Chris Wood says only an AI implosion can bring foreign money back

As per the latest business developments, The global investment landscape has changed dramatically. The AI-led semiconductor boom has pulled capital towards Korea and Taiwan, US bond yields have advanced towards the critical 5% mark, while geopolitical tensions have pushed crude prices sharply elevated. For India, the backdrop is complicated further by a weaker indian rupee, concerns over the future of IT services and the challenge of attracting foreign capital in a world of elevated interest rates. At the same time, there are signs that the long-awaited private-sector investment cycle is beginning, with credit expansion picking up even as domestic mutual-fund flows stay robust.

Against this backdrop, Jefferies’ Global Head of Equity Strategy Chris Wood spoke exclusively to Moneycontrol around the Fed, bond yields, the AI Capex boom, crude prices, foreign flows and the outlook for Indian equities. Edited excerpts:

Were you surprised by the Fed interest-rate gain? And what do you think it means for the inflation trajectory and the path of interest rates going forward? What does it mean for markets, first in the US and then for emerging markets and India?

Three months ago, I wasn't expecting a interest-rate gain, but in the last few weeks, I did expect it. The key development is how the Treasury bond market reacted.

The most important price in world markets is the 10-year Treasury bond yield. If the Fed had not boosted rates last night, the bond market would have sold off more, and a sharp break above 5% would have been negative for equities. We're now in a holding pattern, right at that key 5% level. So the good news is that the bond market remained stable despite the Fed interest-rate gain.

When you look at the US equity markets, do you think they are being complacent?

The US equity market has been so resilient this year because of very firm EPS expansion, and the big driver of that expansion is the AI Capex cycle. To disrupt the US equity market, you need elevated bond yields. If the bond market moved from 5% to 5.5%, the risk of a correction in US equities would climb dramatically. We're right at that key level. If the Fed had not boosted rates, we'd have noted a sharp bond selloff and a more negative environment. So they've bought time by raising rates.

The key point is that this AI Capex cycle is very earnings-accretive in America because the tech firms selling semiconductors and chips put their earnings up front. But the hyperscalers paying for the Capex are in no hurry to fully pay for it through depreciation. On data centres, they're additionally putting leases off balance sheet. So this whole AI Capex cycle driving the US economy is front-end loaded, and that's good for earnings.

What does that mean for the AI trade itself? It's clearly the biggest trade in town, but there have been growing concerns around a slowdown in AI Capex. Are we approaching a point where this trade could break, or is it too early to call?

Right now, we could get a sudden change of view at any time. But the data from the latest earnings seasons of the hyperscalers reveals that they have boosted their Capex guidance.

We're now looking at hyperscaler AI Capex reaching nearly $1 trillion next year, from around $700 billion this year. These are enormous numbers, and the hyperscalers' Capex is translating almost dollar for dollar into earnings for the semiconductor industry. So this is the biggest semiconductor cycle ever. As long as the spending continues and the market believes that spending is justified, the cycle can continue.

The risk is that at some point the market starts questioning whether the hyperscalers will earn a proper return on this investment. My base case is that they will end up wasting a lot of money on AI Capex and that a lot of capital will be destroyed.

But the key question is when the market starts to price that in. It does sound counterintuitive that AI debt issuance is already at these marks, with borrowing costs around 5.5%. Something has to give eventually, doesn't it?

Something will give eventually, without a doubt. The easy money has been made in the AI Capex trade. If you were lucky enough to own all these semiconductor stocks, which have gone up a lot, as a private investor it would make sense to take some earnings.

The easy money has been made because, in the first three years, these hyperscalers were essentially funding their spending with their huge free cash flows. From here on, increasingly, the money will be borrowed rather than coming from cash. They're issuing huge amounts of investment-grade corporate bonds, which is another source of pressure on Treasury funding. They're competing with the Treasury for funding. The more they borrow, the greater the risk that when the downturn comes, it will be a major credit event.

You additionally have the data-centre leases being held off balance sheet, so that cost isn't even fully reflected in their accounts. Then, on top of that, you have the circular financing arrangements between NVIDIA, Microsoft and firms such as OpenAI and Anthropic.

