Market Outlook Q&A: Unpacking AI's Deflationary Wave and Shifting Valuations

Current market narratives may be obscuring fundamental valuation disconnects and the profound, long-term deflationary impact of Artificial Intelligence, creating distinct opportunities in overlooked small-cap stocks and long-duration Treasuries. While widespread consumer adoption of stablecoins faces significant hurdles, their regulatory framework could inadvertently bolster T-bill demand, even as the Federal Reserve contemplates rate cuts primarily to alleviate mounting fiscal pressures rather than to directly stimulate a labor market undergoing structural AI-driven shifts.

Key Insights

Stablecoins: A Niche Solution with Potentially Major T-Bill Implications

The speaker expressed skepticism about the broad consumer utility of stablecoins, questioning their ability to solve problems that existing payment methods don't already address for the average person. However, a critical, and perhaps underappreciated, aspect is the potential impact of regulations like the "Genius Act" on demand for U.S. Treasury Bills.

"If this person then says, well, you know what I want to do? I want to take this $100 and I want to put it in stable coins because I want to use it, then 100% of it must be in US treasuries or T bills. So you go from $5 to $100 in represented because the genius act says that these must be backed dollar for dollar with treasuries."

The core argument is that if stablecoins gain traction, even if driven by retailers seeking to avoid credit card fees or by specific institutional use cases rather than mass consumer adoption, the mandate for 100% backing by Treasuries (primarily T-bills) would create a significant new source of demand. This contrasts sharply with traditional bank deposits, where only a small fraction (e.g., 5%) might find its way into Treasuries for liquidity management. A shift of capital from bank deposits to stablecoins could therefore multiply the demand for short-term government debt. The speaker noted that the stablecoin bill also allows for repos, anticipating that if stablecoin issuance becomes substantial (e.g., $3-4 trillion), there wouldn't be enough T-bills, necessitating repo operations using longer-dated Treasuries as collateral, thereby increasing overall Treasury market liquidity.

For investors, this implies that any significant adoption of regulated stablecoins could act as a structural support for T-bill demand, potentially keeping short-term yields anchored or even compressing them, irrespective of broader consumer enthusiasm for using stablecoins in daily transactions. The primary motivation for consumers remains unclear, as the speaker highlighted: "You still have the consumer on the other side that says, yeah, well what do I need this for?"

The Valuation Chasm: Favoring Small Caps (IWM) Over Large Caps (SPY)

A key strategic position highlighted by the speaker involves being short the S&P 500 (SPY) and long the Russell 2000 (IWM), primarily driven by a stark valuation differential. The speaker views small caps as significantly undervalued, while large caps, particularly the mega-cap growth stocks, appear overextended.

"I am short SPY and I am long IWM mostly on valuation. IWM has an extremely low valuation at this, at the low $200 value. And spy has an extremely high valuation sitting around the $600 value."

Beyond pure valuation metrics, the speaker anticipates that Artificial Intelligence will be a more potent catalyst for smaller companies. Large corporations may integrate AI, but small caps, often resource-constrained (especially in human capital), stand to gain disproportionately. AI can empower them to significantly increase productivity and output, potentially allowing them to capture market share from larger, more established players. This dynamic is expected to lead to a convergence in valuations, with small-cap valuations rising and large-cap valuations moderating.

This contrarian stance challenges the prevailing narrative of large-cap dominance. Investors might consider re-evaluating their allocations, looking for opportunities in the small-cap space where AI adoption could unlock substantial growth and efficiency gains not yet priced in. The trade is not about shorting the "Mag 7" specifically while being long the rest of the market, but rather a broader call on the relative valuation and growth prospects of small versus large enterprises in an AI-driven economy.

TLT's Bullish Case: AI's Deflationary Force vs. Short-Term Trader Narratives

The speaker maintains a constructive, if not outright bullish, long-term view on long-duration U.S. Treasuries (TLT), despite acknowledging that current market action is dominated by traders selling into rallies based on narratives of persistent budget deficits and debt. The core of this positive outlook rests on the powerful deflationary impact of technology, particularly AI.

"I think that as technology finds its way into more and more and more of your everyday life, technology is deflationary. And it is, it does democratize an industry because other smaller companies have access to the technology as well, which allows them to operate at a level higher than they would have 10 years ago."

While plausible arguments exist for a regime shift towards structurally higher neutral rates due to sustained fiscal deficits, the speaker does not subscribe to this view as the most probable outcome. Instead, the pervasive integration of AI is seen as a dominant deflationary force that will enhance productivity and democratize access to advanced capabilities, ultimately putting downward pressure on inflation and, consequently, long-term interest rates. Bond funds, with mandates to invest in fixed income, will continue to require assets, and U.S. Treasuries, despite fiscal concerns, remain a primary destination. The current high yields are viewed as an attractive entry point once the market looks past the prevailing short-term narratives.

For investors, this suggests that patience may be rewarded in long-duration bonds. While timing is "unknowable," the fundamental case for lower yields over time, driven by AI-induced disinflation, remains intact. The key is "time in the market" rather than "timing the market," especially when receiving a positive carry while waiting for the thesis to play out.

AI: The Great Deflator and Labor Market Disruptor

A recurring theme is the transformative and inherently deflationary nature of Artificial Intelligence. The speaker emphasized that AI enhances productivity and democratizes access to capabilities, which fundamentally pushes against broad price level increases. This perspective counters arguments that AI-related capital expenditures (e.g., for chips and data centers) are themselves inflationary.

