Data Center Bottlenecks and Gulf Infrastructure

Podcast has been prepared exclusively. For institutional Wholesale. Professional clients and qualified investors only. as defined by local laws and regulations. Please read other important information, which can be found on the link at the end of the podcast episode. ... morning this is Michael Sembalas with the May two thousand twenty six. I in the Market podcast. Uh this one's called Abandoned Ship, which I'll explain shortly. As you can see here, there's an image of a bunch of well dressed elephants jumping off the SS. two thousand twenty six midterm shipment to the ocean Which is the uh theme. Um, I've been traveling a lot recently. I was in Scottsdale and Um, someplace called the Salamander Hotel in D C and then I was in Bozeman and then Miami and then Laguna Beach. I still don't know where exactly that is. And then Los Angeles. Um, and uh so I was thinking of getting this motorized Um suitcase, but then I decided that I would look completely ridiculous. decided against it and I'm continuing to walk through airport target. Um Uh in any case, uh This side in the market is kind of a compilation. of a lot of the different topics. that I've been talking about the clients recently. uh the midterm elections, relevant barometers, and then all the issues around congressional congressional redistricting. Spring the uh spring thaw on US economic conditions. US earnings and economic resilience and the issue of energy intensity, uh a rationing timeline for the straight or four moves. I'll explain what I mean by that. on hyperscaler earnings, tech valuations, debt financing. Some issues around de data center build out issues. Um and then an idea called the Gulf Super Express, which will probably never happen. is worth reviewing just in case it does. So before we each get started. A couple of weeks ago we published a piece on Methos, given its exceptional ability to wreak havoc by identifying software vulnerabilities and then the race between patching and hacking. Last week, JP Morgan published a really interesting well-researched note. On the cybersecurity vulnerability. of operational technology such as aircraft, autopilot systems, factory robots. power grid controls, rail railway track shifting systems, things like that. It's a very sobering read, but um I think it's worth the effort. Okay, so what is abandoned ship all about? So you probably have s have heard that um so far thirty six house Republicans have decided not to run for reelection. this fall. It's the highest number on record since the data begins in nineteen thirty. So almost a hundred years. And um So can we infer anything from this? When the number of GOP retirements is low, let's say less than ten. Usually There's not much going on in the next election. Um when the retirements have been between ten and twenty. It's a mixed bag. Sometimes Republicans lose seats, sometimes they gain seats. When more than twenty republicans retire from the house, it it is historically been a signal they are about to get routed in the midterm elections. And so um Uh, we have a chart here that shows that trifecta of different conditions in terms of GRP retirements and what tends to happen. in the subsequent election. So You can take a look at that. But some of these Uh some of these dots imply Pretty large losses. uh for the GOP in the midterms we'll see. Some of the challenges the GOP will be facing, of course. is an outright decline in blue collar employment, which I think Well it would be very disappointing to the administration. uh since that was a priority of theirs. So blue collar employment in in terms of utilities. transportation, natural resources, mining, extraction, construction, manufacturing. These things are uh uh absolute uh declines in employment. Um since Trump was inaugurated. Everybody knows there's been Huge increases year to date in terms of commodity prices. National gas has gone down, but the rest of the entire suite. commodities, oil related commodities. And uh refined products. fertilizers, propylene, methanol, sulfur, jet fuel, shipping fuel. fertilizer, you name it, have gone up quite substantially. Anywhere from forty percent to a hundred and twenty percent. And inflation expectations are unsurprisingly rising. They were declining coming into the end of last year. war has reversed some of that. So now you're starting to see inflation expectations pick up. And there's some other things going on that that uh voters may also focus on. Uh there are soaring ACA premiums. So from two thousand nineteen to two thousand twenty five. The ACA marketplace for health care insurance. Um had annual premium increases that were at most seven percent, usually closer to four to five percent. In twenty twenty six, they're gonna go up twenty six percent. Premiums. On an absolute basis. And when you couple that with the loss of the enhanced premium tax credit. It's gonna result in an effective hundred and fourteen percent increases. Uh a hundred and four fourteen percent annual increase. In premium. Um for the ACA enrollees. So Uh, those are pretty eye popping numbers. As you all know. Soon as RFK Jr. gets sworn in as uh Secretary of Health and Human Services, we have the outbreak of a measles epidemic. So that's just a coincidence. And then there were some very strange doings at the Department of Justice. um that are starting to get surfaced as well that I thought would be interesting to talk about. Um We have a chart in here that looks at Going back to two thousand four. The number