Transcription complète de The Bridge Ep. 23: Can AI Deliver Returns, Not Just Hype?

is higher, and therefore raises 34 00:01:57,691 --> 00:02:00,485 the bar for what I can get in other investments. 35 00:02:00,485 --> 00:02:04,697 So higher interest rates has been making it a bit more difficult for the AI 36 00:02:04,697 --> 00:02:04,988 trade. 37 00:02:04,988 --> 00:02:05,239 Well, 38 00:02:05,239 --> 00:02:09,284 It's so interesting what you're saying it sounds like is just credit is on average 39 00:02:09,284 --> 00:02:12,953 or on balance, rather, a little more attractive than equities in the scenario. 40 00:02:12,953 --> 00:02:16,540 Yeah, and if you think about that from a Federal Reserve perspective, this is actually 41 00:02:16,540 --> 00:02:18,541 the whole idea with raising interest rates. 42 00:02:18,541 --> 00:02:21,752 If someone from the Fed were sitting here next to you and me, they would 43 00:02:21,752 --> 00:02:25,005 say, but the reason why we are raising interest rates is that we want to 44 00:02:25,005 --> 00:02:27,507 slow the economy down to get inflation to slowly come down. 45 00:02:27,507 --> 00:02:27,757 Yeah. 46 00:02:27,757 --> 00:02:31,469 So that's why they raise in small increments of 25 basis points because they want 47 00:02:31,469 --> 00:02:33,220 to do this very, very gradually. 48 00:02:33,220 --> 00:02:37,474 And when you think about that from a 60/40 asset allocation perspective, that means 49 00:02:37,474 --> 00:02:41,727 that the Fed is really saying, please take a little bit money out of public 50 00:02:41,727 --> 00:02:45,981 equities and put it instead into fixed income, higher quality credit, things that pay you 51 00:02:45,981 --> 00:02:50,068 a higher level of yield because that is now more attractive in relative terms. 52 00:02:50,068 --> 00:02:50,443 We'll 53 00:02:50,443 --> 00:02:54,530 Talk more about the Federal Reserve because to your credit, you've been talking about higher 54 00:02:54,530 --> 00:02:58,616 for longer, for a very long time, well before the market started even baking in 55 00:02:58,616 --> 00:03:00,493 interest rate hikes for example. 56 00:03:00,493 --> 00:03:04,997 But on AI, what is at stake if the, if the trade really does slow 57 00:03:04,997 --> 00:03:05,831 down? 58 00:03:05,831 --> 00:03:06,957 That's a lot at stake. 59 00:03:06,957 --> 00:03:10,460 If the AI trade does slow down, first of all, a lot of GDP growth 60 00:03:10,460 --> 00:03:12,336 is driven by AI spending at the moment. 61 00:03:12,419 --> 00:03:16,965 We calculate that GDP growth, which is normally 2% today, roughly 1% is point of 62 00:03:16,965 --> 00:03:17,632 that namely 63 00:03:17,632 --> 00:03:19,509 half of that is because of AI. 64 00:03:19,509 --> 00:03:23,595 And it's not only the building of data centers and energy associated with data centers, 65 00:03:23,595 --> 00:03:24,972 it's also spending on tokens. 66 00:03:24,972 --> 00:03:25,389 Mm-hmm . 67 00:03:25,389 --> 00:03:27,807 It's also spending on AI tools for consumers. 68 00:03:27,807 --> 00:03:30,143 It's also spending on AI tools for businesses. 69 00:03:30,143 --> 00:03:34,271 And it's also the wealth effect that has come along with ai naming home price 70 00:03:34,271 --> 00:03:38,441 in San Francisco have been going up because there's a lot of wealth generated as 71 00:03:38,441 --> 00:03:39,567 a result of ai. 72 00:03:39,567 --> 00:03:43,695 So the first answer to your question is if AI does begin to slow down, 73 00:03:43,695 --> 00:03:45,989 it would also slow down the economy. 74 00:03:45,989 --> 00:03:50,910 And most importantly, really is also that AI is absolutely also now everywhere in people's 75 00:03:50,910 --> 00:03:55,872 asset allocation. The equity market, the 10 biggest stocks, they make up 40% of the 76 00:03:55,872 --> 00:03:56,331 index. 77 00:03:56,331 --> 00:03:59,876 And most of the returns in s and p 500 in the last several years 78 00:03:59,876 --> 00:04:01,252 has been driven by ai. 79 00:04:01,252 --> 00:04:05,630 Similarly, in fixed income, if you look at especially public credit, you also have that 80 00:04:05,630 --> 00:04:07,423 hyperscalers have been issuing more debt. 81 00:04:07,423 --> 00:04:08,758 That is also now more AI. 82 00:04:08,758 --> 00:04:13,929 And finally, if you also own venture capital, venture capital used to be pharma, biotech, 83 00:04:13,929 --> 00:04:17,891 prescription drugs, but today 87% of venture capital is also AI. 84 00:04:17,891 --> 00:04:21,936 So the answer to your question is, if AI does not work out, we will 85 00:04:21,936 --> 00:04:24,062 have some problems for the GDP outlook. 86 00:04:24,062 --> 00:04:26,272 We will also have some problems from an investing perspective. 87 00:04:26,272 --> 00:04:30,359 So the conclusion is this AI thing better work out because otherwise we'll have problems 88 00:04:30,359 --> 00:04:33,237 both in the economy and also in financial markets. 89 00:04:33,237 --> 00:04:34,780 Let's define workout, right? 90 00:04:34,780 --> 00:04:36,781 Because you're saying there's a slowdown. 91 00:04:36,781 --> 00:04:39,158 A slowdown is very different from a crash. 92 00:04:39,158 --> 00:04:42,494 I think a lot of people are very nervous out there about the worst scenarios 93 00:04:42,494 --> 00:04:44,079 that could happen in a slowdown here. 94 00:04:44,121 --> 00:04:47,582 And I think that's the art of the moment that we're in is crafting that 95 00:04:47,582 --> 00:04:49,000 landing. 96 00:04:49,000 --> 00:04:53,545 So when you think about what a slowdown really means, you know, does it mean 97 00:04:53,545 --> 00:04:57,674 that, you know, we might see some companies fall into really meaningful distress. 98 00:04:57,674 --> 00:05:02,719 Does it mean that we'll see even a probability of a recession start to rise? 99 00:05:02,719 --> 00:05:03,804 I mean, what does that actually mean to you? 100 00:05:03,804 --> 00:05:04,221 Yeah, so 101 00:05:04,221 --> 00:05:07,307 There are four different buckets of investing in AI. 102 00:05:07,307 --> 00:05:11,810 One is of