"Something is inflationary when it cuts across all the sub industries. Something is not inflationary when within this particular industry the price of something is rising... investing in data centers, oh, the chips are expensive, it's going to be inflationary. No, it's not. It just makes chips expensive, that's all."

The more profound impact of AI, according to the speaker, will be on the labor market. As AI models become increasingly sophisticated and adoption accelerates, companies will inevitably leverage this technology to reduce their human workforce or achieve higher output with existing staff. This isn't a distant prospect; the speaker cited reports of major companies like Amazon already explicitly stating intentions to cut their workforce due to AI. The ease of scalability and relatively low cost of deploying AI solutions (once foundational models exist) means that increased adoption doesn't necessarily translate to inflationary demand for AI itself, but rather to a faster realization of labor efficiencies.

This outlook has significant implications for employment and economic growth models that rely on human labor. Investors should consider the sectors and companies best positioned to leverage AI for productivity gains, but also be mindful of the broader macroeconomic consequences of potential structural unemployment and its impact on consumer demand and social stability, even if these are deemed "irrelevant for finance" in a narrow sense.

Fed Rate Cuts: Primarily a Fiscal Relief Valve

The speaker offered a specific perspective on the potential benefits of Federal Reserve rate cuts, emphasizing the immediate impact on the government's interest expenses rather than a primary focus on stimulating a labor market already facing AI-driven structural changes.

"Well, the biggest benefit right away is interest expense for the government. Interest expense. So if you think about how much the issue in t bills, right, that would be going out instead of at 4.33% would now be going out of 4.08% or even lower. It would begin to lessen the burden on US Finances."

Lowering the federal funds rate would directly reduce the cost of issuing new T-bills and refinancing existing short-term debt, thereby alleviating pressure on the U.S. budget deficit. While acknowledging that lower rates could also translate to modestly lower mortgage and car loan rates for consumers, and encourage business investment by lowering discount rates for capital budgeting, the primary and most direct beneficiary identified is the government's balance sheet. This view subtly reframes the motivation and primary effect of potential easing, suggesting it's as much about fiscal management as it is about traditional macroeconomic stimulus.

For investors, this implies that Fed policy might be increasingly influenced by fiscal imperatives. While rate cuts are generally seen as bullish for risk assets, understanding this underlying driver provides a more nuanced view of the Fed's potential reaction function and the sustainability of such easing if inflationary pressures were to resurface unexpectedly.

Quotes

"Every single price, everywhere is due to positioning. 100% of the price is due to positioning. If you don't take a position in something, you're not either pushing the price down or pushing the price up." - The speaker, on the nature of price discovery.

"I've been critical of the whole crypto space that I've said it before, it is a wonderful, elegant, mathematically beautiful solution to a problem almost nobody has." - The speaker, on the practical utility of cryptocurrencies like Bitcoin.

"This is the thing about the future. It is unknowable. It's not that it's unknown. Unknown means I can figure it out, I just don't know it now. It is unknowable. Meaning no matter what you do, you're not going to know it." - The speaker, on the inherent uncertainty in forecasting.

Market Implications

The insights from this Q&A session point towards several actionable considerations for investors navigating the markets of mid-2025 and beyond. The overarching theme is that powerful, technologically-driven structural shifts, particularly from AI, are creating both opportunities and challenges that may not be fully reflected in current market pricing or mainstream narratives.

1. Long Small Caps / Short Large Caps (Valuation & AI Play): The significant valuation gap between IWM and SPY, coupled with the thesis that AI will disproportionately benefit smaller, resource-constrained firms, suggests a relative value trade. Investors could consider overweighting small-cap equity, potentially financed by underweighting or tactically shorting overvalued large-cap indices. This strategy banks on AI democratizing capabilities and enabling smaller players to compete more effectively, leading to a valuation re-rating.

2. Strategic Allocation to Long-Duration Treasuries (TLT): Despite current headwinds from deficit narratives, the speaker's conviction in AI's long-term deflationary impact underpins a favorable view of TLT. Investors with a longer time horizon might see current yield levels as an attractive entry point, anticipating that disinflationary pressures will eventually pull long-term rates lower. This is a contrarian position against prevailing fears of structurally higher inflation and rates.

3. Scrutinizing Stablecoin Infrastructure for T-Bill Demand: While direct consumer adoption of stablecoins remains questionable, the regulatory requirement for 100% Treasury backing (e.g., via the "Genius Act") could create a stealthy but significant source of demand for T-bills. This could keep short-term rates anchored and provide liquidity to the Treasury market, an indirect positive for government financing costs. This is less of a direct investment strategy and more of a factor to monitor for its impact on fixed-income markets.

4. Investing in AI Enablers and Adopters, Mindful of Labor Disruption: The deflationary productivity boom driven by AI suggests investing in companies that are either key enablers of AI technology or are effectively integrating AI to enhance efficiency and market share. However, the flip side is significant labor market disruption. This could temper overall economic growth and consumer demand in the medium term, creating a complex macroeconomic backdrop that warrants careful sector and company selection.

5. Anticipating Fed Policy Driven by Fiscal Needs: The view that Fed rate cuts would primarily serve to reduce government interest expenses suggests that fiscal considerations might play an increasingly important role in monetary policy decisions. This could lead to a Fed that is more inclined to ease if inflation remains contained, even if traditional labor market indicators are muddled by AI's structural impact.

Collectively, these insights suggest a market environment where discerning between cyclical noise and structural trends is paramount. Opportunities may lie in contrarian positions that embrace the transformative, deflationary power of AI and recognize valuation anomalies, while remaining cautious about the broader economic implications of such rapid technological change.