of cases terminated. each year by the Department of Justice. Sometimes the Department of Justice terminates cases 'cause they go stale. Sometimes they terminate them because their priorities are shifting. There was a by far. Um by by more than a factor of two. The largest spike in case terminations by the Department of Justice. Um under under uh the last year or so. And um The weird thing is that when you look at at by category. The administration reduced the terminated immigration cases, right? Because it was picking up prosecutions of immigration. Increase the pace of case terminations. Labor racketeering. National security, terrorism, organized crime, white collar crime, drugs, corruption, civil rights, you name it. Every single other category listed. showed an increase in declined cases. Um Three hundred cases involving Material support to foreign terrorist organizations, sixty union corruption and labor racketeering cases, five thousand cases of money laundering and federal drug law violation violations. So Some very strange doings at the Department of Justice that uh are also kind of swirling around the midterm election. Now The Republican Party to change some of the math through redistricting. Uh, and this is very much of a process. And We have a chart in here that keeps tabs on what's happened so far. So The GOP. And I remember all of these redrawn districts don't automatically become either Republican or Democrat. The midterm results, you know, the people vote in the midterms. you know, the issue is the way that those new districts are drawn. presumably will result in the assumed gain for the for the parties that redraw them. Texas picks up five. North Carolina picks up one, Ohio picks up two. Missouri may pick up one subject to some state Supreme Court challenges. Then on the Democratic side, California picks up five, Utah picks up one. reasons we explain in the piece. I don't want to go through it now. Um, and then you had the Virginia referendum, which could pick up four seats. Um Uh, DeSantis has recently had a new map proposed that the state ledger approved last week. Um but Florida has an explicit prohibition on partisan gerrymandering. So that's gonna go straight to this to Florida State Supreme Court. Um And then in Tennessee and Louisiana, there might be one seat each that flips to the GOP. based on the decision of the Supreme Court last week, uh related to the Voting Rights Act. And they where they decided that Using race. Uh as a purpose for creating these so called majority minority districts. Is unconstitutional. And so Tennessee and Louisiana each may rush redo their primaries and redrawn districts. We'll see what happens. Bottom line from all of this. Is that In the worst case, the GOP probably loses a seat on that. And in the best case could pick up as much as nine. And then the swing is somewhere in there. I did want to talk for a couple minutes about Virginia. Because there may be a really kind of embarrassing unforced error. Democrats made in Virginia as it relates to the referendum. Let me just spend a minute on that because I think it's interesting. Virginia's state constitution is similar to California's, uh, and it includes protectian gerrymandering. And so in Virginia the the normal rule is that you need a bipartisan commission. to propose new maps. And they can only meet once a decade. Just like California. Virginia held a referendum. So voters could say, Yeah, we want to keep these provisions. But we wanna temporarily or suspend them until the end of the decade so that the legislature instead of a bipartisan commission can redraw the maps and can do it in a very partisan way. So the new congressional map in Virginia would replace the six Democrat, five Republican balance with something like 10 to one. So But on the referendum ballot, unlike in California. Virginia added the phrase that they were doing this to restore fairness. that language actually on the ballot. And so that's raising issues. Fairness to whom? other redistricting efforts all across the country by both parties. These measures don't advance fairness in that state. because they create legislative balances that are much more extreme than the voter population balances by part. And There are legal questions regarding the use of that fairness language on the referendum itself. the Virginia Supreme Court may now evaluate. Um, and that's one of the reasons that a state trial court and joined state officials from certifying or prevent the state officials For them certifying the results. We'll see what happens. Maybe they just let it go through. They could require them to hold it again, but this does seem like something of an unforced error by the state of Virginia. include that kind of language on the ballot itself. Okay. So Let's go to the next topic. The What's a little surprising about So many House Republicans bailing. is that the economic data not num not necessarily the labor market data. The economic data is a lot more resilient than expected. And um Uh we have a series of charts at the eye on the market that we always that we have in our trunk tracker. that shows this. So a weekly there's a weekly index that tracks the economy, comes out of the Dallas Fed. Pretty good. um surveys of business cycle indicators and things like the Empire Manufacturing Survey. uh regional surveys, uh Conference board, consumer confidence, Dallas Fed, things like that. That looks pretty good. My favorite uh indicator is this thing called manufacturing orders less inventory as it measures the