course the frontier labs and the models and those of course that 103 00:05:11,810 --> 00:05:15,105 are exposed directly to the consumer and the user of AI. 104 00:05:15,105 --> 00:05:16,856 These are Open AI, Anthropic, 105 00:05:16,856 --> 00:05:17,565 For example. 106 00:05:17,565 --> 00:05:21,235 They have negative profit margins at the moment because they're developing the technology. 107 00:05:21,235 --> 00:05:22,653 And that of course is expensive. 108 00:05:22,653 --> 00:05:27,365 That's why those that are facing the consumer, which is unusual, have negative profit margins. 109 00:05:27,365 --> 00:05:29,909 The next step in the value chain is the hyperscalers. 110 00:05:29,909 --> 00:05:33,954 Those who are building the data centers, they have positive profit margins, but they of 111 00:05:33,954 --> 00:05:38,040 course are also an important part of whether AI working out or not is going 112 00:05:38,040 --> 00:05:39,333 to be impacting them. 113 00:05:39,333 --> 00:05:41,085 The next step is energy and grit. 114 00:05:41,085 --> 00:05:43,628 So that means that this provides the energy to AI. 115 00:05:43,628 --> 00:05:47,382 They are of course also at risk to the upside and downside as a function 116 00:05:47,382 --> 00:05:49,300 of whether AI is succeeding or not. 117 00:05:49,300 --> 00:05:53,345 And finally we have silicon and equipment, meaning those who built the chips and the 118 00:05:53,345 --> 00:05:57,390 semis, and they of course at the ultimate end because they're the, the ones that 119 00:05:57,390 --> 00:06:01,477 all the models are running on, whether it's closed source, open source, of course the 120 00:06:01,477 --> 00:06:04,521 chips are ultimately what is solving all the problems in AI. 121 00:06:04,521 --> 00:06:08,733 And the answer to your question is different parts of that value chain can absolutely 122 00:06:08,733 --> 00:06:12,652 get differently impacted as a result of what AI not working out exactly means. 123 00:06:12,652 --> 00:06:16,656 Let's talk about that a little more because you had mentioned that Frontier Labs typically 124 00:06:16,656 --> 00:06:19,241 have been losing money from a margin perspective, right? 125 00:06:19,241 --> 00:06:22,828 Um, hyperscalers though that that buffer is much thicker. 126 00:06:22,828 --> 00:06:26,873 Does that mean in an environment like this, there's so many people worried about the 127 00:06:26,873 --> 00:06:31,376 free cash flow impacts the declines in free cash flow, but they're relatively insulated actually. 128 00:06:31,376 --> 00:06:33,712 So are you actually really worried about them raising money? 129 00:06:33,712 --> 00:06:34,004 Yeah. 130 00:06:34,004 --> 00:06:34,170 This 131 00:06:34,170 --> 00:06:34,504 In the market? 132 00:06:34,504 --> 00:06:38,382 Yeah, this, this is a really important discussion because at the end of the day 133 00:06:38,372 --> 00:06:41,458 today, the demand for compute is really going up significantly. 134 00:06:41,468 --> 00:06:46,597 Not only because of all of us writing questions into ChatGPT and to Claude, 135 00:06:46,597 --> 00:06:50,142 but also because of agentic AI becoming much more pronounced. 136 00:06:50,142 --> 00:06:53,186 That means that demand for compute is rising very, very significantly. 137 00:06:53,186 --> 00:06:57,315 Meaning people want to run on chips in data centers, but at the same time, 138 00:06:57,315 --> 00:07:00,400 the competitive landscape is now also changing for the models. 139 00:07:00,400 --> 00:07:04,821 Namely open source models are becoming much more used and much more pronounced in the 140 00:07:04,821 --> 00:07:06,572 landscape of those who use AI. 141 00:07:06,572 --> 00:07:11,326 Whereas closed source models, of course, are now getting more competitive pressure from the open 142 00:07:11,326 --> 00:07:12,160 source models. 143 00:07:12,160 --> 00:07:15,496 This raises all kinds of questions about what is the competitive edge for closed source 144 00:07:15,496 --> 00:07:17,331 models for relative to open source models. 145 00:07:17,331 --> 00:07:21,335 But the answer to your question is this race is demand for compute is going 146 00:07:21,335 --> 00:07:25,338 up very, very rapidly, but at the same time, the price of that compute and 147 00:07:25,338 --> 00:07:29,299 the price of tokens and ultimately the competitive landscape for those who use it has 148 00:07:29,299 --> 00:07:31,718 actually been under more downward and more competitive pressure. 149 00:07:31,718 --> 00:07:35,430 And that's the race in ai that is the most critical part of understanding whether 150 00:07:35,430 --> 00:07:37,390 it's working out or not over the next several 151 00:07:37,390 --> 00:07:37,932 Years. 152 00:07:37,932 --> 00:07:41,476 So very simply, when you watch all these hyperscalers, the, you know, um, Amazons of 153 00:07:41,476 --> 00:07:44,229 the world go out and raise debt in markets, right? 154 00:07:44,229 --> 00:07:45,396 Uh, Alphabet, right? 155 00:07:45,396 --> 00:07:47,773 Do you, do you worry about it? 156 00:07:47,773 --> 00:07:51,818 Well, markets are already voting with their feet on that question because CDS spreads on, 157 00:07:51,818 --> 00:07:54,612 uh, several of these names have been widening out. 158 00:07:54,612 --> 00:07:58,407 CDS spreads of course is measuring what is the probability that these companies might not 159 00:07:58,407 --> 00:08:01,701 be able to pay back their debt in the next five years. 160 00:08:01,701 --> 00:08:05,246 And that means that that premium meaning the price of insuring yourself against the risk 161 00:08:05,246 --> 00:08:08,791 that they will not be paying that debt, has been moving a little bit higher, 162 00:08:08,791 --> 00:08:12,377 which some people are beginning to look at, including me and say, well, we need 163 00:08:12,377 --> 00:08:13,920 to understand better why that's happening. 164 00:08:13,920 --> 00:08:18,757 Similarly, we've also seen spreads on hyperscale debt also

widen out, which is also saying 165 00:08:18,757 --> 00:08:20,884 that the market has not much. 166 00:08:20,884 --> 00:08:24,554 But started to worry a little bit more about what is the trajectory that we are 167 00:08:24,554 --> 00:08:25,346 on here? 168 00:08:25,346 --> 00:08:26,972 Are the revenues going to increase? 169 00:08:26,972 --> 00:08:31,601 And if you look at the consensus expectations from FactSet today, the operating cash flow 170 00:08:31,601 --> 00:08:34,312 in the five hyperscalers is about $600 billion. 171 00:08:34,312 --> 00:08:38,065 And the consensus is expecting that over the next several years will grow from 172 00:08:38,065 --> 00:08:39,566 $600 billion to about $2 trillion. 173 00:08:39,566 --> 00:08:44,445 In other words, a very dramatic increase in the revenues and the cash flows for 174 00:08:44,445 --> 00:08:45,112 the hyperscalers. 175 00:08:45,112 --> 00:08:48,574 And that is the question, if that revenue comes in faster, comes in slower, is 176 00:08:48,574 --> 00:08:49,783 the answer to the question. 177 00:08:49,783 --> 00:08:52,744 Namely, what is the scenario we have ahead of us for 178 00:08:52,744 --> 00:08:53,119 AI? 179 00:08:53,119 --> 00:08:56,580 And it's interesting because we are talking about this as it pertains to the hyperscalers, 180 00:08:56,580 --> 00:08:58,916 but the hyperscalers we just said have a bigger buffer. 181 00:08:58,916 --> 00:08:59,624 Right? 182 00:08:59,624 --> 00:09:01,376 But what about the frontier labs? 183 00:09:01,376 --> 00:09:05,254 At the end of the day, you saw something happen where you didn't really see 184 00:09:05,254 --> 00:09:09,132 this happen in prior years where pre IPO companies are actually raising fairly meaningful amounts 185 00:09:09,132 --> 00:09:10,217 of debt. 186 00:09:10,217 --> 00:09:11,384 Is that healthy? 