be putting more cash to work.
At the time of publication, Rev Shark was long SPCX.