My long-term outlook is that large language models will become commodities and that a lot of capital will be destroyed. What's 100% real, though, is that the semiconductor firms are making real earnings.

And how does all this affect India?

The problem for India is that most foreign equity market participants in India are global emerging-market market participants. They were overweight India for the last 20 years, as I was.

Suddenly, last year, they had to move money into Taiwan and, even more dramatically, into Korea because of the huge earnings these semiconductor firms are making.

Before the AI story kicked in, India was the best structural expansion story in global equities. The problem isn't that India is no longer a good expansion story. It's that the Indian story has been diluted; it's simply not as exciting relative to the AI story.

So, if you wanted foreign money to come pouring back into the Indian market, the best thing that could happen would be for the whole AI story to implode.

Chris, you've been one of the more bullish voices on India. But right now, if you were a global investor, there are plenty of reasons to be wary. The AI story is attracting capital to Korea and Taiwan, US interest rates are much elevated than they were during the era of firm foreign flows into India, and India is more exposed to crude. On top of that, there are concerns around the long-term value of India's IT services exports as AI changes the industry. How do you convince a global investor to come to India today? How do you view the other side of the story?

The data has picked up more than I was expecting. I was last here six months ago, and the latest numbers have been a pleasant surprise.

Credit expansion in India is at present around 18-19%, and nobody was expecting that degree of expansion. There is a base effect at work, partly, but not completely. It additionally seems that we're finally seeing evidence that the private sector Capex cycle is beginning.

For the last five years or more, the government has been carrying the baton on Capex. So I've been pleasantly surprised by the data, and I think that's a positive.

I'm additionally encouraged by how resilient the data has been given what's been happening in the Middle East. In terms of the headlines, that looks very negative for India. When I was last here, the US-Israel attack on Iran was unexpected, both for me and the market. So the subsequent Indian data has been a pleasant surprise.

IT services clearly face a structural challenge, and I think we should assume a structural derating. I've been hoping the GCCs wouldn’t be negatively impacted, but that stays an ongoing offering.

Having stated all that, India is still as good a structural expansion story as any country in emerging markets.

The Korea-Taiwan story is very concentrated in a few firms. These semiconductor firms are anticipated to make three times the earnings of the overall Nifty 50 index this year. That gives you the scale of the opportunity.

But if we suddenly decide that the market doesn't want to finance this Capex anymore, the cycle can collapse very quickly. I'm not saying that's going to happen, but when the AI story ends, it's probably going to end in a violent sell-off.

So, you're seeing firm credit expansion and some early signs of a private-sector capex cycle. But could elevated interest rates and crude-fuelled inflation put a lid on this nascent upcycle?

That is clearly a risk. The RBI will be raising rates. My guess is you'll get two 50-basis-point rate hikes in fairly short order.

I'm hoping the indian rupee has found a natural bottom, helped by the successful NRI bond offering. One of the negatives for foreign market participants last year, apart from the AI story, was the greater-than-anticipated depreciation of the indian rupee. Foreign market participants are always focused on dollar returns.

So, I'm hoping the indian rupee has found a bottom. But yes, rates are an offering and one can't deny that.

Another offering worth being aware of is India's capital upside tax regime. FIIs don't like it; it's much more negative compared with other emerging markets.

In the old days, foreigners were willing to ignore that because India was outperforming and they were overweight India. But now that's a big negative. So that's another reason not to invest in India.

But we've had this tax regime for a long time, and there have been periods when India still attracted an avalanche of foreign flows. Is tax really a deterrent, or does money ultimately come back when the macro and global dynamics turn favourable?

That's true. But with the recent rate hikes, it has become a deterrent.

If a foreign fund manager wanted to invest more money in India today, particularly if he's not the boss, he's going to risk pushback from his boss because of this offering. This is definitely a deterrent.

But obviously, if the macro story is firm and the semiconductor stocks all blow up, there will be money coming back into India. If you ask me what the most interesting part of the Indian market is, my answer would be the same as it has been for the last two years: the small- and mid-cap sector.

India has a lot of entrepreneurial talent and interesting young, small firms. That's a very firm feature of the Indian market that many other markets don't have.

