Michael Hartnett: I coined “Mag7” - Here’s What Ends Their Run

The Master Investor Podcast with Wilfred Frost

Michael Hartnett discusses the structural evolution of the current decade, focusing on the transition from globalization to deglobalization a

Key takeaways

• The 'Magnificent Seven' are shifting from high free cash flow to massive AI CapEx spending exceeding $1 trillion annually.
• Rising bond yields and spreads pose a significant threat to the sustainability of the AI investment cycle.

Main topics

• Magnificent Seven transition
• AI CapEx and bond market risks

Notable quotes

Buy is humiliation and sell hubris.

Conclusion

The episode provides a strategic framework for navigating a decade def

Transcript preview

Speaker 1 (0:00) Part of the reason to say they're magnificent is because they made magnificent amounts of cash and didn't spend any of it. That's why they were magnificent. Now they're spending a trillion plus a year on AI capex and their negative cash flow to the tune of 200 billion. So they have to be kind of subservient to the bond market. If the bond market pushes up yields or spreads too much, you're not going to get the spending. You know, if you look at what happened with the railroads, you know, what kind of ended it was social upheaval. A kind of a social upheaval that can happen when an industrial revolution creates enormous inequality and a lot of workers strike. And that's why, you know, these midterms look quite fascinating in terms of how people will vote. But the other thing that pops, bubbles and booms and balls. is bonds. That's what we've been talking about. And so we're still waiting for that level to do that. I feel that... The market in its entirety is not yet convinced that you're at this major secular inflection point. You were in equities in 2008, as you say. You were in 2016 when we had Brexit, Trump in terms of commodities. Those were regime-changing years. But people don't yet think that 2026 is going to be a regime-changing year for bonds. The question is, is it going to be for AI? Speaker 2 (1:31) Welcome to the Master Investor Podcast with me, Wilfred Frost, where we celebrate and learn from the success of the greatest investors, business leaders, and politicians in the world, giving you, our listeners, an edge. The Master Investor Podcast is sponsored by LSEG, Interactive Brokers, the World Gold Council, and BNY Investments. Please Speaker 1 (1:52) do remember the views expressed in Speaker 2 (1:54) this podcast are for general information purposes only. Nothing in the podcast constitutes a financial promotion, investment advice or a personal recommendation. More on that in the show notes. My guest today is Michael Hartnett, the famed chief investment strategist of Bank of America Global Research, who is always immaculately researched and focused on the facts. but yet still manages to make very bold contrarian predictions. And it is also very rare to have him on an extended podcast. Michael, welcome to the Master Investor Podcast. And thanks so Speaker 1 (2:32) much for joining us. Yeah, thanks very much for having me, Will. Pleasure Speaker 2 (2:34) to be here. Great to be with you here in London. Two Brits that have spent lots of time in New York, but connecting here. I also failed to say in the intro. You coined the phrase Magnificent Seven. I did. I did. Purely by luck than judgment, as is most of the case. I always thought that was Speaker 1 (2:53) a Jim Cramer coinage. Speaker 2 (2:54) And I, in my research for this, have corrected myself on that. Yeah, Speaker 1 (2:57) yeah. No, no. He's actually once come up to me and congratulated me on that. Because he'd done Fang, which was a sort of short-lived predecessor. Yes, yes, yes. Speaker 2 (3:07) And yours has lasted much longer. Speaker 1 (3:09) Yeah, it seems to have. I mean, you know. Remember with the Magnificent Seven, only two of them. you know, we're alive at the end. So, you know, we'll see where that pans out. Well, I Speaker 2 (3:18) was going to say, as part of this conversation, maybe we will explore as to whether it will be still the key moniker for the next five years or not. And we can unpack that. But to start with, if we could just set the scene of sort of, Speaker 1 (3:31) not Speaker 2 (3:32) all of time, but of this decade that we're halfway through so far. And you've written about this over a period of time, but... This decade, you think, is very much been shaped by the response to COVID. Speaker 1 (3:47) Yes. I mean, I think this is a decade of extraordinary change. Certainly, you know, comparable, I would say the only recent comparison is probably the 1980s, you know, in that you have. Big things happening, you know, and big things changing. So we've gone from a world of