187 00:09:11,384 --> 00:09:14,971 Well, one first observation about this, that these companies are private. 188 00:09:14,971 --> 00:09:18,265 So this tells you and me a very important conclusion that you and I have 189 00:09:18,265 --> 00:09:21,559 talked about for many years, namely, that a very significant part of the economy is 190 00:09:21,559 --> 00:09:23,102 outside the S&P 500, right? 191 00:09:23,102 --> 00:09:26,147 And there are a lot of private companies that are wildly successful. 192 00:09:26,147 --> 00:09:30,150 In fact, if you look at businesses in the U.S. that have revenue of more 193 00:09:30,150 --> 00:09:33,611 than a hundred million dollars, 90% of them are actually not public. 194 00:09:33,611 --> 00:09:36,905 So there's a different way of saying there's a lot of private companies including an 195 00:09:36,905 --> 00:09:40,158 Open AI and Anthropic that are very successful at what they do and generate a lot of 196 00:09:40,158 --> 00:09:40,784 revenue. 197 00:09:40,784 --> 00:09:44,161 So in that sense, they are not publishing the same way. 198 00:09:44,161 --> 00:09:47,915 Of course the companies in S&P 500 are doing, but

if they are about to 199 00:09:47,915 --> 00:09:51,668 do IPO, of course this will give much more insight, much more light and transparency 200 00:09:51,668 --> 00:09:55,379 in terms of where are they making money and how are they making money? 201 00:09:55,379 --> 00:09:59,257 And that will give the market a better idea about this competitive landscape that we're 202 00:09:59,257 --> 00:10:01,676 seeing between open source models and closed source models. 203 00:10:01,676 --> 00:10:05,137 The reason I ask this also is because in private markets there's the venture capital 204 00:10:05,137 --> 00:10:08,640 aspect, which we've talked about the, you know, the the growth equity ven, uh, private 205 00:10:08,640 --> 00:10:10,684 equity type aspect that we were talking about. 206 00:10:10,684 --> 00:10:14,687 But even data centers to a large degree are tied to the credit ratings of 207 00:10:14,687 --> 00:10:17,689 these firms and the credit health of these firms. 208 00:10:17,689 --> 00:10:20,734 And so there's a whole ecosystem that hinges on this question it feels like. 209 00:10:20,734 --> 00:10:25,404 And and that's why ultimately in particular from a GDP perspective, data center buildout 210 00:10:25,404 --> 00:10:28,907 is absolutely critical for anyone's forecast for GDP growth. 211 00:10:28,907 --> 00:10:33,327 So normally people would say, oh, CapEx and business spending, which data center, the data 212 00:10:33,327 --> 00:10:37,122 center buildout is, is normally a smaller issue in my forecast. 213 00:10:37,122 --> 00:10:41,209 Normally it's all about the consumer, but now your entire forecast depends almost completely on 214 00:10:41,209 --> 00:10:43,961 what is your view on the data center buildout. 215 00:10:43,961 --> 00:10:47,756 And it's very clear, yeah, that the data center buildout depends on whether the 216 00:10:47,756 --> 00:10:51,551 hyperscalers are going to generate all the revenue on the back of all the compute 217 00:10:51,551 --> 00:10:52,552 that's being created. 218 00:10:52,552 --> 00:10:56,847 So yes, there's unlimited demand for compute, but the question is over time whether the 219 00:10:56,847 --> 00:11:00,850 price of that compute is at risk potentially of eventually beginning to go down. 220 00:11:00,850 --> 00:11:04,145 Because if that begins to go down, then you will have two opposite forces. 221 00:11:04,145 --> 00:11:08,023 Yes, we all want to do more at Agentic AI and use AI, but at 222 00:11:08,023 --> 00:11:11,859 the same time if the price of that usage, especially with the competition from open 223 00:11:11,859 --> 00:11:15,738 source models starts to go down, then of course there will be some questions exactly 224 00:11:15,738 --> 00:11:19,366 about what does that then mean for the overall data center build out 225 00:11:19,366 --> 00:11:21,242 Bullish or bearish? 226 00:11:21,242 --> 00:11:24,870 I am still bullish on the economic output because I still think that the most 227 00:11:24,870 --> 00:11:27,497 important impact of AI is also on the labor market. 228 00:11:27,497 --> 00:11:31,667 That yes, there will be some people that likely will lose their jobs, but I 229 00:11:31,667 --> 00:11:35,879 think that a much more important effect on the labor market is that the moment 230 00:11:35,879 --> 00:11:40,049 today in the census data, we are seeing the most businesses created in U.S. economy 231 00:11:40,049 --> 00:11:41,467 ever in U.S. history. 232 00:11:41,467 --> 00:11:46,305 In other words, the business dynamics that have appeared because of AI have just been 233 00:11:46,305 --> 00:11:46,847 incredible. 234 00:11:46,847 --> 00:11:49,474 People are leaving finance to open their own business. 235 00:11:49,474 --> 00:11:54,144 They're leaving consulting, they're leaving media, they're leading or leaving of course legal services and 236 00:11:54,144 --> 00:11:58,565 they go home to their basement and they basically start a solo founder firm. 237 00:11:58,565 --> 00:12:01,192 There are many more solo founder firms now than multi founder. 238 00:12:01,192 --> 00:12:04,695 And that is of course if some of these businesses, it's just a fraction of 239 00:12:04,695 --> 00:12:08,156 the many business that are created at the moment end up creating some success, they 240 00:12:08,156 --> 00:12:09,657 will also create more jobs. 241 00:12:09,657 --> 00:12:13,244 And I think when we put that up on the scale, that will be positive 242 00:12:13,244 --> 00:12:13,911 for employment. 243 00:12:13,911 --> 00:12:14,119 And 244 00:12:14,119 --> 00:12:14,870 You think that sticks? 245 00:12:14,870 --> 00:12:15,370 I truly, even 246 00:12:15,370 --> 00:12:19,457 The last, I truly think AI is a miracle drug that will both create higher 247 00:12:19,457 --> 00:12:20,833 productivity and also higher employment. 248 00:12:20,833 --> 00:12:23,210 And that's by the way also what the data is showing so far. 249 00:12:23,210 --> 00:12:26,671 The employment report, as you and I have talked about, continues to be strong, has 250 00:12:26,671 --> 00:12:30,133 been strong for the last six months so far at this point, there is no 251 00:12:30,133 --> 00:12:33,594 effect of the labor displacement effect, meaning the effect that people are losing their jobs 252 00:12:33,594 --> 00:12:35,012 because of AI being particularly significant. 253 00:12:35,012 --> 00:12:38,181 Okay, one more, one more question on AI before we move to the macro. 254 00:12:38,181 --> 00:12:40,600 We'll put some AI in there too because it's so related. 255 00:12:40,600 --> 00:12:45,229 But a tough question I had gotten this week from a large investor in your 256 00:12:45,229 --> 00:12:47,272 space was what happens? 257 00:12:47,272 --> 00:12:51,442 You have multiple companies now, three of them at least, that have surged past a 258 00:12:51,442 --> 00:12:55,612 trillion dollars in value in a timeframe we have never seen before reaching almost 259 00:12:55,612 --> 00:12:58,781 $2 trillion in some

