Category: Investment Perspective

Resilience And Risks

Buoyed by a resilient corporate sector, equity markets have largely shrugged off an unsettled backdrop and the day’s often-distracting headlines. Stocks continued to climb over the summer, reflecting investor confidence in companies’ ability to navigate an ever-shifting economic and political landscape. Meanwhile, bond yields drifted lower as markets anticipated an eventual easing of Federal Reserve policy and a slow-but-positive pace of economic growth.

Despite significant tariff-related costs and a more cautious consumer, second-quarter earnings results were quite strong, reassuring markets that corporate America could take steps to mitigate the headwinds. The S&P 500 achieved 11% year-over-year profit growth, well above analysts’ 4% target. The so-called “Magnificent Seven” again led the way, but the strength proved broad-based: the median S&P 500 company boosted earnings by 8%. Moreover, eight in ten firms delivered positive surprises with many raising guidance for the remainder of the year.

Central intelligence

As an investment theme, artificial intelligence has been a key stock market driver since late 2022 when OpenAI introduced the world to ChatGPT. More recently, the AI buildout has also become a key macroeconomic driver, supporting growth as consumer spending softens. Data-center-related investment—those massive buildings full of GPUs (graphics processing units) and servers used by AI firms to train and run models—may have accounted for roughly half of total U.S. GDP growth during the first half of the year.

The big five “hyperscalers” constructing AI infrastructure—Alphabet, Amazon, Microsoft, Meta, and Oracle—are projected to allocate about $350 billion to capital spending in 2025, a 60% increase from the prior year. Over the past twelve months, their combined spending on capex has equaled about 1% of GDP. Yet, while optimism around AI’s potential seems high, some observers have begun to question both the pace of this heavy investment and the ultimate returns these firms will achieve.

Maintaining momentum

Whether corporate earnings momentum continues will heavily influence the near-term path of stock prices. Trade policy remains in flux, and the full impact of tariffs has likely not yet been felt. On the other hand, new corporate tax provisions in the OBBBA—such as 100% bonus depreciation on most equipment and immediate expensing of R&D outlays and factory costs—could lift corporate cash flows by several percentage points.

While larger businesses have not generally sounded alarms about the economy, many still report that economic uncertainty is weighing on customer behavior and delaying investment decisions. In response, many executives have turned to cost management and efficiency improvements to protect profit margins.

Fed at a crossroads

Consequently, the labor market has softened this year as businesses become more conservative in their hiring and expansion plans. Concerned about this trend, the Federal Reserve reduced its policy rate by ¼ percentage point in mid-September, the first cut in nearly a year. Policymakers have signaled the potential for two additional cuts in the months ahead.

The central bank’s mandates are to maintain stable prices while also promoting full employment. The Fed faces an unenviable balancing act today: inflation remains stubbornly near 3%, above its 2% target, even as employment shows signs of strain. The conventional cure for inflation—higher rates—directly conflicts with the remedy for labor market weakness—lower rates. By choosing to cut, policymakers are prioritizing support for jobs while hoping inflation continues to moderate.

Pushing the bankers

The Federal Reserve has been under intense political pressure from the Trump administration to aggressively ease monetary policy to spur growth. Earlier this year, the president publicly mused about removing Chair Powell and later sought to dismiss Governor Lisa Cook, alleging misconduct. The Supreme Court is expected to review the Cook case in January.

Political pressure on the Fed is nothing new, though the public and confrontational nature of today’s actions is unprecedented. Lyndon Johnson leaned on William McChesney Martin to keep rates low to help fund his Great Society programs and the Vietnam War. Richard Nixon aggressively pushed Arthur Burns to ease policy ahead of the 1972 election to ensure a strong economy.

While Martin resisted Johnson’s demands, Burns eventually succumbed to Nixon’s pressure. Burns’ Fed lowered interest rates and greatly expanded the money supply. Cheap credit fueled a rapid economic expansion, and Nixon won re-election in a landslide. However, the Nixon-Burns era vividly illustrates the danger of sacrificing the Fed’s independence in the name of short-term political expediency.

Cost of caving

Yielding to political influence can carry steep economic costs and lasting institutional damage. Burns’ stimulus unleashed a wave of inflation which quadrupled from 3% to 12% in just two years. The policies also set the stage for a wage-price spiral, a deep recession, and nearly a decade of very high interest rates.

More damaging still was the erosion of public trust. The Fed’s credibility as an inflation fighter collapsed. Markets lost confidence that the central bank would resist political interference or adopt tough measures to control prices. Paul Volcker’s Fed in the early 1980s had to take painful, politically unpopular, recession-inducing measures to restore that lost credibility—credibility the Fed still benefits from today.