pace at which manufacturing orders for new equipment are outstripping inventory growth. Pretty good. Um a measure of flatbed trucking demand is is picking up, or whatever that's worth. Some people like that. loan demand at the banks is rising. And so the number there's a lot more people uh banks uh reporting an increase in loan demand. And then just basic durable goods orders. Or and shipments are also rising. So the US economy is actually proving to be pretty resilient. in the face of this war. Um Along with that resilience has come Uh some inflation measures which are no longer fall. And so in the next time in the market in June to celebrate the new Fed chair, you know, good luck to him. Some some what's that phrase? Some don't wish for something, you may get it. Um the new Fed chair is going to be stepping in right around the time that higher oil prices are set to produce to boost producer prices. Um There's an inflation surprise index in the US that's going up. And uh the new Fed share is also gonna have to deal with rising prices paid. data and then core P E C E is rising again. Now I I saw some I saw some recent commentary. where the new fed chair says, you know. We should probably use trimmed PCE. To be tracking inflation. That's the one inflation measure measure that happens to be going down right now. The problem is that was an abysmal measure. If you were trying to use it to track the inflation surge. uh that took place under Biden, which presumably all these Trump people are still criticizing. Um, and that would have been an abysmal way to try and track the fight inflation era. So Uh interesting that they have cherry picked the one area that is currently showing lower inflation. We'll see how that works out. Anyway, that's for the Juni and the Mark. It's not just the US economy that's been proving resilient. It's also S P earning. And and that's really I think the best explanation for why you've had this V shaped recovery. Markets recently. Um Now, you know, while the while the commodity shock from the war is still playing through. There's other forces upsetting it. Lower tariffs. Uh particularly after the Supreme Court decision. uh individual tax cuts, corporate tax cuts, all of those things are providing stimulus of roughly two percent of GDP this year. As for Q one earnings so far, around half of the companies have reported. Um Sales growth of ten percent, earnings growth around twenty to twenty five percent. positive news on surprises. And only a handful, literally a handful of companies have revised their 2026 earnings guidance down so far. In spite of the war. So um This looks pretty resilient to terms of an earnings picture. Now, of course, one of the reasons for that is the primary driver. are technology related issues, which We'll talk about in a few minutes. Um, but I did want to show this one chart 'cause I think it's really important and we've been talking about this ever since the war started and in our energy paper in March. gasoline prices still matter, right? The US is a commuter society. We don't have very good public transit. A lot of people drive. They drive. SUVs and and other cars primarily that have pretty crappy gas pileage. We don't have a a gas uh a national large gasoline tax, et cetera, et cetera. That all set. The oil intensity of the United States. Is Either half Or Twenty percent. of what it was when I started working at JP Morgan almost forty years ago. And we have a chart in here that looks at the oil intensity of GDP. Which is down by half since then. Uh and better, the oil intensity of S P And economy wide profits is down anywhere from seventy five to eighty percent. And so I think that's An important way of understanding why the economy in the stock market might be more resilient. So oil shocks then it has then it would have been an app. ten years ago, fifteen years ago, or twenty years ago. And as semiconductor consumption continues to rise. And as ener energy efficiency and fuel switching continue. I would expect these oil intensity numbers to continue to fall. uh in the years ahead. So this is one way Up understanding. profits and growth may be more resilient to these oil shocks in the United States. Now that said. coast is not entirely clear. Because what's happening is The the world is facing the prospect of declining global oil inventories. And you can't draw them down past a certain level. So we have a chart in here that looks at global oil and refined product inventories. That have range. Somewhere in the neighborhood they of eight and a half. eight eight and a half billion barrels. um over the last few years. Um and Global oil and refined product inventories refers to oil that's sitting around in storage tanks, in terminals, in pipelines, in floating tankers, or in strategic reserves. Now they're being drawn down by a Bay eight million barrels a day. And by June or July sometime. uh they we you may hit an operational stress point. And for those of you that work in the oil and gas industry or the pipeline industry. You'll understand you can't You can't Let the pressure in oil and gas pipelines fall below a certain level or else you kind of lose the ability to have it function properly. And so By June or July we're gonna start hitting globally some operational stress points. Below which Uh I think it would be difficult for inventory to continue to be drawn down. And if that's the case, if the strained of Hormuz has reopened by then. you're gonna start seeing more fuel rationing primarily in Asia and Europe, but that's