The US Economy Is About To Take Off And Bring Stocks With It | David Cervantes

This episode unpacks the dynamic US economic landscape, revealing how massive fiscal deficits and shifting Federal Reserve strategies are shaping investment opportunities, with crucial implications for capital flows into innovative sectors like Crypto AI.

Navigating Early 2025 Market Volatility

• David Cervantes, founder of Pine Brick Capital, recounts his initial bullish stance on growth at the end of last year, driven by an economy "firing on all cylinders."
• However, the new administration's talk of deficit cuts and reduced government expenditure began to weigh on markets, signaling less fiscal impulse.
• Cervantes admits to being "slow to react" to the subsequent sell-off, anchored by the "Trump 4047 experience" where policy talk often didn't translate into immediate market impact.
• The introduction of tariffs further compounded market anxieties. Cervantes, though initially hesitant, eventually pivoted aggressively, hedging all US risk.
  • A key strategic move was shorting Rest of World (RoW) stocks, particularly as European and Asian markets were outperforming. He noted, "typically you after two standard deviations uh the out performance of the rest of the world relative to the US kind of um mean reverts to its historical uh trend."
• This hedge significantly preserved capital during the market downturn in late March and early April. When tariffs were walked back, Cervantes "repivoted, reloaded, got super long, sell volatility," leading to a year-to-date performance of just shy of 27%.
• Strategic Implication for Crypto AI: Cervantes's experience underscores the necessity for agility in volatile markets. For Crypto AI investors, this means being prepared to adjust allocations quickly based on macroeconomic shifts that can impact funding and risk appetite for emerging technologies.

The Big Macro Picture: Deficits and the "Teflon Economy"

• Cervantes outlines his "Big Macro Picture" (BMP), emphasizing the profound impact of enormous government deficits.
• He dismissed early talk of significant budget reductions as "trivial" and "rounding errors."
• The core of his BMP is that "a public sector deficit is a private sector surplus," creating a "wall of money hitting the private economy." This, he argues, inoculates the economy against typical recessionary shocks.
• During the late March sell-off, Cervantes remained hedged but never fully bought into a crash-into-recession narrative, believing there was a window for policy walk-backs due to this underlying fiscal support. He describes the economy as a "Teflon economy or the beach ball economy...it'll bot back up."
• Trump's subsequent tax proposals, including changes to the SALT (State and Local Tax) deduction—which allows taxpayers to deduct certain state and local taxes on their federal income tax returns—were seen by Cervantes as "game over," signaling a highly stimulative fiscal impulse rather than a reduction.
• Actionable Insight for Crypto AI Researchers: Sustained fiscal stimulus can create a favorable environment for R&D funding and investment in speculative tech like AI and crypto, as capital seeks higher returns in a growth-oriented environment.

The Paradox of Fiscal Deficits and Interest Payments

• The discussion explores the composition of the high fiscal deficit, particularly the role of increased interest payments.
• It's posited that rising interest payments, a consequence of the Federal Reserve's rate hikes aimed at slowing the economy, are paradoxically contributing to economic resilience by injecting money back into the private sector.
• Cervantes agrees this dynamic "raises the bar or make it harder to send the economy into a recession," though he stops short of calling a recession "impossible," cautioning against anchoring to extremes.
• MMT (Modern Monetary Theory) is briefly mentioned as a worldview Cervantes doesn't fully subscribe to, but he acknowledges the element of government recycling interest payments back into the private economy, providing a stimulative effect. MMT is an economic theory suggesting that monetarily sovereign countries can (and should) print as much money as they need to spend, as they cannot default on debt in their own currency, with inflation being the main constraint.
• Strategic Implication for Crypto AI: If higher rates inadvertently fuel nominal growth through interest payments, the cost of capital for AI compute or crypto mining might remain elevated, yet the overall economic environment could still support demand for innovative solutions.

Navigating Market Narratives and Economic Lags

• The conversation touches on the importance of not getting overly anchored to prevailing market narratives and understanding economic data lags.
• Cervantes highlights the "bullwhip effects" from tariffs, where current data can be an "echo of past activity." Bullwhip effect refers to the phenomenon where orders to the supplier tend to have larger variance than sales to the buyer, and this distortion propagates up the supply chain in an amplified form.
• The negative Q1 GDP print was cited as a "false positive" (likely meant "false negative" in context, as it suggested weakness that wasn't necessarily fundamental), largely driven by net exports.
• The key is to "separate the signal from the noise" and focus on underlying trends like consumer spending and employment to understand implications for corporate earnings.
• Actionable Insight for Crypto AI Investors: In rapidly evolving fields like Crypto AI, it's crucial to discern long-term technological trends from short-term market noise driven by lagging or misinterpreted economic data.