of those cases. 260 00:12:58,781 --> 00:13:02,243 What happens if one of those companies doesn't exist in the next five years? 261 00:13:02,243 --> 00:13:02,535 Yeah, 262 00:13:02,535 --> 00:13:03,911 This is really, really important. 263 00:13:03,911 --> 00:13:08,164 So that's also why the famous discussion at the moment is about the moat. 264 00:13:08,164 --> 00:13:12,626 What is really the moat that different businesses, especially in the tech world have? 265 00:13:12,626 --> 00:13:16,838 Because if the tech companies, the broadly speaking, the magnificent seven and the hyperscalers, if 266 00:13:16,838 --> 00:13:21,008 they do not have a moat where they can protect themselves, then of course they 267 00:13:21,008 --> 00:13:24,553 will ultimately begin to shrink and they will be more at risk. 268 00:13:24,553 --> 00:13:28,264 So the question of course to ask will all the hyperscalers survive? 269 00:13:28,264 --> 00:13:32,893 Are some of them at risk of going down because they might not have the 270 00:13:32,893 --> 00:13:37,564 right moat or are we seeing all of them surviving and growing into even much 271 00:13:37,564 --> 00:13:38,356 bigger companies? 272 00:13:38,356 --> 00:13:42,526 And that becomes hugely a function of this question around is it open source models 273 00:13:42,526 --> 00:13:43,694 that are winning? 274 00:13:43,694 --> 00:13:45,487 Is it closed source models that are winning? 275 00:13:45,487 --> 00:13:47,322 What is regulation going to look like? 276 00:13:47,322 --> 00:13:48,615 Are we going to see regulation? 277 00:13:48,615 --> 00:13:52,284 There's a lot of talk at the moment about human extinction, maybe everyone losing their 278 00:13:52,284 --> 00:13:52,910 jobs. 279 00:13:52,910 --> 00:13:56,996 I mean all these impacts of AI on the economy ultimately will be very critical 280 00:13:56,996 --> 00:14:01,041 for the answer to the question of who are the winners and who are the 281 00:14:01,041 --> 00:14:01,292 losers. 282 00:14:01,292 --> 00:14:05,420 So another way of saying this is many in Silicon Valley talk about technology as 283 00:14:05,420 --> 00:14:06,129 an S-curve. 284 00:14:06,129 --> 00:14:09,549 First we invented the technology and now we're trying to figure out how do we 285 00:14:09,549 --> 00:14:10,466 use this technology? 286 00:14:10,466 --> 00:14:11,634 How do we implement it? 287 00:14:11,634 --> 00:14:15,303 If that implementation phase takes six months, well then we're certainly off to the races 288 00:14:15,303 --> 00:14:18,931 and saying this is how the technology should be used, this is going to pay 289 00:14:18,931 --> 00:14:19,432 off. 290 00:14:19,432 --> 00:14:23,060 But if that implementation phase takes like 2, 3, 4 years, then we have a 291 00:14:23,060 --> 00:14:25,729 risk that the takeoff is only going to come later. 292 00:14:25,729 --> 00:14:29,940 And if there is an S-curve in implementation, maybe to your question, there's also an 293 00:14:29,940 --> 00:14:30,775 S-curve in valuations. 294 00:14:30,775 --> 00:14:31,192 Hmm. 295 00:14:31,192 --> 00:14:34,986 And if that's the case, maybe the companies that invented the technology are not the 296 00:14:34,986 --> 00:14:37,905 ones that ultimately will be winning once the technology is used. 297 00:14:37,905 --> 00:14:42,117 So that's a different way of saying the magnificent seven and hyperscalers did very well 298 00:14:42,117 --> 00:14:46,329 initially, but maybe what we're waiting for now is the s and p 4 93, 299 00:14:46,329 --> 00:14:50,541 meaning the rest of the economy that now needs to take off and show the 300 00:14:50,541 --> 00:14:53,627 returns of AI adoption in healthcare in airlines, in consumer products. 301 00:14:53,627 --> 00:14:57,630 Because if that takeoff takes a longer time, then of course we will not get 302 00:14:57,630 --> 00:15:01,091 the payoff from all the investments that were done to develop the technology. 303 00:15:01,091 --> 00:15:01,508 Yeah, absolutely. 304 00:15:01,508 --> 00:15:05,261 So lemme say there was a very slightly different words, let's think about the invention 305 00:15:05,261 --> 00:15:06,221 of Ozempic. 306 00:15:06,221 --> 00:15:10,432 Ozempic was invented and therefore there was several years where those who invented Ozempic were 307 00:15:10,432 --> 00:15:14,769 able to generate higher profits because this was the only GLP-1 in the market. 308 00:15:14,769 --> 00:15:17,271 Then later on other GLP-1s came to the market. 309 00:15:17,271 --> 00:15:21,859 But that long period generated a situation where you could create some pricing power to 310 00:15:21,859 --> 00:15:23,568 pay back your development cost. 311 00:15:23,568 --> 00:15:27,697 But today the difference between the closed source models and the open source models is 312 00:15:27,697 --> 00:15:29,907 only like three, four months in terms of 313 00:15:29,907 --> 00:15:30,407 capability. 314 00:15:30,407 --> 00:15:32,451 It's like generic drugs versus premium drugs. 315 00:15:32,451 --> 00:15:32,951 Exactly. 316 00:15:32,951 --> 00:15:36,871 That's why there is a risk that we don't have a long period where you 317 00:15:36,871 --> 00:15:40,749 can squeeze out high, high pricing power because they're just right behind you, the open 318 00:15:40,749 --> 00:15:41,333 source models. 319 00:15:41,333 --> 00:15:44,836 And that creates all kinds of corporate finance questions around, normally our textbook would say, 320 00:15:44,836 --> 00:15:48,381 we invent you and I a new product, therefore we have that on the market 321 00:15:48,381 --> 00:15:49,298 for a period. 322 00:15:49,298 --> 00:15:52,843 But that period becomes really, really important for what were the revenue and the profitability 323 00:15:52,843 --> 00:15:56,429 be of our business in particular if that period is at risk of being relatively 324 00:15:56,429 --> 00:15:56,804 short. 325 00:15:56,804 --> 00:15:57,096 Okay. 326 00:15:57,096 --> 00:16:00,683 So I could be completely off on this, but I do