gonna have some economic aftershock effects for the US as well. Now if the straits not open by September then you're definitely gonna hit some kind of floor. Um a little bit below seven billion barrels. where you'd really start to see a lot of demand destruction. So Putting a rough timetable on it where we're sitting right now, um, you know, the administration has about a month and a half to try to get the straight reopen. before you start seeing more severe economic consequences. You remember a few minutes ago I talked about how uh the oil intensity of GDP has gone down, well and of profits. That's because The AI intensity of GDP and profits has gone up. And We w I we have this table in here that we had in the beginning of the year. Since Jack since Jack G P T was launched at the end of two thousand twenty two. There's about a forty two AI related stocks. include some of the turbine manufacturers and other companies that feed off of the AI ecosystem. These forty two companies in the SSP five hundred have accounted for seventy five to eighty five percent of the price returns. Earnings growth. and and R and D growth in the entire SP five part. This is an unbelievably concentrated bet. that's taking place in the US. Um Uh the latest earnings from the hyperscalers and things like that suggest that for adoption of AI and adjant AI is is generating some revenue growth, the productivity numbers are generally moving in the right direction. So the AI trade is very much alive and well. Interesting. is as we've been talking about Um, the damage that the agentic AI programs like Claude and and uh And open AI. Crushed. some of the software stocks to the point where there was a huge drawdown in s in broader technology PEs. of almost forty percent at its worst level, still the the PEs are still down thirty percent. And this is the amazing thing. You're not gonna believe this chart until you see it. But if we look at all these different sectors and regional markets. US technology stocks have the lowest ratio. of price to earnings divided by earnings growth. Right. So this is what's called a peg ratio. And It has to do with what's the PE divided by earnings growth though, what's the price you pay for earnings growth. At this point. um looks to be the cheapest on this entire chart. Now, some of these stocks are now cheap for a reason because some of the SaaS vendor stocks are gonna find it very difficult to recover, but as we've written about before, we think there've been too much selling. And that there's gonna be more resilience in that sector that's been twisting so far. But I thought it was interesting to look at just how tech sector has become on we're using this particular lens. Um The latest The latest projections from the hyperscalers. Is Twenty twenty six, the next twelve months or so is the last huge surge. in capital spending R and D before it starts to level out in twenty twenty seven. Just to be clear, these companies are spending Forty, fifty, and sixty percent of their revenue is on capital's bet. I think that's that's gargantuan that compares to average tech stock. Um in in the S B five hundred, which spends eighteen percent. of its revenues on capital spending and R D. So that's just kind of basic. Because of those soaring expenditures. in in terms of capital spending, the hyperscaler free cash flow margins are starting Come down. Um I think the markets will have some patience here, but at some point these these projected pre-cash flow margin is going to have to pick back up again. I I wanted to spend a minute on something because we're getting a ton of questions on this. And it's an example of something where I think This issue was less of a problem than it's often made out. We're among the first people to show this chart, which is yes. There's an enormous amount of hyperscaler debt financing going on. until the fourth quarter of twenty twenty five. really see Google. and Microsoft and Meta and Amazon. And Salesforce. issuing lots of debt. And then all of a sudden in the fourth quarter of last year and in the first quarter of this year. We're starting to see hundred literally hundreds of billions of dollars of hyperscaler debt issuance to finance data center. If we use a lens of looking at the amount of debt you have relative to your cash flow. Um, and in debt we're including bonds and loans and and triple net leases and all that kind of off balancing stuff too. Oracle is still the outlier. Oracle is still the company. has a much higher ratio of debt to cash flow. than even the median the immediate and the S P. Whereas the rest of them Even meta. uh and Microsoft and Apple and Google Um Uh these numbers are pretty low. And so even with all the in other words, even with all the borrowing that has taken place. their ratios of debt to cash flow are still pretty low. because they're so profitable and they have a lot of cash and marketable securities on their balance sheet to upset that. And um We've shown this chart before, but biggest difference between the dot com boom and today. is in both of those periods, you had a spike in capital spending. The difference was last time Capital spending got finance with debt. And this time it's still mostly being financed. with internally generated cash flow. And that's the reason why um credit spreads other than Oracle, right? Species. That's the reason why credit spreads the other hyperscalers are still pretty tight trading and investment rate levels. Okay, just a couple more things on AI and And and data centers. Um The the latest data