Labor Market Dynamics: Beyond Layoffs

• Cervantes offers a nuanced view of the labor market, suggesting that a recessionary labor market can emerge without mass layoffs.
• While weekly jobless claims remain low, he points to a slowdown in hiring as a concern, drawing parallels to the post-dot-com bubble period, which led to a "jobless recovery."
• He describes the current environment as a "no hire, no fire type of labor market." If this persists, it could introduce recessionary pressures.
• U3 unemployment rate is the most commonly reported official unemployment rate. NFP (Non-Farm Payrolls) is a key economic indicator representing the total number of paid U.S. workers of any business, excluding general government employees, private household employees, employees of nonprofit organizations that provide assistance to individuals, and farm employees.
• Strategic Implication for Crypto AI: A "no hire, no fire" environment could mean talent acquisition in specialized fields like AI and blockchain development remains competitive, even if the broader labor market shows subtle signs of weakening.

Immigration's Shifting Impact on Labor Supply

• The discussion highlights the significant, and now reversing, impact of immigration on labor market statistics.
• Last year, a surge in immigration increased the labor supply, leading to rises in the U3 unemployment rate even as NFP numbers were decent. Cervantes correctly identified this as a labor supply issue, not a fundamental economic slowdown.
• Now, with immigration slowing, the labor market is effectively shrinking. This means even softer NFP prints (e.g., sub-100,000) might not cause a significant rise in the U3 rate or trigger the Sahm Rule. The Sahm Rule is an economic indicator that signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.
• Cervantes states, "I'm going to start fading uh soft NFP prints. I think there's going to be a lot of noise there."
• Actionable Insight for Crypto AI Researchers: Understanding these demographic shifts is crucial for interpreting labor market data accurately, which can influence expectations for wage inflation and overall economic health, impacting investment in future-oriented technologies.

Federal Reserve Policy and Inflation Outlook

• Cervantes anticipates the Federal Reserve's next moves, suggesting they prioritize the labor market and may front-run economic weakness.
• He believes the Fed has shown a willingness to "pinch their nose and look the other way of inflation to protect the labor market."
• He forecasts Core PCE (Personal Consumption Expenditures), the Fed's preferred inflation measure, to show a month-over-month increase of around 0.12% for April, potentially bringing the year-over-year rate to around 2.56%.
• Cervantes still calls for a June interest rate cut, viewing it as a limited window before potential re-acceleration of the economy and inflation from tariffs makes further cuts politically difficult. He terms this a "one and done in June."
• This view contrasts with market expectations, which largely price in a pause. Cervantes attributes his contrarian call to the Fed's "Roman Rorr playbook" (likely a mishearing of a different term, or a unique personal analogy) of front-running weakness rather than reacting to lagging data.
• Strategic Implication for Crypto AI: A potential surprise rate cut could lower the cost of capital and boost risk appetite, benefiting capital-intensive AI development and crypto markets. However, a "one and done" scenario suggests this window might be brief.

Growth Outlook and S&P 500 Projections

• Despite potential near-term slowdowns, Cervantes maintains a constructive outlook for economic growth and equity markets, driven by fiscal stimulus and market front-running behavior.
• His earlier S&P 500 price target of 7200+ is unlikely, but he sees a "solid chance" of exceeding the consensus (around 6300-6400). S&P 500 is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.
• The market, he argues, is already looking past 2025 earnings to 2026, willing to "kick the can on earnings" as long as a recession is avoided.
• Actionable Insight for Crypto AI Investors: A resilient equity market, even if driven by forward expectations, can sustain investor confidence in growth-oriented sectors like AI and crypto. However, the disconnect between current earnings and future projections warrants caution.

Retail Investor Behavior and Market Support

• The conversation highlights the significant role of retail investors and the "buy the dip" mentality in supporting markets.
• Cervantes references a chart showing approximately $7 trillion in money market funds, indicating substantial retail cash on the sidelines.
• He believes retail investors have been "conditioned to buy the dip," a behavior somewhat "institutionalized in a social mindset."
• This structural bid, fueled by interest income accumulating in accounts, makes it hard to bet against the market without a significant shock. "It's just like, okay, buy the dip, you know."
• Strategic Implication for Crypto AI: The "buy the dip" mentality observed in traditional markets often mirrors behavior in crypto markets. This persistent retail interest can provide a floor for asset prices but also contribute to volatility.