want to kind of 327 00:16:00,683 --> 00:16:04,227 give you the victory lap here on the higher for longer thing because when the 328 00:16:04,227 --> 00:16:07,772 feds, uh, summary of economic projections came out and I saw that higher neutral rate 329 00:16:07,772 --> 00:16:11,858 baked in, I just wanted to sign your name at the bottom of it, . 330 00:16:11,858 --> 00:16:16,112 And so what does this all mean at the end when the Federal Reserve unanimously 331 00:16:16,112 --> 00:16:20,366 voted for a higher interest rate in the most recent FLMC, um, they're projecting another 332 00:16:20,366 --> 00:16:23,868 rate hike for the rest of the year at least one. 333 00:16:23,868 --> 00:16:28,289 Um, and they're looking at longer term rates being higher. 334 00:16:28,289 --> 00:16:29,665 What does that amount to in the end? 335 00:16:29,665 --> 00:16:29,957 Yeah, 336 00:16:29,957 --> 00:16:33,168 This is really important because the economy is doing well because of AI spending and 337 00:16:33,168 --> 00:16:36,421 they wanna Big Beautiful Bill, but that's another part of the economy that 338 00:16:36,421 --> 00:16:37,296 is not doing well. 339 00:16:37,296 --> 00:16:40,966 And that's the part that's sensitive to interest rates and that part that's sensitive to 340 00:16:40,966 --> 00:16:43,468 interest rates is housing is not doing well. 341 00:16:43,468 --> 00:16:48,013 Mortgage rates during the pandemic where 2.7 normally mortgage rates are at a level of 342 00:16:48,013 --> 00:16:51,683 around three and four, but today mortgage rates are now seven. 343 00:16:51,683 --> 00:16:55,311 So that means we've seen a very significant increase in mortgage rates that is weighing 344 00:16:55,311 --> 00:16:57,396 dramatically on the housing market at the moment. 345 00:16:57,396 --> 00:17:01,692 Similarly, auto sector and car sales have also been dragged down by interest rates going 346 00:17:01,692 --> 00:17:05,987 up because signing a lease to buy a car, the monthly payment has just gone 347 00:17:05,987 --> 00:17:08,072 up because interest rates have gone up. 348 00:17:08,072 --> 00:17:11,992 So we have a bifurcated economy where the boom is happening in AI spending and 349 00:17:11,992 --> 00:17:14,369 in the one Big Beautiful Bill the fiscal expansion. 350 00:17:14,369 --> 00:17:17,872 But we have another part of the economy that is dragging things down, namely housing 351 00:17:17,872 --> 00:17:18,581 and autos. 352 00:17:18,581 --> 00:17:23,293 The good news from a macroeconomic perspective is that the Fed still is experiencing that 353 00:17:23,293 --> 00:17:28,047 the tailwind coming from AI spending is so strong that they still see more hikes 354 00:17:28,047 --> 00:17:30,757 coming along because the economy still does well. 355 00:17:30,757 --> 00:17:34,510 But that just gets back to the discussion around, well, if AI does not continue 356 00:17:34,510 --> 00:17:38,264 to do well, if there is any type of slowdown, either because the models are 357 00:17:38,264 --> 00:17:42,017 dangerous or because there's risk to the models in terms of security and safety or 358 00:17:42,017 --> 00:17:45,728 if that's the case, that may also mean that the tailwind to the economy from 359 00:17:45,728 --> 00:17:49,481 AI would also be weaker and that could potentially begin to, to ultimately slow the 360 00:17:49,481 --> 00:17:50,148 economy down. 361 00:17:50,148 --> 00:17:53,902 Maybe sometime in our view, sometimes in the middle of 2027. 362 00:17:53,902 --> 00:17:57,905 But at this point where we're sitting here still in 2026, we still have strong 363 00:17:57,905 --> 00:18:01,950 growth from AI coming and that is the reason why the Fed is seeing higher 364 00:18:01,950 --> 00:18:06,037 inflation combined also with higher oil prices and combined with some delayed effects of tariffs. 365 00:18:06,037 --> 00:18:09,081 But all that is arguing for still a strong economy, at least for the next 366 00:18:09,081 --> 00:18:09,915 six to nine months. 367 00:18:09,915 --> 00:18:10,332 Right. 368 00:18:10,332 --> 00:18:15,086 The, the job market seemed to have kept enough room for a rate hike to 369 00:18:15,086 --> 00:18:19,047 happen, but do you ultimately agree that a hiking cycle is warranted? 370 00:18:19,047 --> 00:18:22,217 Well, the risk of course with beginning to raise rates because markets, as you said, 371 00:18:22,217 --> 00:18:25,136 are out pricing a hike this year and then two more hikes next year. 372 00:18:25,136 --> 00:18:25,595 Yeah. 373 00:18:25,595 --> 00:18:29,348 The risk is of course that the interest rate sensitive parts of the economy begins 374 00:18:29,348 --> 00:18:30,974 to slow down even more. 375 00:18:30,974 --> 00:18:33,601 And if that's the case, then of course is it warranted. 376 00:18:33,601 --> 00:18:37,354 Well, you are going to still continue to see a significant drag downwards in housing 377 00:18:37,354 --> 00:18:40,065 and autos because those sectors are sensitive to interest rates. 378 00:18:40,065 --> 00:18:43,484 So that's why it's a very difficult balance that they FMC is striking here. 379 00:18:43,484 --> 00:18:43,943 Right. 380 00:18:43,943 --> 00:18:47,404 The main thing that they are telling us at the last meeting is that, well, 381 00:18:47,404 --> 00:18:50,866 we still have inflation today, which is in round number three and a half at 382 00:18:50,866 --> 00:18:54,327 the peak during the pandemic it was nine, now it's three and a half, but 383 00:18:54,327 --> 00:18:57,788 we still have the last mile of getting inflation down to 2% and that's still 384 00:18:57,788 --> 00:18:59,706 turning out to be a lot harder. 385 00:18:59,706 --> 00:19:03,960 And that's why Kevin Warsh, and therefore FMC voted for unanimously, we need to do 386 00:19:03,960 --> 00:19:08,213 more to get inflation down and importantly to raise interest rates to slow the interest 387 00:19:08,213 --> 00:19:12,467 rates since and parts of the economy down in a very, very gradual and 388

00:19:12,467 --> 00:19:13,509 hopefully controlled way. 389 00:19:13,509 --> 00:19:17,388 And that's why of course the economy is as we look into next year, expected 390 00:19:17,388 --> 00:19:19,473 to begin to moderate in terms of growth. 391 00:19:19,473 --> 00:19:19,973 Right. 392 00:19:19,973 --> 00:19:24,477 I mean it just seems to me like it risks a little bit more of 393 00:19:24,477 --> 00:19:28,981 a K-shaped economy headed into the midterms at a time where their monetary policy as 394 00:19:28,981 --> 00:19:32,108 a blunt instrument can't fix that K shape. 395 00:19:32,108 --> 00:19:36,403 And if you had to fix it, it would really be the fiscal, but now 396 00:19:36,403 --> 00:19:40,740 you have a fiscal where if you added more to the pain you're you're also 397 00:19:40,740 --> 00:19:43,326 adding more pain to the higher cost of interest. 398 00:19:43,367 --> 00:19:45,828 So how do you think about that burden? 399 00:19:45,828 --> 00:19:46,120 Yeah, 400 00:19:46,120 --> 00:19:49,998 The real challenge is the Federal Reserve cannot do anything else, rather other than raise 401 00:19:49,998 --> 00:19:51,583 interest rates or lower interest rates. 402 00:19:51,583 --> 00:19:54,377 And as you say, exactly, that's a very blunt tool compared to a lot of 403 00:19:54,377 --> 00:19:55,878 the other things that are going on. 404 00:19:55,878 --> 00:20:00,382 So that's why fiscal policy is of course, in many cases a way to try 405 00:20:00,382 --> 00:20:04,844 to address some of the challenges, everything from the K-shaped economy, everything from what you 406 00:20:04,844 --> 00:20:08,430 might wanna do on taxes, what you wanna do on expenditures. 