The Fed’s institutional design helps insulate it from day-to-day political control. Governors serve staggered 14-year terms, making it harder for any single president to “stack” the board. The policymaking Federal Open Market Committee (FOMC) also includes five regional Reserve Bank presidents, providing additional balance and independence. And the Fed funds its operations through portfolio income, not congressional appropriations, further limiting political leverage.

Structural shifts

Even so, concerns about central bank independence—and inflation more broadly—are resurfacing as some structural disinflationary forces of the past quarter-century weaken. Globalization, which for years delivered cheap imports and kept goods prices low, has been waning. Pandemic-era disruptions led many firms to prioritize resilience over efficiency and consider “reshoring” portions of their supply chains back to the United States. Current trade policies have accelerated this shift.

At the same time, demographic pressures and potential labor shortages may embed inflationary forces over time. Like most developed nations, the U.S. faces an aging population and declining fertility rates. Fewer workers are supporting a growing retiree base, and immigration—a key source of labor force growth—has slowed. Tighter labor markets could put upward pressure on wages and potentially sustain a somewhat higher inflation baseline.

Encouragingly, generative AI may emerge as a powerful offsetting force. Though adoption remains in the early stages, AI has the potential to boost productivity, lower costs, and reshape entire industries—from software and pharmaceuticals to media and manufacturing. History suggests, however, that transformative technologies often take one to three decades to deliver broad productivity gains. Like two breakthroughs before it—electricity and personal computing—AI’s true economic impact will unfold gradually, not overnight.

Crosscurrents

Financial markets today are navigating a complex mix of resilience and risk. Corporate America has delivered strong earnings despite higher costs and policy uncertainty. The Federal Reserve is walking a tightrope between competing mandates while political pressure tests its autonomy. Meanwhile, deep structural changes—from retreating globalization to the rise of AI—may be quietly redrawing the long-term inflation landscape.

The path ahead will not be linear. Inflation may remain somewhat higher and more volatile than in the past several decades, yet innovation and productivity gains could serve as natural offsets. Investors should expect crosscurrents rather than clear trends, and remain focused on quality, diversification, and discipline as the cycle evolves.

– Christopher J. Singleton, CFA, Managing Director

October 15, 2025

Gradually, Then Suddenly

Three months ago, stock-market investors were in full-fledged panic mode after President Trump unveiled a sweeping new tariff regime. Bond investors also revolted, pushing the 10-year Treasury yield up by half a percentage point within days. Markets feared that a global trade war would stifle U.S. economic growth and fuel inflation.

Confronted by mounting financial market turmoil, the administration quickly backtracked, temporarily delaying many of the proposed tariffs. Fast forward to Independence Day and the major stock market indexes had recovered all of their losses, with the S&P 500 and Nasdaq Composite achieving new record highs.

No deal

This sharp market reversal seems at odds with the still-unsettled trade situation. Back in April, White House trade advisor Peter Navarro boldly predicted “90 deals in 90 days”, expecting U.S. trading partners to eagerly offer concessions to avoid massive import taxes. But the 90-day window came and went with only two agreements to show for it—one with the United Kingdom and another with Vietnam. Trump has also announced the framework for a deal with China, though the details remain fuzzy.

The president has since extended the negotiation deadline to August 1 and tinkered with his threatened tariffs, leaving the global trading system pretty much where it stood three months ago—in a state of limbo. Yet the incessant drama on the trade policy front has been met by an absence of drama in the financial markets. Despite the ongoing uncertainty, investors have grown curiously indifferent to the risks of a trade war.

Going stag

This apparent complacency suggests investors are betting on one of two favorable outcomes: Either significant concessions from major trading partners will soon materialize, or the White House will once again back away from its line in the sand if faced with renewed market backlash. While dozens of trade deals remain theoretically possible, the reality is that such agreements typically take months, if not years, to finalize and implement.

Meanwhile, the unpredictability of trade policy has left businesses in a state of suspended animation, causing firms to delay investment and reevaluate their global supply chains. Surveys show a contraction in new orders and a noticeable pullback in capital spending plans. Uncertainty, after all, is the enemy of business decision-making. CEOs cannot commit to long-term investment when the rules of the game are not clear.

Despite the temporary reprieve, the average effective tariff rate on U.S. imports has climbed to approximately 16%, a dramatic increase from the 2.5% average levy in place prior to Trump 2.0. Tariff hikes are classic stagflationary shocks: They simultaneously slow growth and push prices higher. As tariffs arrive in force, economic momentum will weaken, unemployment could rise and consumer spending may decline.

Heads I win, tails you lose

As Federal Reserve Chair Jerome Powell has warned, someone must ultimately pay these taxes. If companies pass higher import costs on to consumers, inflation could rise and from a base that is already above the Fed’s comfort zone. That would likely push interest rates higher, pressuring both stock and bond prices. Alternatively, if companies absorb the added costs, profit margins will shrink—also bad news for equities.