globalization to deglobalization. We've gone from a world of monetary excess to fiscal excess. We've gone from peace to war, elitism in terms of our politics to populism. So there's a lot of sort of new stuff that, you know, the market and the economy has had to, you know, digest. And I think that all of those things. you know, have created a backdrop for financial markets of an economy that is booming in nominal terms. I mean, the U.S. in particular. I mean, the U.S. is a massive economy. Yeah. And yet. That massive economy has grown, I kid you not, 66 % in six years. I mean, the US has added three United Kingdoms in terms of GDP in the past six years. And again, it's driven by the fiscal excess. Nominally. Nominally. So you've Speaker 2 (5:02) got Speaker 1 (5:02) growth and inflation. which is a very important point to make, and that's why profits obviously have done quite well. So I think that right now we're just in this steady state. I mean, it's not steady, but an unsteady state, if you like, of nominal boom. And, of course, that in turn has created an environment where people don't want to own bonds and only want to own equities. It's had a pronounced impact on asset allocation as we've gone through the decade. And Speaker 2 (5:32) just, by the way, to... to pick up on that. A reminder for this episode, we do have some charts for our viewers. If you're listening and want to watch, there'll be some charts that sort of pair up at times, including that nominal GDP growth to what Michael's saying, but no need to move if you are listening. And I guess part of what's driven that huge nominal growth and accompanying inflation has been the stimulus that came out of COVID. And that stimulus was what initially? monetary and also fiscal picking up the slack during that process or fiscal stimulus as well throughout. Speaker 1 (6:10) Yes. I mean, I think, you know, as you remember back in, you know, the global financial crisis, we responded to that primarily through monetary policy, quantitative easing, zero rates, negative rates. So even 20 years ago, never heard of this stuff, but that became the norm. But it wasn't fiscal spending. You know, the UK. Europe, you know, was still sort of very much try and balance your budget as best as you can. COVID changed that. You know, like you say, there was an enormous monetary response, enormous, enormous. But at the same time, that was joined, you know, by fiscal policy. And again, I think COVID obviously was the catalyst for it. But again, I think the rise of populism contributed to that because there was a big political... We've got to stop the populace from getting power, so we've got to find ways to spend to keep the electorate happy. And the other part of it obviously was the geopolitics is that, you know, wars cost money. So, you know, that was another side of it that also added to the fiscal excess. But, you know, as I said, all of it has contributed to probably, you know, you think of the great investment trends this decade. One is ABB, anything but bombs. The other one is obviously AI, you know, and that's probably, you know, they are connected. I mean, to a certain extent, the rise of the MAG-7 was because nobody wanted to hold government bonds. I don't want the government balance sheet. They spend like drunken sailors. Why do I want to lend to them? I'd rather put my money with companies that have tons of cash and don't spend any of it. That was the MAG-7. And I guess just to dwell on that, that Speaker 2 (7:59) what you would expect has happened in the market, i.e. Equities, particularly those AI companies, have done incredibly well in that 66 % growth in nominal GDP. And bonds, particularly long bonds Speaker 1 (8:12) in the government side of Speaker 2 (8:13) the Speaker 1 (8:13) market, have done very poorly. Yes. I mean, the question becomes, you know, can that continue indefinitely? You know, is there a yield? Is there a cost of capital that impedes that AI capex story? Because let's not forget that the... you know, the MagSem, the Hyperscalers, whatever you want to call them. Part of the reason to say they're magnificent is because they made magnificent amounts of cash and didn't spend any of it. That's why they were magnificent, you know. Now, you know, they're spending a trillion plus a year on AI CapEx and their negative cash flow to the tune of, you know, 200 billion. So that's... you know, the bond market now becomes, they have to be kind of subservient to the bond market. You know, if the bond market pushes up yields or spreads too much, you're not going to get the spending. So there's lots of things to unpack there. And Speaker 2 (9:09) I think the first one I just want to kind of dwell on, on one of these big, big shifts has been the rise we've seen in