407 00:20:08,430 --> 00:20:13,142 But the problem is, as we all know that it's becoming more and more complicated 408 00:20:13,142 --> 00:20:16,562 to see any major national compromise on a fiscal deal. 409 00:20:16,562 --> 00:20:19,272 The challenge is that debt levels are just going to go up. 410 00:20:19,272 --> 00:20:23,359 And as we know at the moment, a lot of the spending by the government 411 00:20:23,359 --> 00:20:24,944 is just really, really significant. 412 00:20:24,944 --> 00:20:30,073 And an important statistic is that roughly two thirds of government spending is discretionary spending 413 00:20:30,073 --> 00:20:31,282 on entitlements. 414 00:20:31,282 --> 00:20:34,285 Entitlements meaning spending on Medicare, Medicaid and social security. 415 00:20:34,285 --> 00:20:39,039 And one very simple problem is that about 75 million people today get social security. 416 00:20:39,039 --> 00:20:42,500 So it's become very, very difficult politically to solve this problem. 417 00:20:42,500 --> 00:20:45,919 And you and we and us, everyone has now to deal with the cards that 418 00:20:45,919 --> 00:20:49,297 we've been dealt and say, well, there's not a great hand we have, but at 419 00:20:49,297 --> 00:20:52,717 the moment, well if interest rates are going to stay higher because the fiscal situation 420 00:20:52,717 --> 00:20:56,136 is going to continue to be bad, I just need to plan accordingly as an 421 00:20:56,136 --> 00:20:56,345 investor. 422 00:20:56,345 --> 00:21:00,932 And that just means cutting coupons in fixed income, benefiting from higher quality credit, still 423 00:21:00,932 --> 00:21:03,684 paying you will continues to be a good strategy. 424 00:21:03,684 --> 00:21:07,479 Because this is ultimately what is the consequence, both of short-term interest rates going up 425 00:21:07,479 --> 00:21:08,980 and long-term interest rates going up. 426 00:21:08,980 --> 00:21:12,316 How much do you think it encourages saving versus investing? 427 00:21:12,316 --> 00:21:15,569 I think this is very important because a lot of money has gone into money 428 00:21:15,569 --> 00:21:18,822 market funds and you and I spoke about this also several years ago, that money 429 00:21:18,822 --> 00:21:21,074 market funds have seen a very significant increase. 430 00:21:21,074 --> 00:21:25,035 Interestingly enough, if you look at the ETF flows, households are very, very eager to 431 00:21:25,035 --> 00:21:29,039 buy short-term government debt, T-bills, meaning money market funds because that has also gone 432 00:21:29,039 --> 00:21:30,039 up in yield. 433 00:21:30,039 --> 00:21:34,668 But households are actually selling over the last several years long-term government debt. 434 00:21:34,668 --> 00:21:38,213 So there are really not many households who are willing to lend money to the 435 00:21:38,213 --> 00:21:40,089 US government for the next 30 years. 436 00:21:40,089 --> 00:21:42,842 So that has meant that interest rates have gone up, but most of this has 437 00:21:42,842 --> 00:21:44,593 gone through the front end of the yield curve. 438 00:21:44,593 --> 00:21:47,137 Does that create a financial stability issue? 439 00:21:47,137 --> 00:21:48,221 I still think that we are. 440 00:21:48,221 --> 00:21:48,555 Okay. 441 00:21:48,555 --> 00:21:53,225 And I still think that because we have an AI boom and we still have 442 00:21:53,225 --> 00:21:57,854 a significant tailwind in growth, that the fiscal issues are still helped by significant tax 443 00:21:57,854 --> 00:22:02,483 payments, of course significant growth that will help ultimately still provide some more tax revenue 444 00:22:02,483 --> 00:22:03,859 on the fiscal side. 445 00:22:03,859 --> 00:22:08,238 But the problem is that if the economy does enter a recession for whatever reason, 446 00:22:08,238 --> 00:22:12,575 then you normally see the public deficit go from at the moment around 5% and 447 00:22:12,575 --> 00:22:14,952 you normally add about 4% points. 448 00:22:14,952 --> 00:22:19,080 So that means that we would get from basically having a 5% deficit for the 449 00:22:19,080 --> 00:22:20,915 government to basically a 10% deficit. 450 00:22:20,915 --> 00:22:24,501 And that's a very dramatic need to raise more money because if you have a 451 00:22:24,501 --> 00:22:28,129 recession,

you need to pay more in unemployment benefits and of course you get less 452 00:22:28,129 --> 00:22:28,880 tax revenue. 453 00:22:28,880 --> 00:22:32,091 So therefore the deterioration will come along in the government finances. 454 00:22:32,091 --> 00:22:35,010 So the problem today is that we have a really good economy and we still 455 00:22:35,010 --> 00:22:35,886 have a significant deficit. 456 00:22:35,886 --> 00:22:41,057 So I don't think that will create fiscal and financial instability problems, but I'm still, 457 00:22:41,057 --> 00:22:43,892 of course, we are watching very carefully what the consequences are and especially if we 458 00:22:43,892 --> 00:22:47,896 have an environment where rates are higher for longer because then the debt servicing costs 459 00:22:47,896 --> 00:22:50,606 for the government will also be higher for longer. 460 00:22:50,606 --> 00:22:55,027 So what do you make of the Treasury’s moves in relation to what's happening at 461 00:22:55,027 --> 00:22:56,069 the Federal Reserve? 462 00:22:56,069 --> 00:22:59,155 Yeah, I I, I have seen that like, and you and I also talk about 463 00:22:59,155 --> 00:23:01,991 this, it's a very important move because it is telling you that this 464 00:23:01,991 --> 00:23:04,451 To buy back long bonds absolutely using T-bills, 465 00:23:04,451 --> 00:23:08,538 Trump and the Treasury was trying to say, well, we are worried about long-term interest 466 00:23:08,538 --> 00:23:12,958 rates, so let's instead take from $2 billion in buybacks to now $6 billion buybacks. 467 00:23:12,958 --> 00:23:17,253 And this is really putting a cloud over the rates market and saying there is 468 00:23:17,253 --> 00:23:21,590 a chance we could do something, but 2 billion, 6 billion are very, very small 469 00:23:21,590 --> 00:23:24,259 numbers when total government debt is 40 trillion. 470 00:23:24,259 --> 00:23:27,095 So that's a different way of saying it's not so much the numbers that have 471 00:23:27,095 --> 00:23:27,887 had an impact. 472 00:23:27,887 --> 00:23:31,682 It's really more the threatening of hanging a cloud over rates market is that we 473 00:23:31,682 --> 00:23:35,477 could suddenly come with some headline on your Bloomberg screen that will say, well we 474 00:23:35,477 --> 00:23:36,770 are doing this now. 475 00:23:36,770 --> 00:23:39,856 And if that happens, then you want to be prepared that, well if 476 00:23:39,856 --> 00:23:42,941 that risk certainly will come out of the blue, well maybe then I should be 477 00:23:42,941 --> 00:23:45,777 a little bit more worried about betting on, on rates continues to going up. 478 00:23:45,777 --> 00:23:49,155 But nevertheless, we have still seen interest rates going up and we have now seen 479 00:23:49,155 --> 00:23:50,614 the Fed also raise interest rates. 480 00:23:50,614 --> 00:23:53,867 So the direction of travel for interest rates both in the front end because of 481 00:23:53,867 --> 00:23:57,162 inflation is higher and in the long end also