So far, the broader economy has been partially insulated from the full impact of tariffs thanks to strategic inventory building early in the year. In addition, many firms have shouldered the initial cost of tariffs. But those buffers are fading. With supply chains strained, manufacturers struggling with steeper input costs, and retailers’ inventories dwindling, higher consumer prices are all but inevitable. Walmart, Target and others have already warned of price hikes. The Yale Budget Lab estimates that if current tariff rates persist, the median household could see a 2% hit to income.

Fiscal follies

While the trade war poses a near-term risk for both the U.S. economy and financial markets, a deeper and more structural challenge looms: the nation’s deteriorating fiscal condition. The U.S. public debt trajectory was already unsustainable long before the passage of the so-called One Big Beautiful Bill (OBBB), which introduced a mix of tax cuts and spending changes. On one hand, the OBBB should boost economic growth over the next few years since the more expansionary measures (tax cuts) are front-end loaded while the restrictive aspects (spending cuts) will be concentrated later in the decade.

However, the longer-term fiscal implications are troubling. Incremental economic growth will not be sufficient to prevent a worsening of the U.S. fiscal position. All major, non-partisan budget authorities agree that this legislation will significantly expand annual deficits over the next 10 years. The U.S. will need to issue ever-larger volumes of debt just as interest costs on existing obligations are ballooning. In short, there is no free lunch here.

Annual budget deficits are projected to hover around 7% of GDP, levels previously seen only during recessions or wartime. Analysts forecast government spending to run $7 trillion annually, while revenues remain closer to $5 trillion. This means federal debt, currently equal to 100% of GDP (roughly $230,000 per household), could rise to 130% ($425,000 per household) over the next decade. Debt service—principal and interest—will jump from $10 trillion to $18 trillion per year. Annual interest payments alone are set to double from $1 trillion to $2 trillion, already exceeding what the U.S. spends on Medicare or national defense.

Gradual truths

Mounting deficits and debt could eventually trigger structurally higher interest rates as bondholders demand greater compensation to absorb the supply and accept the growing credit risk. It may take a rebellion by the bond market—led by so-called bond vigilantes forcing up yields—to prod policymakers into action and alter the trajectory of the debt cycle. Yet history offers little assurance that either party is willing to confront hard fiscal truths. Political leaders have repeatedly chosen to avoid tough choices rather than risk voter backlash.

The potential consequences extend far beyond the budget ledger. Ballooning debt also translates into fewer available resources for public investment in areas such as infrastructure, scientific research, and defense—engines of productivity growth, economic vitality, and national security. Moreover, an overleveraged government will have less flexibility to respond to future recessions, crises, or security threats.

In Ernest Hemingway’s novel, The Sun Also Rises, one of the characters describes his descent into bankruptcy as happening “Two ways. Gradually, then suddenly.” The United States is certainly not on the edge of financial ruin. It still commands the world’s most dynamic economy, deepest capital markets, most trusted currency, unrivaled military, and most innovative private sector. But federal finances have been drifting for decades toward a breaking point. Eventually, the shift from gradual to sudden could arrive—and with little warning.

Reckoning at some point

While uncertainty surrounding the OBBB’s passage has been resolved, the global trade outlook remains deeply unsettled. Rewriting trade rules is a slow, complex affair. And seemingly emboldened by resilient U.S. financial markets, the president continues to float new tariff threats with little warning.

Together, the twin pressures of trade and fiscal dysfunction present an unusually potent cocktail—one that could destabilize the economy and markets over time. And the Federal Reserve, already constrained by elevated inflation, lacks the tools to come to the rescue. Investors may continue to shrug off the risks for now, but the longer these issues fester, the greater the chance that market sentiment turns.

There is little compelling economic or financial rationale for a broad, indiscriminate trade war against both allies and adversaries. And decades-long fiscal inaction will eventually exact a price. The time for structural reform is now. Waiting for a crisis to impose discipline will make the reckoning far more painful.

— Christopher J. Singleton, CFA, Managing Director

July 15, 2025

Trade Winds

A global trade war is brewing as the United States imposes sweeping new tariffs on a host of countries, heightening concerns about economic growth and roiling stock, bond, and currency markets around the world.  Policy details continue to shift, amplifying financial market instability and undermining investor confidence.

Some assert that this tariff barrage is a negotiating tactic to gain leverage and extract more favorable trade terms.  But that view overlooks President Trump’s long-standing support for tariffs.  He has consistently touted them as a vehicle to restore America’s “hollowed out” manufacturing base.  Furthermore, the tax revenues generated by sizable tariffs could help fund the administration’s broader policy initiatives.

Hoover’s vacuum

On April 2, President Trump announced an aggressive new tariff regime, targeting nearly every nation, from major trading partners to remote, sparsely populated island nations.  Effective April 5, the program applied a minimum, near-universal tariff of 10% on all goods imported to the United States.

