Markups in LLM company valuations drive a large share of some MAG 7 earnings

The large AI beneficiaries reported strong first-quarter results, but some of their headline profits came from higher valuations assigned to private LLM investments rather than core operating businesses. Michael Cembalest, of JP Morgan, noted that “other income” accounted for 60% of Alphabet’s Q1 profits, 51% of Amazon’s, and 27% of Nvidia’s, including gains on stakes in companies such as OpenAI and Anthropic. This does not diminish the strength of cloud, advertising, and semiconductor demand, but it does complicate the quality-of-earnings story. The circularity is worth watching: hyperscalers invest in AI labs, the labs commit to buying their compute capacity, and the resulting valuation gains feed back into hyperscaler-reported profits.

• The underlying AI businesses remain strong, but these gains are not the same as recurring operating cash flow
• Private-market markups can flatter earnings today, but they can also reverse if valuations come down
• This creates a circular dynamic: investment in LLM companies drives cloud demand, which then supports the earnings of the companies making those investments
• The largest risk is that LLM providers eventually become commoditized as cheaper open-source and Chinese models improve
• If model pricing and margins fall, the private valuations supporting these gains could come under pressure
• The market will eventually focus less on headline EPS and more on whether AI capex is producing an adequate return on investment

Inflation breaks back above 4%

May’s PCE report, the Fed’s preferred inflation gauge, came in uncomfortably hot this week. Headline PCE rose 0.4% month-over-month and 4.1% year-over-year, the first reading above 4% since April 2023. Core PCE increased 0.3% for the month and 3.4% year-over-year. Energy was a key driver, with gasoline and other energy goods surging 6.5%, but the pressure was broader: services rose 0.5%, transportation services climbed 0.8%, and financial services and insurance jumped 1.2%. Consumer spending remained solid, rising 0.7% nominally and 0.3% in real terms, while the personal saving rate held at a low 3.0%.The takeaway is straightforward: even if falling oil prices eventually ease headline inflation, core and services inflation are still too sticky for the Fed to comfortably resume rate cuts anytime soon.

• Headline PCE has returned above 4%, creating a significant problem for the Fed
• Inflation was not confined to energy; services inflation also accelerated
• Core PCE has now risen 0.3% for three consecutive months
• Consumers continue to spend robustly, reducing the urgency for the Fed to cut rates
• Markets are increasingly pricing in the possibility that the Fed’s next move could be a hike rather than a cut
• Lower oil prices may provide relief in coming months, but this report underscores that underlying inflation remains sticky

AI costs bleed into consumer product prices

The AI investment boom is now showing up in consumer electronics prices. This week, Apple raised prices across several MacBooks and iPads, citing its inability to continue absorbing higher costs for memory and storage chips driven by AI data-center demand. The entry-level MacBook rose from $599 to $699, a MacBook Air with 512 GB of storage jumped from $1,099 to $1,299, and an iPad Air with 128 GB increased from $599 to $749.The supply pressure is evident: Micron reported record quarterly revenue, an 84.6% gross margin, and $22 billion in long-term customer commitments to secure memory supply. The broader implication is clear: AI is no longer just creating winners in chips and data centers; it is beginning to raise costs for consumers and squeeze margins for companies that rely on memory but do not manufacture it.

• AI-related demand is turning memory chips into a genuine supply bottleneck
• Apple, widely regarded as one of the best supply-chain operators in the world, felt compelled to raise prices, a notable signal
• This is a clear positive for memory producers like Micron, but a negative for consumer electronics firms that must absorb or pass on higher costs
• Technology has historically been deflationary for consumers; this is an early sign that the dynamic may be shifting
• The inflationary impact remains narrow for now, but it illustrates another second-order effect of the AI investment surge across the economy
• The next question is whether higher device prices will eventually weaken demand for PCs, tablets, and smartphones

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