Eye On The Market: Back to Our Regularly Scheduled Programming
Hosted by Michael Cembalest
Release Date: May 13, 2025
Michael Cembalest returns in this episode of Eye On The Market to provide an insightful analysis of the current economic landscape, the evolving trade policies, and the burgeoning influence of Artificial Intelligence (AI) on markets and corporate strategies. Below is a comprehensive summary of the key discussions, insights, and conclusions from the episode.
1. US Economic Landscape and 'Sell America' Episode
Cembalest opens by addressing a significant shift in the US economy, referencing what's termed the "Sell America" episode—the first of its kind since 1982. This scenario is characterized by a simultaneous decline in US equities, the dollar, and treasury bonds, alongside US equity underperformance relative to global markets.
Michael Cembalest [02:00]: "Like Blanche Dubois in A Streetcar Named Desire, the US relies a lot on the kindness of strangers."
He highlights that the US is nearly entirely dependent on foreign net savings, emphasizing the country's vulnerability in the current economic setup.
2. Update on Tariff Policies
Discussing recent trade policies, Cembalest notes that President Trump is set to implement a reciprocal tariff rate of 10% on China, aligning it with tariffs imposed on other countries. This adjustment is part of an equilibrium strategy following extensive negotiations.
Michael Cembalest [05:30]: "We're approaching a roughly 10% reciprocal tariff on a bunch of goods, which is a lot lower than what it was a month and a half ago."
Despite being the largest tariff increase in seven decades, the reduced rate is anticipated to allow countries and companies to adapt more smoothly to the new trade environment.
3. Shifting Focus Back to Artificial Intelligence
With the stabilization of tariff rates, Cembalest redirects attention to AI, previously the primary driver of US equity markets before the onset of the trade war. Even amidst trade tensions, US companies have prioritized AI adoption over tariff-related discussions in their Q1 earnings calls.
Michael Cembalest [09:15]: "AI is at least as important as tariffs to equity investors, if not more so."
He underscores that the market capitalization of AI-benefiting companies is 2.5 times larger than those adversely affected by tariffs, highlighting AI's pivotal role in current market dynamics.
4. Valuation vs. Fundamentals: US vs. Global Equities
Addressing concerns about US equities appearing expensive compared to Europe or Japan based on Price-to-Earnings (PE) multiples, Cembalest argues that US companies' higher profitability justifies their valuations. Utilizing metrics like Return on Equity (ROE) against Price-to-Book ratios, he demonstrates that US equities may not be as mispriced as they seem when fundamentals are accounted for.
Michael Cembalest [13:45]: "The more that a sector's ROE, the higher the price to book ratio."
He points out the tech sector's dominance, now accounting for 35% of all market earnings—a significant increase from 19% a decade ago—driven largely by AI advancements.
5. Advancements in AI Capabilities
Cembalest reviews a Stanford chart illustrating AI models' performance against human benchmarks across various tasks, including image classification, visual reasoning, language understanding, and scientific problem-solving. He notes that AI capabilities have matched or exceeded human performance in many areas, accompanied by a dramatic reduction in costs.
Michael Cembalest [18:20]: "Inference costs for a system performing at the level of GPT-3.5 dropped by almost 300 times between November 2022 and October 2024."
This progress signifies that AI is becoming more accessible and efficient, further cementing its role in driving market growth.
6. Hyperscaler Spending and AI Revenue Growth
The episode delves into the massive capital and R&D expenditures by hyperscalers—major cloud service providers like Microsoft, Google, and Amazon. Cembalest reveals that these companies spent $450 billion in 2024 on AI-related activities, with expectations to increase spending by 30% in 2025.
Michael Cembalest [22:50]: "Capital spending growth is overtaking the overall revenues of these businesses."
However, he expresses concern about whether this spending will translate into proportional AI revenue growth, citing the necessity for hyperscalers to demonstrate tangible returns on their significant investments.