from the Census Bureau As of January shows Electric power. uh generation in in construction spending. data center construction spending are continuing to go up and up and up. Um The question is, can it really continue at that pace? And are there any things that suggest that we may see a s a partial slowdown? And I think we are starting to see signs of possible slowdown. Th there are some people that did some satellite and other Measurements. Of all the data center capacity. that's supposed to be worked on in twenty twenty seven. And Way more than fifty percent of it, there there's no construction observed. Now sometimes it's permitting that permitting issues that are temporary, but other times it's because they can't get the necessary combustion turbines. They can't get the enough skilled labor. They can't get the transformers to connect it to the grid. And so Um, some of these equipment, labor and permitting issues are beginning to In the way. of the of the pace of the of the data center construction build out. And As a reminder all the forty seven categories in the producer price report. The second highest level of inflation that we've seen. is in transformers and power regulators. So this data center build out has really created some supply chain bottlenecks. Slowing the pace of data center expansion. Just since two thousand twenty two, right? And so three and a half years. the delivery time to get one of the generation step up transformers that's that's needed to connect these things to grid. has risen from about a year to three years. So that's not even for a turbine. That's just for the transform. These kinds of problems can be solved with additional investment in productive capacity. Question is Who's gonna do that? And and and right now we're not seeing the the supply chain. Um Increased. Okay, last topic. I read this interesting paper. From Uh the so rice Um Rice University, by the way, when it grew up, people used to call Rice the Harvard of the South. I don't know if they continue to do that. I have no idea if it's accurate. Let's just uh you know, I like the voice assume that it is. So Rice University has this thing. Baker uh Institute for Public Policy. And they They issued a report. They went into some detail. on something call the Gulf Super Express. Now I don't know that this is ever gonna happen. Um, because it would require a lot of coordination between the Gulf countries. And you just saw the Emirates pull out of OPEC. So maybe now's the the best time for me to be writing about this. Um The the region if the sides cooperate. Can reduce the Iranian threat. By essentially building a pipeline. Basra in southern Iraq. All the way to the Indian Ocean along the coast of Haman. And it would bypass it would it would bypass the straight up or moves, it would bypass Bob Alman Depths uh uh straight where the Houthis are active. It would it would mean they wouldn't have to go through the the Red Sea. and the Suez Canal and they would just be able to go straight to Asia and India. And Um some of the numbers are interesting, right? So they they spec out Um Two fifty six inch pipelines. That could carry ten million barrels each. uh a spur to a local port. A lot of storage capacity. capital cost estimates would include both passive and active defenses. a strategic long lead equipment reserve in case that was damaged. And cost for this entire multi country project. Would be about fifty five billion, which is around what Saudi Arabia has spent. on the Neon project so far. I'm not sure what that would show for it. Uh and it would and it would take uh let's call it five years to build. Um Now if if it if it did cost that much. at its full capacity of ten million dollars uh barrels a day. you'd end up with about $55 per barrel per day. And that would rank at the lower end the real pipeline costs within a universe of all the pipelines that have been built around the world since the year two thousand. So This could be done at a cost competitive Basis. shipping oil first through a pipeline and then through a VLCC tanker. would cost more than just shipping it to the tanker. If you can't ship it through the tanker because Iran's gonna close the straight, then it's a moot point, isn't it? So anyway, I thought this was interesting. And there are options for the region to try to reduce their exposure to uh And and I I think chances are Better than fifty fifty. that either this project or something like it at some point. um starts to get built in the region. So anyway, that that's enough for today. Um And uh thank you for listening. And again in in June we're gonna take a look. um the challenges facing the new Fed share. And then in July we'll have a special Uh we get this word right. semi quincentennial on the market. looking at uh US At the dollar, US equities and US fixed income. at a time of the two hundred and fiftieth anniversary. the United States. So thank you for listening and I'll see you next time. Bye. Michael Semblist's eye on the market offers a unique perspective on the economy. Current events, markets and investment portfolios, and is a production of JP Morgan Asset and Wealth Management. Michael Semblist is the chairman of Market and Investment Strategy for JP Morgan Asset Management and is one of our most renowned and provocative speakers. For more information, please subscribe to The Eye on the Market by contacting your JP Morgan representative. If you would like to hear more, please explore episodes on iTunes. 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