The administration appears to embrace the idea that all of our bilateral trade deficits stem from unfair practices by foreign powers.  As such, higher tariffs will be imposed on “bad actors” — friends and foes alike — that run large trade surpluses with the U.S.  For instance, imports from the European Union will be subject to a 20% duty; Japan, 24%.  Imports from major trading partners in southeast Asia will face among the highest levies:  Vietnam 46%, China 34% (subsequently increased), Taiwan 32%, South Korea 25%.

By some estimates, the average effective tariff on U.S. imports could surge to 25% this year — a stark rise from the prevailing 2% average duty.  The last comparable hike occurred in 1930 when President Herbert Hoover signed the infamous Smoot-Hawley Tariff Act, sparking retaliatory tariffs from other nations and crippling global trade.

Dazed and confused

Though tariffs were a central pillar of Trump’s 2024 campaign, the speed and scale of the policy shift caught markets off guard.  Indeed, on April 3, the Dow shed 2,800 points.  The trade shock also led to a 10.5% plunge by the S&P 500 stock index, the largest one-day drop since March 2020 when a different existential threat reared its head.

The bond market convulsed as well.  The yield on the 10-year Treasury jumped half a percentage point to 4.49%, its sharpest weekly rise since markets reeled in the aftermath of the 9/11 terrorist attacks.  Investors dumped U.S. assets amid growing fears over the trade war and perhaps a loss of confidence in U.S. policy.

In response to the market turmoil, the administration has partially retreated.  While the 10% base tariff generally remains in effect, most of the harsher, country-specific levies have been paused for 90 days to allow time for negotiations.  Many U.S. trading partners appear open to making concessions, but progress may be hindered by the administration’s inconsistent messaging and lack of clearly articulated objectives.

China, however, has declined to bend the knee.  As the U.S.’s second-largest trading partner — and the source of one-quarter of America’s $1.2 trillion merchandise trade deficit — it has matched U.S. tariffs tit-for-tat.  At the moment, both countries seem to have settled on 125% levies on the other’s goods.  The standoff would seem almost comical if the potential economic consequences were not so serious for the global economy.

Taxation without representation

The U.S. economy was already losing momentum before the trade war escalated.  Many consumers have started to appear tapped out, with spending slowing and incomes stagnating.  Delinquency rates on credit card and automobile loans have climbed to their highest levels in over a decade.  Job openings continue to decline, pushing up measures of unemployment.  Surveys of both consumers and small businesses reveal growing pessimism about the economic outlook.

Recessions often start when a major shock hits an already vulnerable economy.  A broad-based trade war could serve as that trigger.  Tariffs are taxes paid by importers, not foreign producers — meaning they raise domestic prices, stoking domestic inflation.  The impact cascades through supply chains, raising input costs for businesses, much of which is passed onto consumers.  Companies’ profit margins narrow while higher prices erode consumer purchasing power and hurt demand.

Retaliatory tariffs abroad would jeopardize U.S. exporters, threatening their revenues as well as their jobs.  American companies could also lose market share as other countries forge trade agreements, giving preferential treatment to non-U.S. firms.  Meanwhile, foreign consumers could certainly turn away from U.S. brands.  And the administration’s trade math ignores services, a major American export.  In 2024, the U.S. had a $300 billion trade surplus in services.  Countries cannot easily impose tariffs on services, but they can tax, fine, or even ban U.S. companies.

While tariffs are inflationary and will weigh on growth, the ambiguity around U.S. trade policy will compound the harm to the economy.  Businesses need predictability to make long-term investment decisions.  Policy uncertainty paralyzes their decision-making, leading CEOs to pause or cancel hiring, capital spending, and expansion plans.  Such hesitation can ripple quickly through the broader economy.

Batten down the hatches

A recession is not inevitable — yet.  If negotiations proceed or financial markets force a change in policy direction, the administration may scale back the size and scope of the tariffs.  Failing that, a shift into a period of stagflation, an environment of weak economic growth and rising joblessness alongside rising inflation, may become more likely.  Such a backdrop would require the Federal Reserve to tread carefully.  Higher inflation would curb the central bank’s ability to cut rates aggressively in support of a slowing economy.

Corporate earnings could also take a hit.  While S&P 500 companies are expected to report 7% earnings growth for the first quarter, Wall Street’s forecast for 10% full-year growth seems increasingly optimistic.  An uncertain operating environment will likely lead many firms to suspend 2025 guidance and analysts to lower profit expectations.

Markets will remain highly sensitive to the headlines of the day, particularly as they relate to the trade situation.  Stocks will be volatile until investors gain more clarity on the path for economic and corporate profit growth.  In turbulent times like these, the instinct to sell stocks and flee to cash is strong.  But history indicates that abandoning stocks often locks in losses while missing the sharp gains that tend to occur at the start of a recovery.  The broad stock market has always rebounded from downturns to attain new highs — but that knowledge doesn’t make it any easier to sit tight in the middle of a storm.