because of the fiscal problems is 482 00:23:57,162 --> 00:23:57,579 also higher. 483 00:23:57,620 --> 00:24:02,374 And there is really, unfortunately not much the Treasury Department can do about that. 484 00:24:02,374 --> 00:24:05,752 You don't need to have a view on this I guess, but do you have 485 00:24:05,752 --> 00:24:08,755 a feeling about where that ceiling is on rates on the long end? 486 00:24:08,755 --> 00:24:12,466 Because I think that that's what's kept a lot of people away this idea that 487 00:24:12,466 --> 00:24:16,177 why would I buy a 10 year at 4.8 or 4.9 if I think it's 488 00:24:16,177 --> 00:24:17,345 it'll go to 5.5. 489 00:24:17,345 --> 00:24:17,845 Exactly. 490 00:24:17,887 --> 00:24:21,640 So that's from an investing perspective, also extremely important because now it becomes important question, 491 00:24:21,640 --> 00:24:25,393 namely when are rates peaking, when do we get to a point where it is 492 00:24:25,393 --> 00:24:29,105 optimal for you and me to take a hundred dollars and put into interest rates 493 00:24:29,105 --> 00:24:30,856 because now they begin to go down. 494 00:24:30,940 --> 00:24:31,273 Right. 495 00:24:31,565 --> 00:24:35,235 I still think at this point, given the AI growth story is so strong that 496 00:24:35,235 --> 00:24:38,946 it's a little bit too early to do that, but it's very clear to watch 497 00:24:38,946 --> 00:24:42,616 the other parts of the economy, housing, autos, other things that are interest rate sensitive 498 00:24:42,616 --> 00:24:46,077 because they continue to be dragged down if interest rates continue to go up. 499 00:24:46,161 --> 00:24:49,538 So if that's the case, it becomes a race where on the one hand high 500 00:24:49,538 --> 00:24:52,916 hand you have both AI doing well, but on the other hand you have other 501 00:24:52,916 --> 00:24:55,585 parts of the economy naming housing and autos doing less well. 502 00:24:55,585 --> 00:24:59,297 So in that race we are watching very carefully not only AI, which has had 503 00:24:59,297 --> 00:25:03,008 a lot of hooray, hooray for a long time, but also watching the parts that 504 00:25:03,008 --> 00:25:04,009 are not doing well. 505 00:25:04,009 --> 00:25:05,760 Namely what are they saying, what are they doing? 506 00:25:05,760 --> 00:25:09,472 And if it gets worse, how big weight should we give to those parts that 507 00:25:09,472 --> 00:25:11,348 are dragging down in my GDP forecast? 508 00:25:11,348 --> 00:25:15,101 And therefore, ultimately the answer to your question is those things that are interest rate 509 00:25:15,101 --> 00:25:18,896 sensitive, will they become so big that it will begin to ultimately become a problem 510 00:25:18,896 --> 00:25:19,939 for the overall economy? 511 00:25:19,939 --> 00:25:23,316 That's not what we're seeing at the moment, but if you have a combination both 512 00:25:23,316 --> 00:25:26,694 of interest rates going up and AI slowing down at the same time, then you 513 00:25:26,694 --> 00:25:30,072 could have both the interest rates since its passed, pulling lower, and also AI beginning 514 00:25:30,072 --> 00:25:31,073 to pull lower. 515 00:25:31,073 --> 00:25:34,659 So what does this mean for one of the most highly talked about areas of 516 00:25:34,659 --> 00:25:36,077 the market this year? 517 00:25:36,077 --> 00:25:40,831 Private credit? On one hand, as a floating rate asset class on balance, it actually 518 00:25:40,831 --> 00:25:43,416 kind of becomes more attractive it feels like. 519 00:25:43,416 --> 00:25:47,628 But on the other hand, you have a whole host of borrowers that will be 520 00:25:47,628 --> 00:25:49,630 beholden to higher debt servicing costs. 521 00:25:49,630 --> 00:25:49,838 Yes. 522 00:25:49,838 --> 00:25:54,009 And there it becomes extremely important therefore to look under the hood and say, what 523 00:25:54,009 --> 00:25:58,179 are different types of credit doing in this environment when we have interest rates higher 524 00:25:58,179 --> 00:25:59,054 for longer? 525 00:25:59,054 --> 00:26:03,266 And the simple answer to that is that businesses in private credit that have been 526 00:26:03,266 --> 00:26:07,478 lent to that are very, very sensitive to interest rates higher for longer is in 527 00:26:07,478 --> 00:26:08,687 particular software. 528 00:26:08,687 --> 00:26:12,482 Software makes up 25% of all direct lending outstanding. 529 00:26:12,482 --> 00:26:17,361 It's an asset class direct lending that is about $2 trillion and roughly $500 billion 530 00:26:17,361 --> 00:26:22,240 of that $2 trillion is lending to software companies in particular lending to application software 531 00:26:22,240 --> 00:26:26,119 companies and less lending to infrastructure and less lending to cybersecurity. 532 00:26:26,119 --> 00:26:29,872 The problem with this is that AI is now a threat in terms of disrupting 533 00:26:29,872 --> 00:26:32,124 the business model for a lot of software companies. 534 00:26:32,124 --> 00:26:35,335 Because if I want to learn a language I would use to download an app, 535 00:26:35,335 --> 00:26:38,546 but now I can learn the language also of course on Claude or ChatGPT. 536 00:26:38,546 --> 00:26:41,632 If I have to take the ACT, the SAT or a test. 537 00:26:41,632 --> 00:26:44,968 Now I can also just use Claude, uh, of course ChatGPT for that. 538 00:26:44,968 --> 00:26:48,971 So that means there's an AI disruption risk, which is threatening, especially applications. 539 00:26:48,971 --> 00:26:53,683 But there's also the higher for longer risk because software companies generally are characterized 540 00:26:53,683 --> 00:26:54,809 by two things. 541 00:26:54,809 --> 00:26:59,104 They generally have a lot of leverage and they generally have very low coverage ratios. 542 00:26:59,104 --> 00:27:04,234 Coverage ratio measures my earnings divided by my debt servicing cost, and the software sector 543 00:27:04,234 --> 00:27:09,405 stands out dramatically from everything else in private

