The Capital Cycle & AI

For a very long-time technology oriented businesses have been seen as quality and non-cyclical in nature. The idea is there businesses margins are structurally higher and recession proof. At least, this is how the market has priced these securities. When we buy cyclical businesses one of the most important things we flag is where is capital going. If capital has fled an industry the "boom" period is likely behind it and a period of recover is underway. Recovery for cyclicals is different depending on the product produced and so forth. The important part though is not the timing of when the industry recovers, it is really understanding supply/demand dynamics which is actually very easy to see but does not always lead to a correlation in how equity prices move.

During the Shale Revolution oil companies were foaming at the mouth to drill unprofitable wells and further crush their supply/demand dynamics. In China from 2020-2023/24 the countries scale of overproduction was equal and in excess of the combined demand of the US & Europe. During this time, China felt Steel was an incredibly important piece to their economy and to have natural providence of that resource was more important than generating returns on their industrial base. This can fly in China because of the authoritarian nature of their government and they can operate at a deflationary selling price for a very long time. Eventually though, economics 101 dictates they pair back and actually make money.

I bring up the example of steel because the sheer size of the overproduction and the speed at which the country can overproduce a product they view as a bottle neck. This brings me to the question of where is capital going as it relates to AI/AI build out. As we speak hundreds of billions is being allocated to AI infrastructure spend in the West with the claim that things like DRAM (memory) chips are a bottle neck to new supply. So new capacity is being built and a huge % of GDP is spent on data center build out globally. The problem we see is that China wants this tech and they see it, rightfully so, as a matter of national security. They have already begun developing state directed plants to build out memory chips and while the market points to DRAM as a 3 player monopoly market, that is only true as long as China allows it to be. DRAM chips are really not that difficult to develop and it just comes down to spending the money.

I fear for investors in the memory/AI build out story because they do not understand what China is capable of when they see a bottle neck to their own build out of a critical material. They will flood the market with cheap memory chips and destroy pricing for the entire industry. As these things always happen, something will happen to demand just at that time and it will be a double edge sword. Poor pricing (oversupply) on top of falling demand will crater pricing and a lot of speculative paper "wealth" will be destroyed quickly.

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