— Christopher J. Singleton, CFA, Managing Director
April 16, 2025

Despite incessant political, geopolitical, and financial chatter, 2024 turned out to be another record-setting year on Wall Street. Buoyed by a resilient U.S. economy and more accommodative Federal Reserve, investors propelled the S&P 500 stock index to 57 record closes. Improved corporate earnings and a series of interest rate cuts further boosted market confidence.

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Cut To The Chase

Powell’s pivot

After launching an all-out battle against inflation thirty months ago, driving borrowing costs to a two-decade high, the Fed reversed course in mid-September. With inflation nearing the 2% target and continuing to moderate, the central bank has moved into a new phase of its battle, now focused on unwinding earlier tightening to protect a cooling labor market.

The Fed’s ability to engineer a so-called soft landing will have significant implications for households, businesses, and financial markets. A soft landing refers to recalibrating interest rate policy to reduce inflation without triggering a sharp rise in unemployment or pushing the economy into recession.

Policymakers voted to reduce short-term interest rates by half a percentage point, signaling the beginning of the end to the tightest monetary policy regime in recent memory. While this shift was widely anticipated, the size of the move surprised many observers. To some, the magnitude of the initial cut suggests that the Fed has become concerned that it is falling behind the curve.

Economic turning points are notoriously difficult to judge, and monetary policy is hard to recalibrate due to policy lags. The Fed previously faced considerable scrutiny for being late to tighten policy after the pandemic, having initially underestimated inflation’s threat. Fed Chair Powell pushed back against the notion that they are again tardy, countering that the ½-point cut can be taken “as a sign of our commitment not to get behind.” Time will tell.

Yellow signals

The labor market has slowed this year but, so far, the slippage has been fairly mild. Businesses appear hesitant to let workers go, but they are also not hiring aggressively. Between March and July, the unemployment rate moved up from 3.8% to 4.3%. While the number of unemployed has risen, workers entering the labor force have driven much of the overall increase in the unemployment rate. Job openings have dropped sharply but remain above pre-pandemic levels and still exceed the number of unemployed.

Newton’s First Law of Motion states that an object in motion stays in motion unless acted upon by an unbalanced force. While the economy does not follow physical laws, the unemployment rate tends to keep rising once it begins to climb. Other labor market signals have also been cautionary, such as fewer Americans quitting their jobs and more people finding only part-time work.

The Fed aims to be that ‘unbalanced force’, preventing further labor market deterioration. Though not robust, the economy retains decent momentum. Second quarter GDP growth was revised up to a 3% annualized rate and forecasts for the third quarter suggest a 2% to 3% growth rate. Economic data released since the Fed ratcheted down interest rates reinforces this outlook. In September, employers added 254,000 jobs — 100,000 more than expected — while the unemployment rate ticked down for the second month to 4.1%.

Street cred

During previous Fed easing cycles, the stock market has typically produced positive returns over the twelve-month period after an initial interest-rate cut. However, some periods have been followed by significant stock market weakness. The distinguishing factor is whether the Fed is proactively cutting rates from a position of strength or reacting to economic weakness.

For example, in the rate-cut cycles of 2001 and 2007, the central bank’s easing came too late to forestall recessions. Economic contractions led to sharply lower corporate earnings and stock prices. But both of those periods were associated with major imbalances — the dot.com implosion and housing/banking crisis, respectively. Today’s economic environment does not resemble those times, even accounting for some of the euphoria around artificial intelligence.

If investors continue to view the Federal Reserve as credible and in control, capable of managing a soft landing, stock prices should have support. In contrast, if investors perceive the central bank as reactionary, slashing rates amid the threat of recession, market sentiment will shift. While many hope for swift and substantial rate cuts, such a scenario would actually signal more imminent risk to the economy and stock prices. Ideally, the Fed will have the flexibility to gradually normalize policy.

Kick the can

Lost in the excitement over Fed rate cuts, the Congressional Budget Office (CBO) just reported that the U.S. budget deficit topped $1.8 trillion in fiscal 2024. Said another way, federal government expenditures exceeded tax collections by almost $2 trillion last year.

By design, deficits typically widen during recessions as tax revenues fall and spending jumps due to economic stabilizers such as unemployment benefits. The COVID-19 pandemic caused a surge in deficits in 2020-21, but the federal deficit has been in a significant structural uptrend since 2016.

The U.S. government last achieved a budget surplus in 2001. Decades of accumulating deficits have required the nation to issue increasing amounts of Treasury bonds to cover the gaps. As bonds come due, the U.S. Treasury issues new ones to roll over the debt. The department must also issue additional bonds to finance the most recent budget deficit.