In many markets around the world, the small-cap sector is being ignored as market participants increasingly concentrate on large caps. This has been encouraged by the trend towards indexing and passive investing. In India, it's the opposite.

The small- and mid-cap sector has the best earnings expansion and is the most interesting area of the market.

Foreign ownership of mid- and small-cap firms has additionally risen, with foreign institutions investing in many more firms across the broader market than they were two or three years ago. Are you seeing more active fund managers looking at India? Is this trend gaining momentum?

This is definitely a positive theme. The problem is that the bigger the fund, the harder it is to invest in small caps. It's simply a question of portfolio size.

But if you're investing in India, particularly as a domestic investor and you're indian rupee-based, it makes a lot of sense not to allocate only to the big caps.

The big caps are additionally not as exciting as they used to be. For 20 years, Indian private-sector banks, from the late 1990s to 2020, were very exciting stories.

There are no disastrous stories today, but the expansion profile of the big caps simply isn't as good as it used to be.

What is your base case for crude for the rest of the year? How likely is it that prices stay elevated, say $100-$120, for a year or two? And if that happens, what would be the impact on India's expansion?

I don't have an assumption around the oil price. I have an assumption around Iran's behaviour.

Since this conflict kicked off six months ago, one constant has been that Iran has done what it says it's going to do, whereas what the US president says is not necessarily what happens.

Right now, I'm assuming Iran maintains its current stance through the midterms. It will only talk to the US if the US negotiates on the basis of the MOU signed by Donald Trump a few months ago. That's important because it means any de-escalation of tensions has to come from the US side.

Iran is going to maintain its current stance because Donald Trump is saying today that Iran is talking around making a deal. I don't believe that. Iran will only make a deal if the US does so on the basis of the MoU it signed.

That means my base case is that the standoff continues through the midterms.

Then we have the further noted complication of what has happened in the Red Sea during the past week. Given the news flow, the only amazing thing is that oil isn't much elevated.

And it's not just crude. The disruption is showing up even more sharply in oil products, particularly because of the refinery disruptions.

Yes. Financial markets are obsessed with the listed crude price, but you're absolutely right: in the real world, the problems are much better captured in the products.

That's why, in my presentation, I have the diesel cracks prepared. I don't have the oil price because diesel cracks give a much clearer indication of the climb in costs.

Another example is gas prices in Europe. Gas prices in Germany and the UK are 10 times the level in the US. So there is already real pain out there.

Another important point is that China has done the world a favour in the last few months. China has big stockpiles of oil and has definitely bought less, which is one of the reasons the oil price hasn't gone up more.

There's additionally an element of demand destruction in China because of the growing use of EVs.

So, actually, if anybody has leverage over this situation, it's China, not the US.

If China wanted to put leverage on the US, it could suddenly start buying a lot of oil, which would put pressure on Donald Trump going into the midterms. And if anybody has leverage over Iran, it's China, not the US.

Looking one year out, where do you see Indian markets? Do you expect them to be elevated, flat or softer from here?

At the index level, the biggest problem is that whenever the market picks up and sentiment improves—as it did in the three or four months before the renewed Middle East tensions—we get a big gain in supply.

India has a very healthy capital market, with robust domestic mutual-fund inflows that have remained impressively resilient, particularly through SIP schemes.

But there is additionally a great willingness among firms to offering equity. So while that's a very vibrant capital market, it means that at the index level, equity issuance is effectively capping the market.

Last month, we saw a big gain in supply, and that's having the practical effect of capping the index, particularly at the large-cap level.

One final question. What's the mood at the Jefferies India conference this time? Is it more upbeat than last year, or more wary?

The mood is fairly balanced. It's not euphoric, but it's not gripped by fear either.

People are beginning to see that firms are finally starting to invest.

During the second and now the third Modi administration, we've noted a big gain in government Capex, particularly during the second term. The government sector has effectively been saying, in this relay race, "When is the private sector going to take up the baton?"

There has been a lot of frustration around that. But now we're beginning to see evidence that the private sector is taking up the baton. That's probably the most positive thing, actually.