yields, which, as you said, the turning point might have been a few years ago, but I think the acceleration has been more recent. Gauge for me, Michael, the scale. of the recent increase in yields and I guess the impact we've seen but perhaps not seen yet. I mean, is it underwhelmed the sell-off and equities you might have expected to see in relation to such a sharp spike in Speaker 1 (9:39) yields? Speaker 2 (9:39) Yes, I mean, Speaker 1 (9:40) I think, I always think, you know, try and keep things super, super simple. You know, markets, it's about interest rates and earnings. That's it. You know, if the UK budget, which is coming up, impacts interest rates or corporate earnings, it matters. If it doesn't, it's irrelevant. You know, so the point of mentioning that is that you are absolutely right. The cost of capital, zero, you know, to 2020 and it's now five, you know, plus. And yet the stock market's close to a record high. How is that possible? Well, it's possible because of the earnings. You know, that you haven't reached a level of yields, a cost of capital that is compromising the ability of the U.S. corporate sector to make money. There will be a moment when you get there, but we're obviously not there yet. That's one answer. The other answer is actually it has. You know, and when we've seen, I mean, 2022 being a great example, when you see a disorderly rise in interest rates, and I think that's... What you're referring to more recently is suddenly it was so disorderly that Betten has to come in, double buybacks on bonds or intervene in currency markets because 5 % is the measure no line. They do not want the 10-year treasury to exceed 5%, and that's when they intervene and they panic and do things. So clearly that move to 5 % under the hood of the market. has caused a tremendous amount of pain and a lot of pain in fixed income, you know, because of the flattening of the yield curve. But in the equity market, as of last week, sort of early, sort of early, mid, late September, you had more than half the companies in the S &P that were trading below their 200 day moving averages. So it there is it has caused pain, but at an index level, unless you hit the big stuff. you know, the index is going to stay relatively high. Speaker 2 (11:41) Can we just unpack the first explanation that you just mentioned of when bond yields rising should or shouldn't hit equities? And essentially your point there being at the moment it's risen, but all of these companies are still able to continue to grow their earnings. It hasn't derailed the economy, which I totally get. At the same time, you could say the alternative for people who... might buy equities or bonds, bonds has got a lot more attractive. Speaker 1 (12:12) And Speaker 2 (12:13) yet the earnings growth on offer from these companies hasn't got more attractive. It might not have collapsed, but it hasn't got more attractive. So to what extent does that, in all the investors you speak to, enter their psyche? I mean, I have to say, it really enters my psyche. I graduated in 2008, could not put any money to work without taking risk until recent years. Speaker 1 (12:32) And Speaker 2 (12:32) now I can. Speaker 1 (12:33) It's Speaker 2 (12:34) very attractive. But I don't think many people think like I do. They Speaker 1 (12:37) don't. Speaker 1 (12:39) So that fact is not really relevant, that there's this attractive risk-free asset? Look, I think that there is a huge amount of money that would very happily take the gains that they've had in equities and park that. In a five year T-bill or a six percent, 10 year yield. And, you know, I would say certainly there is a large body of investors that are waiting for a level, a moment, a catalyst to say, I can now shift from here, shift to there. Is it an election? Is it? A recession? Is it, you know, a bubble bursting? You know, there is potential catalysts to say yields are coming down. The problem is that you still have this huge psyche, which is this is not 1980, 1979. You know, 1980, 1979, you had a society that said, I am sick of this inflation. I'm sick of being able not to not being able to afford things. I'm sick of the strikes. I'm sick of this government. I want something completely different. I don't care if it's a grocer's daughter. I don't care if it's a Hollywood actor. I want people that will reduce the deficit, reduce the spending and get interest rates lower. And that was a huge inflection point. And right now, there is not yet a sense that you have not just the politicians, but also the electorate that is willing to vote for people that want to. do things, government things that will make bond yields more attractive, which is why people will say, yields are not going to go up in a disorderly way. They'll stop