Debt tipping point

Federal debt held by the public currently stands at $27 trillion, roughly equivalent to the nation’s gross domestic product. In 2007, the debt level was only about one-third of GDP. Despite this worsening trend, politicians have so far avoided a reckoning because the government has managed to service its debt. But that may not always be the case. In 2024, the United States paid $950 billion in net interest on the debt, a 34% increase driven largely by higher rates. Interest payments now consume 14% of total federal spending, surpassing defense spending. Net interest and other mandatory spending such as Social Security and Medicare are on a path to demand an ever-greater share of government revenues.

The CBO projects that under current law, government debt will exceed 120% of GDP in the next decade. Politicians in both major parties often talk about reducing budget deficits but they sharply disagree on the methods. Unfortunately, tax and spending proposals from the Harris and Trump campaigns suggest that both candidates’ programs would add to the deficit and worsen the U.S. fiscal position. Down the road, it may ultimately take a bond market revolt — in the form of sharply higher Treasury yields — to force policymakers into difficult decisions.

Elections and the stock market

Historically, the outcome of presidential elections has had less impact on financial markets than media narratives suggest. Over the last 50 years, the S&P 500 produced double-digit annualized returns over the term of every president except George W. Bush. Furthermore, there has been no consistent pattern between the officeholder’s party affiliation and the performance of specific asset classes or industry sectors.

In the short-term, sentiment often drives market movements, but over longer periods, fundamental factors such as earnings growth, interest rates, and valuations dictate the market’s direction. Although valuations seem a bit stretched at the moment, long-term rates have declined, and earnings are expected to rise at a double-digit pace in 2025. The Fed’s quest to extend the economic cycle will be a key to market performance.

– Christopher J. Singleton, CFA, Managing Director

October 16, 2024

The AI Gold Rush

Investor enthusiasm for the transformative potential of artificial intelligence (AI) has continued to drive the stock market. The S&P 500 Index has achieved numerous record highs this year, largely propelled by mega-cap technology stocks. Indeed, the so-called Magnificent 7 companies have accounted for over half of the index’s price return in 2024. As of mid-year, this cohort was up 33% while the other 493 stocks had risen by 5%.

The past eighteen months have witnessed outsized performance by a select few names, leading the stock market to become increasingly concentrated. Apple, Microsoft, and Nvidia each surpassed the $3 trillion market cap threshold and now comprise one-fifth of the S&P 500’s value. Together, the 10 largest companies represent nearly 40% of the index. In contrast, at the peak of the dot-com boom in 2000, the top 10 stocks accounted for 27% of the market’s total value.

Rhyming not repeating

Drawing parallels to the 1999-2000 period, some observers suggest that history may be repeating itself. In hindsight, the March 2000 stock split by Cisco, a highflyer of that era, coincided with the peak of the IT-fueled bull market. Meanwhile, the current cycle’s darling — chipmaker Nvidia — just split its shares 10-for-1 in early June.

Sir John Templeton famously cautioned that the four most dangerous words in investing are “this time is different”. However, valuations today seem significantly less stretched than they were 25 years ago. Back then, many surging technology and telecommunications companies were burning through their cash, and some were only marginally profitable. Even “old economy” stocks such as GE and Walmart traded at 40-50 times their earnings.

Today’s market leaders have sizable, growing revenues and earnings, fortress-like balance sheets, and worldwide franchises. Investors will ultimately determine whether stock prices remain overvalued. Excluding the top 10, the stock market’s valuation is on the higher side of historical averages but within its 20-year range. So, while this time might not be different, neither is it entirely analogous to the dot-com mania of the late 1990s.

Generating a buzz

As a formal discipline, artificial intelligence has been in existence since the mid-20th century. However, its impact had been largely imperceptible. For many, Deep Blue’s (IBM) 1997 defeat of reigning world chess champion, Gary Kasparov, marked the first memorable AI milestone. More recently, the AI-powered voice assistants, Alexa and Siri, have become integrated into many of our lives.

AI hit an inflection point in public consciousness and adoption with OpenAI’s November 2022 release of its ChatGPT tool. This generative AI system, easily accessible and profoundly useful, acquired 100 million users within two months of its launch. To put this in context, Facebook required 4.5 years to hit the 100-million mark, Instagram took 2.5 years while TikTok achieved it in 9 months. ChatGPT’s explosive global popularity has allowed many to sense AI’s disruptive potential. And it is not the only game in town. Both Microsoft (Copilot) and Google (Gemini) have integrated comparable systems into their widely used platforms.

Content is king

Generative AI refers to a type of artificial intelligence that can create original content in response to user prompts or requests. This content can range from text, images, video, audio, to more complex data analysis. Rather than being explicitly programmed to perform a task, Gen AI systems are trained on massive amounts of data. They use patterns and insight “learned” from that data to make predictions and decisions or create content.

Businesses’ adoption of Gen AI remains in its early stages due to the cost and complexity of developing models to incorporate the technology into work processes. But real-world applications are emerging. In healthcare, for instance, AI tools are being used to facilitate drug discovery. Financial services firms utilize AI models to assess credit risks and detect fraud. The entertainment industry increasingly leans on AI to develop storylines, scenes, and visual effects.