US vs. Rest of World (RoW) Equities and the Dollar

• David Cervantes discusses the narrative of selling America and the US dollar's reserve currency status.
• He dismisses the idea of the dollar losing its reserve currency status as "sensationalist noise," primarily because "the US is the only market large enough to absorb all of these flows." He believes it would take a catastrophic event like losing a "kinetic war to China" for this to change significantly in our lifetime.
• While he previously profited from shorting RoW stocks against the US, he notes the US underperformance has persisted longer than typical, with the US lagging Europe by three standard deviations on a 100-day rolling basis.
• This makes him question if there's a "regime change" or "fundamental realignment of economics," possibly linked to the durability of tariffs. He is currently holding off on re-establishing a strong directional bet here, acknowledging the need to revisit his thesis.
• Actionable Insight for Crypto AI Investors & Researchers: Global capital flow dynamics are critical. A sustained shift of investment away from the US could impact the funding landscape for US-based AI and crypto innovation, potentially favoring other regions if they demonstrate more robust growth or favorable regulatory environments.

Sector-Specific Opportunities and Fixed Income

• The discussion shifts to identifying specific sectors and the outlook for fixed income.
• Cervantes emphasizes the need to be sector-specific, especially in RoW investments. European defense stocks (e.g., an ETF like EUAB, though the specific ticker might vary) are highlighted as being in a "secular bull market" due to geopolitical shifts.
• Regarding fixed income, he views yields as range-bound, likely between 4.20% and 4.80% on the 10-year Treasury, assuming no recession. He considers bonds "for the most part shitty investments right now," better suited for tactical trading than as a core holding.
• Strategic Implication for Crypto AI: The search for yield and growth in a challenging fixed income environment could drive more capital towards alternative assets, including crypto and AI-related ventures, especially those with strong sector-specific narratives like defense tech or specialized AI applications.

Gold as a Portfolio Diversifier

• Gold is presented as an increasingly important asset for portfolio diversification, potentially taking on the role traditionally held by fixed income.
• Cervantes notes "very aggressive central bank buying, particularly China," as a supportive factor for gold.
• He sees gold in a "secular bull market," with potential to reach $3,000-$4,000 per ounce by year-end.
• "I think gold is starting to fill that that role of a portfolio diversifier," Cervantes states, especially given the current positive stock-bond correlation.
• Actionable Insight for Crypto AI Investors: While not directly related, the factors driving gold (geopolitical uncertainty, search for non-correlated assets) can also influence sentiment towards certain crypto assets perceived as "digital gold" or safe havens, though this is a highly debated and volatile correlation.

Small Caps vs. Large Caps: A Structural Divide

• Cervantes provides a bearish outlook on small-cap stocks (using Russell 2000 (R2K) as his universe) compared to large caps.
• He points out that roughly 42% of R2K companies are unprofitable, calling them "not a great collection of companies." He attributes this partly to a "selection bias" where higher-quality companies find it cheaper to stay private due to the regulatory environment post-Dodd-Frank and GFC, raising the cost of public equity capital.
• Small caps are viewed as a "high yield trade in drag for normies," sensitive to funding costs. Outperformance typically occurs as a "recovery trade" when credit spreads blow out and then normalize.
• The traditional French-Fama factors (like small-cap and value premiums) "doesn't work" as consistently anymore. The French-Fama model is an asset pricing model that expands on the capital asset pricing model (CAPM) by adding size risk and value risk factors to the market risk factor in CAPM.
• Strategic Implication for Crypto AI: Many innovative AI and crypto projects are small-cap or private ventures. Their reliance on funding and sensitivity to interest rates, as highlighted in the small-cap discussion, is a critical consideration. The "flows over factors" comment suggests that narrative and capital momentum can be more decisive than traditional value metrics in these speculative areas.

A Niche Opportunity: Small Cap Banks and Deregulation

• Despite the generally bleak outlook for small caps, Cervantes identifies a potential niche: small-cap banks.
• Anticipated bank deregulation, potentially rolling back post-GFC (Global Financial Crisis) regulations, could benefit this sector.
• Changes could include raising the threshold for what constitutes a SIFI (Systemically Important Financial Institution) and easing SLR (Supplementary Leverage Ratio) requirements. The SLR is a capital adequacy measure that requires banks to hold a minimum level of capital against their total leverage exposure.
• This could reduce the regulatory burden on mid-size banks, making them more attractive. Defense contractors are another narrow field, but many are privately held.
• "If there is one area of of potential strength in the small cap universe, it will likely be in um small cap banks," Cervantes suggests.
• Actionable Insight for Crypto AI Researchers: Regulatory shifts in traditional finance can have knock-on effects. For instance, more lenient banking regulations could free up capital for lending or investment, potentially benefiting the funding environment for tech startups, including those in Crypto AI.

Conclusion: Navigating Fiscal Tides and Market Agility

• This episode underscores how substantial fiscal injections are buoying the US economy, creating a complex environment where traditional recession signals may be muted. For Crypto AI investors and researchers, the key takeaway is the heightened importance of nimble strategies and a deep understanding of how macroeconomic crosscurrents—from Fed policy to global capital flows—can rapidly alter the landscape for funding and innovation in high-growth, speculative sectors.
• Tracking fiscal policy and its impact on overall market liquidity will be crucial.