credit because the other parts of credit 544 00:27:09,405 --> 00:27:13,241 that are in the private markets is hotels, restaurants, machinery, construction. 545 00:27:13,241 --> 00:27:17,620 They generally have much less leverage and they generally have much higher coverage ratio, much 546 00:27:17,620 --> 00:27:19,496 better ability to service that debt. 547 00:27:19,496 --> 00:27:22,123 So that's a different way of saying inside credit. 548 00:27:22,123 --> 00:27:26,544 When you look under the hood in private credit, different managers have different strategies and 549 00:27:26,544 --> 00:27:30,964 managers that have strategies that are more vulnerable to interest rates higher for longer are 550 00:27:30,964 --> 00:27:32,424 going to have more headwinds. 551 00:27:32,424 --> 00:27:36,761 Because these strategies, especially in software that have high levels of debt and very little 552 00:27:36,761 --> 00:27:41,098 ability to service that debt, they of course will have more problems with servicing that 553 00:27:41,098 --> 00:27:43,391 debt servicing cost when interest rates are high. 554 00:27:43,391 --> 00:27:47,853 Whereas again, for example, hotels, restaurants, they have revenue, they have earning, they have customers, 555 00:27:47,853 --> 00:27:49,897 whereas software is waiting to develop that. 556 00:27:49,897 --> 00:27:51,356 They only get customers down the road. 557 00:27:51,356 --> 00:27:55,026 So that means that those types of loans in private credit are actually going to 558 00:27:55,026 --> 00:27:55,860 do relatively better. 559 00:27:55,860 --> 00:28:00,322 So that's why it is not about private credit as an asset class, it's really 560 00:28:00,322 --> 00:28:03,700 about what did different private credit managers actually lend money to? 561 00:28:03,700 --> 00:28:08,412 Which type of businesses was it and were those businesses sensitive to interest rates higher for longer? 562 00:28:08,412 --> 00:28:10,580 It's been hard for people to understand what's been going on under the hood. 563 00:28:10,580 --> 00:28:15,835 There was this great story by my former colleagues over at Bloomberg, private credit defaults 564 00:28:15,835 --> 00:28:19,338 are 1%, 6% or 19% depending on who you ask. 565 00:28:19,338 --> 00:28:20,005 Yeah. 566 00:28:20,005 --> 00:28:22,340 So what is your view on where they're headed? 567 00:28:22,340 --> 00:28:26,302 This is important because this is exactly a matter of where do I measure? 568 00:28:26,302 --> 00:28:27,761 If I lend to a software company? 569 00:28:27,761 --> 00:28:31,514 Default rates of course have been higher if I lend to hotels and restaurants, default 570 00:28:31,514 --> 00:28:32,682 rates have been lower. 571 00:28:32,682 --> 00:28:36,143 So that's why if you measure in certain parts of the leverage spectrum, in some 572 00:28:36,143 --> 00:28:39,604 parts of the leverage spectrum, there's been more vulnerability in other parts of the leverage 573 00:28:39,604 --> 00:28:41,064 spectrum, there's been lower vulnerability. 574 00:28:41,064 --> 00:28:45,318 So this is a very difficult issue because it becomes a matter of discussion around 575 00:28:45,318 --> 00:28:49,571 what type of industries are we talking about or what areas of the economy are 576 00:28:49,571 --> 00:28:52,991 doing well, what areas of the economy are doing not so well? 577 00:28:52,991 --> 00:28:56,619 And in this case, for the rates higher for longer discussion, what areas of the 578 00:28:56,619 --> 00:29:00,247 economy is it that are more sensitive to interest rates and what areas of the 579 00:29:00,247 --> 00:29:02,665 economy is it that are less sensitive to interest rates? 580 00:29:02,665 --> 00:29:06,544 So put in different words, the vintages that were underwritten in 2021 and 22, for 581 00:29:06,544 --> 00:29:07,836 a lot of private credit. 582 00:29:07,836 --> 00:29:08,253 Mm-hmm . 583 00:29:08,253 --> 00:29:12,465 Those who underwrote vintages with a seven year bullet, meaning a seven year fixed interest 584 00:29:12,465 --> 00:29:16,677 rate, they need to reset now as we get to 2028 and 2029 and those 585 00:29:16,677 --> 00:29:20,889 private credit managers and those parts of credit that did do vintages in those years 586 00:29:20,889 --> 00:29:25,059 under the assumption that interest rates would never go up, those are the areas where 587 00:29:25,059 --> 00:29:26,769 we have seen higher default rates. 588 00:29:26,769 --> 00:29:30,563 Whereas those that were underwritten with their assumption that maybe interest rates could go up, 589 00:29:30,563 --> 00:29:32,357 then they of course are less vulnerable. 590 00:29:32,357 --> 00:29:35,443 And that's why default rates have been lower in those parts of the economy. 591 00:29:35,443 --> 00:29:37,903 Same question applies to private equity that Absolutely. 592 00:29:37,903 --> 00:29:38,570 That backs a lot of this. 593 00:29:38,570 --> 00:29:39,613 Last question for you. 594 00:29:39,613 --> 00:29:43,616 What do higher interest rates mean for private equity, especially when there's still a number 595 00:29:43,616 --> 00:29:46,035 of deals that were written in those vintages? 596 00:29:46,035 --> 00:29:46,327 Yeah, 597 00:29:46,327 --> 00:29:50,038 Because those vintages that were underwritten also in 2020 and 21 and 22, of course 598 00:29:50,038 --> 00:29:53,791 they were likely underwritten with the idea that interest rates are not going to go 599 00:29:53,791 --> 00:29:54,542 up. 600 00:29:54,542 --> 00:29:58,086 And raising the bar for private equity also means that companies that have cash flows 601 00:29:58,086 --> 00:30:01,798 far, far out in the future are now going to be more vulnerable, both in 602 00:30:01,798 --> 00:30:03,841 public markets and also in private markets. 603 00:30:03,841 --> 00:30:08,345 That means in private equity, it really is very essential to ask the question if 604 00:30:08,345 --> 00:30:12,849 the debt servicing costs are high, are the companies that I'm investing in private 605 00:30:12,849 --> 00:30:16,351 equity, are they able to pay the higher debt servicing costs? 606 00:30:16,351 --> 00:30:19,604 In other words, this is all about growth versus value. 607 00:30:19,604 --> 00:30:23,941 Value means that our companies today that you invest in is companies that have higher 608 00:30:23,941 --> 00:30:28,278 ability to pay for the higher debt servicing cost that comes along when interest rates 609 00:30:28,278 --> 00:30:29,446 are higher for longer. 610 00:30:29,487 --> 00:30:33,866 So the short answer to your question is in private equity, what has been outperforming 611 00:30:33,866 --> 00:30:38,245 is high quality companies that have, of course, ability to pay their debt servicing cost. 612 00:30:38,245 --> 00:30:42,415 Whereas companies that do not have much earnings and have cashflows in the future, they 613 00:30:42,415 --> 00:30:43,582 have been struggling more. 614 00:30:43,582 --> 00:30:43,874 Yeah. 615 00:30:43,874 --> 00:30:48,211 It's time to pull out the AI tools with all of those DCF capabilities. 616 00:30:48,211 --> 00:30:49,337 Exactly. 617 00:30:49,337 --> 00:30:50,380 Torsten, thank you for joining. 618 00:30:50,380 --> 00:30:51,547 That is Torsten Slok. 619 00:30:51,547 --> 00:30:56,051 He is the chief economist at Apollo Global Management at a critical inflection point in 620 00:30:56,051 --> 00:30:57,886 the macro and for artificial intelligence. 621 00:30:57,886 --> 00:31:00,471 And you've been watching The Bridge by iCapital.