A next wave

The introduction of personal computers revolutionized business operations, enabling more efficient data processing and communication. The internet further accelerated this transformation by providing a global platform for information sharing and e-commerce. AI builds upon these advancements, with the potential to automate and enhance a wide range of cognitive tasks, from data analysis to decision making. Its ability to learn and adapt sets AI apart from previous technological advances.

In 2023, enterprises invested $19 billion to develop Gen AI solutions for their operations according to International Data Corporation. IDC expects this pace to double in 2024, reaching $150 billion of annual spending by 2027. Meanwhile, high-tech giants like Amazon, Microsoft, and Google continue to make massive investments in IT infrastructure, specifically data centers that provide computing power to train and run AI models. And unlike many dot-com era firms that invested heavily in capex in the late 1990s, these juggernauts have deep pockets.

Disruptive possibilities

The IT revolution of the 1990s, driven by the extensive computer deployment and software advances, led to a decade-long surge in productivity. U.S. labor productivity growth accelerated from an average annual rate of 1.6% in the early 1990s to a 3.2% pace by the early 2000s. Rising productivity represents a key driver of economic growth and a higher standard of living. The hope is that the AI revolution will also have a salutary effect, eventually jumpstarting the meager productivity growth rate of the past ten years.

Since the release of ChatGPT, two-thirds of the rise in the overall equity market has stemmed from expanding stock multiples (as opposed to higher earnings forecasts). This suggests that investors are optimistic about AI’s ultimate impact on economic growth. Gen AI has the potential to transform labor productivity by automating routine tasks, enhancing decision-making, and accelerating innovation. A number of bullish private sector forecasts subscribe to this view.

For instance, Goldman Sachs estimates that AI could boost U.S productivity growth by 1.5 percentage points annually over a 10-year period, assuming “widespread” adoption. The Brookings Institute sees an annual boost of 1.8 points over ten to twenty years. Studies by McKinsey suggest that AI-related technologies could enhance global productivity by 0.5 to 3.4 percentage points through 2040. These bullish forecasts assume that AI will automate a significant share of existing work tasks and lead to the creation of new tasks, as previous technology waves have done (prior examples include roles such as webpage designers, software engineers, digital marketing professionals).

However, there are also analysts skeptical of the hype, disputing the notion that artificial intelligence will supercharge economic growth. The counterargument points to the fact that enterprises will find AI exceptionally expensive and challenging to implement. For businesses to earn an adequate return on investment, AI applications must solve extremely complex and important problems. Fewer tasks may prove cost-effective to automate than some forecasts suggest. Additionally, as job functions are automated, the resulting productivity may not entirely translate into economic growth if workers are displaced.

Revolutionary potential

Bill Gates wrote last year in his blog that he had seen two demonstrations of technology over his lifetime that had struck him as “revolutionary”. He said the first instance occurred in 1980 when he was introduced to the graphical user interface, the forerunner of every modern computer operating system. The second event occurred in 2022 at a meeting with the OpenAI team who showed him the capabilities of a Gen AI model.

AI’s transformative potential will unfold over time. While large tech companies continue to invest heavily in AI infrastructure, investors will eventually demand evidence of “killer apps” to justify expectations embedded in some stock prices. During the gold rush, the providers of the picks and shovels proved the true winners, not the miners themselves. If the current wave of innovation ultimately proves to be revolutionary, a much broader spectrum of companies and industries will reap the commercial benefits in the years ahead. In the meantime, history suggests investors take care not to become overly exuberant.

— Christopher J. Singleton, CFA, Managing Director
July 17, 2024

Overcoming Hurdles

The U.S. stock market maintained its momentum in early 2024, with the S&P 500 Index notching a second straight double-digit quarterly return — a feat not seen since 2012.  In recent months, improving economic news has led investors to increasingly embrace the idea that the economy may have weathered the worst of the spike in interest rates and dodged a recession.

Cutting to the chase

Market strength persisted despite two events that, at first glance, should have dampened sentiment and derailed the rally.  First, the Federal Reserve punted on interest rate cuts.  Initially, investors expected six cuts in 2024, with the first as soon as this past March.  That mindset had fueled the year-end rally.  Instead, the Fed has kept the short-term policy rate at its elevated level and foresees the need for only three cuts this year.

The Fed’s lack of urgency to reduce rates and stave off a potential recession reflects an economy that keeps surprising to the upside.  Fourth quarter GDP grew by 3.4% (annualized), driven by buoyant consumer spending.  And this followed a 4.9% surge in the third quarter.  Consequently, the central bank revised its 2024 GDP growth outlook from 1.4% to 2.1%.  However, inflation has been sticky and remains well above the 2% target level, explaining the Fed’s hesitancy to lower rates prematurely.

