Why This Economy Refuses To Break | David Cervantes

David Cervantes identifies three main drivers keeping the US economy resilient: federal fiscal deficits running at 6 to 7 percent of GDP, the AI capital expenditure buildout approaching one trillion dollars, and informal wealth transfers from baby boomers to adult children. His core argument is that public deficits are private sector surpluses, meaning money fights its way through the economy regardless of distributional concerns, making recession very difficult to envision under current conditions.

The AI buildout is Cervantes's single biggest macro driver given the scale of capital involved. Hyperscalers initially funded AI infrastructure from free cash flow instead of buybacks, then moved to debt markets, and are now issuing equity, with Google's 80 billion dollar equity issuance cited as a sign of the times. He flags a bubble in earnings expectations, warning that AI hardware obsolescence cycles of roughly five years mean earnings capture must happen fast enough to fund asset replacement before those assets become functionally obsolete. Unlike prior episodes of market exuberance, he argues current equity valuations are driven by earnings expansion rather than pure price-to-earnings multiple expansion, and describes the current productivity boom as the first pro-cyclical productivity boom since the 1990s, manifesting in profit margin expansion.

On consumer resilience, Cervantes points to three reinforcing factors. Between 40 and 60 percent of the population no longer carries a mortgage, freeing up spending capacity. The S&P 500 has returned approximately 300 percent since 2009, reducing the savings rate through wealth effects, though he acknowledges stock market gains do not reach the bottom 50 percent of the population. The third factor is informal boomer transfers to adult children covering expenses like vacations and childcare, which he concedes relies partly on conjecture because transfers below the roughly 13,000 dollar annual gift tax exclusion threshold are never reported. Complicating signals include the PCE savings rate falling below 3 percent, consumption growth running above income growth, and credit card delinquency rates accelerating meaningfully.

On inflation, Cervantes called none and done on March 1st, predicting zero rate cuts by year end. January CPI printed at 0.42 month over month, which he says showed the inflationary impulse was already broadening before any oil price shock. The low-hanging disinflationary fruit from declining rents has been harvested and rents may not fall at the same rate going forward. The ISM prices paid component is showing numbers not seen since 2022, unemployment fell from approximately 4.4 in January and could reach 4 percent by year end, and Cervantes argues it is incongruent to simultaneously forecast recession and rising employment.

Cervantes is skeptical of Kevin Warsh's push to replace core PCE with the Dallas Fed trimmed mean as the Fed's preferred inflation metric. The Dallas methodology asymmetrically cuts the top 34 percent of high prices but only the bottom 20-something percent of low prices, mechanically producing a lower reading. The Dallas trimmed mean currently reads around 2.5 percent, the Cleveland Fed symmetric trimmed mean is near 2.9 to 3 percent, and traditional core PCE is at 3.3 percent year over year. He predicts Warsh will struggle to build FOMC consensus, with a good chance of a visible dove-hawk split. Beth Hammack stated publicly that continued inflationary prints would shift the conversation toward hikes, and Christopher Waller, whom Cervantes calls the smartest person in the room on the prior inflationary episode, is now turning hawkish. Cervantes predicts rate hike pricing in the curve will accelerate as markets front-run policy before any actual hike occurs, and notes the bigger risk for bond investors is not the level of rates but uncertainty about the Fed's policy framework and unclear reaction functions.

On oil, Cervantes says China acted as a de facto central oil banker starting in early May by cutting imports and releasing from its strategic petroleum reserve, with both China and the United States conducting large SPR releases that suppressed prices and surprised bulls who had expected oil above 150 dollars per barrel by June. He views SPR resources as finite and expects the drawdown period to end around late July to early August, at which point physical commodity market pressure should resurface.

Cervantes describes the South Korean equity market as having gone parabolic in 2024, with the broader Korean economy performing strongly beyond Samsung and semiconductor names, which together represent approximately 50 percent of the Korean index. The South Korea price-to-earnings ratio was around six shortly after a ceasefire announcement, making the trade what he calls a no-brainer that has worked out, though he acknowledges the valuation is no longer as cheap as it was even if still cheap relative to history.