7. AI Adoption in the Corporate Sector
Cembalest references surveys from McKinsey and Bain, indicating that approximately 50% of companies anticipate employee cost reductions and revenue increases through generative AI adoption over the next three years. Despite these optimistic projections, the expected impact per company remains modest.
Michael Cembalest [24:10]: "The most frequent three-year reduction expected was 3 to 10% of employees."
He shares an anecdote about a Mexican used car platform that successfully replaced its outbound sales team with an AI voice model, demonstrating AI's potential to outperform human counterparts in specific functions.
8. Challenges in AI: Hallucinations and Reliability
A significant portion of the discussion centers on the reliability of AI models, particularly regarding "hallucinations"—instances where AI generates incorrect or misleading information. Cembalest highlights that current reasoning models exhibit a 50% hallucination rate, posing risks in critical applications like air traffic control or medical diagnostics.
Michael Cembalest [26:40]: "The hallucination risk for the reasoning models is still very high and it's still a problem that has to be solved."
He emphasizes the importance of mitigating these risks through robust engineering solutions to ensure AI's reliability in enterprise settings.
9. Impact on the Job Market
Exploring AI's broader societal impacts, Cembalest references an Atlantic article suggesting that AI may be influencing labor market trends. Specifically, he notes a divergence where recent college graduates now experience higher unemployment rates than the overall market—a reversal from historical patterns.
Michael Cembalest [27:30]: "If that's what AI is getting better at, and if that's what AI is being used for, that would help explain this."
This observation serves as indirect evidence of AI's growing influence on job functions typically performed by recent graduates, such as data aggregation and information summarization.
10. Future Outlook and Capital Spending Concerns
Looking ahead, Cembalest warns that the unprecedented capital spending by the tech sector—reaching new highs in R&D as a percentage of revenues—requires continued AI adoption to justify these investments. He warns of potential market concerns should free cash flow margins dip below 20%, indicating that capital spending may outpace AI revenue generation.
Michael Cembalest [29:20]: "The bottom line is this thing better work and the AI adoption rates are going to have to continue to start going up pretty soon."
11. Regulatory and Health Sector Developments
In a notable shift, Cembalest touches upon developments in the health sector, particularly FDA approvals of AI-powered medical devices. However, he also highlights concerns regarding declining drug approval rates and vaccination rates, drawing a parallel to public health challenges exacerbated by misinformation and waning trust in vaccines.
Michael Cembalest [30:30]: "The CDC is recommending that individuals vaccinated between 1963 and 1967 get a new live vaccine."
He underscores the critical need for maintaining high vaccination rates to prevent diseases like measles from becoming endemic again.
12. Conclusion
Cembalest concludes by emphasizing the dual-edged nature of AI advancements: while they present significant opportunities for market growth and operational efficiencies, they also bring substantial challenges in terms of reliability, ethical considerations, and societal impacts. The tech sector's massive investments in AI underscore a pivotal period where the success of these technologies will shape future economic and market landscapes.
Michael Cembalest [32:00]: "This is the biggest capital spending experiment on record by the tech sector. The bottom line is this thing better work."
Key Takeaways:
- Economic Dependence: The US's reliance on foreign net savings poses economic vulnerabilities.
- Tariff Adjustments: Current tariff rates aim to balance trade relations while reducing historical tariff levels.
- AI's Dominant Role: AI continues to be a crucial driver for US equities, overshadowing traditional trade concerns.
- Investment Concerns: Massive AI-related capital spending by hyperscalers necessitates corresponding revenue growth to maintain market confidence.
- Reliability Issues: High hallucination rates in AI models remain a significant hurdle for widespread, critical applications.
- Societal Impacts: AI's influence extends beyond markets, potentially affecting employment trends and public health initiatives.
This episode provides a multifaceted exploration of how geopolitical factors and technological advancements intersect to shape the current and future state of markets and the broader economy.