Gang of 4

Second, the stock market rally persisted despite cracks in the Magnificent Seven trade.  Tesla plummeted 30% in the first quarter, becoming the worst-performing holding in the S&P 500.  Apple’s stock price also fell by double-digits while Alphabet needed a late-period rally to eke out a gain.  Nonetheless, the remaining four (Amazon, Meta, Microsoft, Nvidia) still accounted for about half of the index’s return over the first three months.

Last year, weakness among the leaders could have easily short-circuited the stock market.  However, in 2024, the market has so far shrugged off these challenges.  Strong U.S. growth has encouraged investors to diversify, scooping up a broad array of stocks, not just a handful of technology companies riding the A.I. wave.  Indeed, in March, over half of S&P 500 constituents hit new highs, and all major industry sectors outside of real estate saw gains.

The transition from a narrow market to one with a greater dispersion of strength represents a positive signal.  Bull markets cannot be sustained by a handful of companies or one or two sectors; they must either extend to other pockets of the market or perish.

Profits or else

Can this rally endure?  There are signs that investors have become overly optimistic.  Risk appetites have jumped across a variety of asset classes in both public and private markets.  At the end of March, the AAII Investor Sentiment survey indicated that half of individual investors shared a bullish near-term outlook while only 20% were bearish.  Moreover, by most measures, stock valuations are on the higher side of long-term averages.  History suggests that while such an environment can persist, it also implies the possibility of a pullback or, at the very least, a pause.

The next leg up in stock prices will require ongoing support from rising corporate profits.  A resilient economy and robust consumer demand are expected to fuel an increase in earnings growth for S&P 500 companies for a second straight quarter, following three quarterly contractions.  Based on analyst estimates, FactSet Research and S&P Global both expect earnings to expand at an accelerating annual rate through the year, reaching 20% growth by the fourth quarter after starting at a low single-digit pace.

At this point, Wall Street forecasts that S&P 500 operating profits will rise 10-11% in 2024.  Collectively, the Mag 7 are expected to achieve very solid but slowing earnings growth as the year progresses.  Conversely, the remaining 493 companies are expected to post accelerating growth, surpassing the Mag 7’s pace by the fourth quarter.   If so, investors should continue to rotate towards other areas of the market.

As goes the consumer

Of course, one should be skeptical of forecasts, particularly those issued by Wall Street.  Regardless, after helping the country avoid recession in 2023, the American consumer will remain critical to the growth outlook.  A steady rise in household finances has boosted consumer confidence.  For many, it must seem like the Roaring 2020’s:  Home values, stock prices, and household net worth are at or near all-time highs while savers can earn 5% on their cash.

A surprisingly strong labor market has also supported consumer spending.  Job creation has been solid, and the unemployment rate stands below 4%.  Nevertheless, there are some subtle fissures indicating a softening labor market.  While still elevated, the number of job openings has dropped significantly over the past two years.  A reduction in openings often precedes layoffs. Additionally, the number of quits has declined sharply, suggesting that workers are less willing to leave their current jobs.

Tug of war

Since the Fed embarked on its aggressive campaign to tame inflation, financial markets have fixated on the threat of an ensuing recession — for that is typically how such cycles have played out.  While those fears have largely dissipated, the tug of war between growth and inflation persists.

Core inflation continues to come in too hot for the Fed’s liking.   In March, the core Consumer Price Index advanced 3.8% year-over-year, surpassing market expectations.  Once again, higher shelter costs (+5.7%) drove more than half of the overall increase.  Core inflation has stubbornly settled around a 4% pace for the last seven months.

Recent inflation figures, coupled with a strong March jobs report, have further jeopardized the timing of a Fed pivot.  Policymakers have not seen enough evidence that inflation is on a solid path to the 2% goal.  Interest rate cuts will likely be pushed even further out, which could cause bond yields to reset higher temporarily while throwing some water on the blazing stock market.

Stay tuned

Fortunately, a hardy economy with gradually decelerating inflation provides the Fed with flexibility, including the option of delaying rate cuts.  And based on trends in wage growth and rent prices, headline inflation numbers should continue to trickle down.  The alternative scenario — a strong economy with accelerating inflation — could force Powell’s hand, producing rate hikes and additional rounds of pain for financial markets.  Thus, eyes will stay glued to the monthly inflation prints.

Over the last two quarters, equity investors have benefited from a series of favorable economic reports that propelled stock prices higher.  As Federal Reserve policy has yet to become a tailwind, stocks will primarily take their cue from corporate profits trends.  And perhaps more so than usual, investors will also need to be attuned to the potential impact from external factors — such as the conflicts in Europe and the Middle East, rising tensions between the United States and China, and of course, the 2024 U.S. presidential election.

— Christopher J. Singleton, CFA, Managing Director
April 15, 2024

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