The U.S. economy remains resilient…but for how long?
In May, a changing of the guard occurred at the U.S. Federal Reserve as Trump appointee Kevin Warsh took the helm as the central bank’s newest Chair. With the president forcefully arguing for lower rates, investors wrongfully expected Warsh to strongly push towards a more dovish interest rate position at the Fed. Following the June meeting of the Federal Open Market Committee, the new Chair’s unexpectedly hawkish statement emphasized that the central bank would not be comfortable with inflation remaining persistently above its 2.0% target and reiterated that monetary policy decisions would remain driven by incoming economic data, rather than political considerations or market expectations.
Following these comments, and combined with several months of stubbornly elevated inflation readings, the market’s interest rate expectations shifted meaningfully. Rather than anticipating one or two interest rate cuts, as many economists expected at the year’s start, consensus forecasts now call for one or two rate increases before year-end. Providing additional support for Chair Warsh’s position was a late-June Supreme Court decision reaffirming, at least for now, the Federal Reserve’s longstanding independence. By declining to permit the immediate removal of sitting Federal Reserve Governor Lisa Cook, the Court reinforced Congress’ long-established objective that monetary policy remain insulated from short-term political pressures. Beyond its legal implications, the ruling served as an important reminder of the value financial markets place on the credibility and independence of the nation’s central bank.
Despite the year’s extremely turbulent geo-political environment, the U.S. economy continues to demonstrate surprising resilience although the pace of growth in recent months has moderated. Real GDP increased at an annualized rate of 1.6% during the year’s first quarter – largely supported by continued strength in consumer spending and robust investment in artificial intelligence infrastructure. Early estimates suggest that 2nd quarter growth remained positive despite heightened geopolitical uncertainty and elevated interest rates.
This year, unemployment has modestly declined from an already historically low 4.3% to an even lower 4.2% level at May-end. However, the unemployment rate does not tell the entire story. Much of the recent improvement has reflected a modest decline in labor force participation rather than a meaningful acceleration in hiring, suggesting that the labor market may be less strong than headline figures imply. Meanwhile, the jobs market has shown unexpected strength with new openings doubling in the second quarter to ~135,000 new positions/month – a sharp turnaround from year-end 2025’s soft job’s market. While employment conditions have been a recent source of economic strength, inflation remains the economy’s most pressing concern.
Inflation trends during the year’s first half reinforced the view that returning to the Fed’s long-term 2.0% objective is likely to remain a prolonged and drawn-out challenge. Although inflation has declined significantly from the Covid-era highs of 2022, progress became less consistent as the year unfolded. The Federal Reserve’s preferred measure of inflation, the core Personal Consumption Expenditures Price Index, accelerated during the Spring from 3.0% to 3.4%, reflecting both higher energy prices and lingering underlying price pressures. Recent readings suggest that restoring actual inflation back to the Fed’s 2.0% objective may prove more challenging than many investors had previously anticipated. Our longstanding view remains that returning inflation all the way to the Fed’s target will prove quite difficult. Achieving this goal without overly slowing economic growth will remain the Federal Reserve’s primary objective, and biggest challenge, over coming quarters.
Taken together, recent economic data portrays an economy that is slowing but not yet stalling. While inflation remains above the Federal Reserve’s long-term objective and geopolitical risks continue to cloud the outlook, the underlying fundamentals of the U.S. economy remain sound. Against this backdrop, investors have understandably remained focused on how these crosscurrents are influencing financial markets.
Equity markets continue rising as bond investors struggle…
The U.S. stock market recovered appreciably in the 2nd quarter after an almost 10% initial decline following the start of the U.S./Iran conflict. Wall Street ended the quarter with a double-digit advance – largely on the back of massive corporate outlay on artificial intelligence and its infrastructure buildout. Currently, the ten most valuable companies in the U.S. are all tech firms – each of whom is intimately entangled in the artificial intelligence (“AI”) wave. They now comprise more than 35% of the market’s overall value. However, the sentiment surrounding the AI buildout is beginning to shift on the back of a more hawkish Fed, stretched valuations, and the growing chorus of concern about possible overinvestment in the space.
One consequence of the economy’s continued resilience has been a meaningful shift in interest rate expectations. Entering the year, many investors anticipated that moderating inflation would allow the Federal Reserve to continue reducing short-term rates. Instead, stronger-than-expected economic growth and more persistent inflation have caused markets to reassess their interest rate outlook. The 10-year Treasury yield has risen from 4.15% in January to more than 4.55% in mid-July as investors have recognized that interest rates are likely to remain elevated for longer than previously expected.
Given current interest rates, richly valued companies will struggle should their profits fail to meet the market’s elevated growth expectations. With equity valuations already well above historical averages, the recent rise in interest rates further reinforces our view that the margin of error for stock investors has meaningfully narrowed. By one measure, the equity risk premium, stocks are as nearly as richly valued as they were before the dot-com bubble burst in 2000. This extra reward for owning stocks, having briefly dipped below zero last year when Treasury yields rallied, still remains appreciably lower than historic norms.
The debate among equity investors now is whether stocks’ recent advance to record highs is justified by the surging profits at America’s largest companies. The argument is that the AI boom is just beginning and that companies will see an even bigger boost to earnings as they sell, adopt, and improve the technology thereby powering broader economic growth in the process. However, there is some skepticism arising around the likely duration of the current tidal wave of AI spending. No matter, any argument for optimism for continued stock advances this year remains contingent on a successful, and immediate, resolution to the current Middle East conflict.
As we look forward to the just commencing 2nd quarter’s earnings season, corporate profits are set to post records. However, the numbers are not necessarily as they appear largely because of an accounting quirk. Companies like Alphabet, Amazon, and Nvidia are booking enormous paper gains as their private stakes in AI firms such as Anthropic and OpenAI have been marked at ever-higher valuations. This creates a potential circular valuation loop where inflated private AI valuations flow back into the earnings figures of publicly traded tech companies which then stokes additional optimism for the privately listed companies. Unfortunately, some analysts’ forecasts appear to assume this dynamic continues without letting up rather than reversing itself within the next several years.
Despite the performance of the mega cap tech companies, every market sector is trading higher year to date – an encouragingly healthy sign that this rally is broader based rather than singularly concentrated in the tech/AI space. While opportunities still exist, meaningful concerns exist regarding the duration, and amount, of the current AI buildout. Maintaining diversification and sticking to one’s long-term investment strategy remains crucial in times such as these. We hope all of you are enjoying this summer and encourage you to reach out to us with any questions or issues that we may assist you with.
