Well, that went over like a lead balloon. Fed chair Kevin Warsh spoke, and the bond vigilantes acted. One tenth of one percent – ten basis points in finance-speak – may not sound like much. emmblema.co paperstrawwarehouse.com But when a staid Treasury bond yield goes up by that much in a matter of minutes, it is a big, big deal. And it is a big, big problem for the new Fed chair as he tries to establish the same level of credibility with the bond market – his most important audience – that his predecessors Powell, Yellen and Bernanke had. sms-marketing.gr

The Substance and the Style

We watched the FOMC press conference as it was happening, starting at 2:30 pm this past Wednesday. To be perfectly honest, we found things with which to agree in the substance of Warsh’s remarks. He noted that the Fed only has direct control over one interest rate – the overnight Fed funds rate – and that market rates elsewhere on the yield curve had been moving up recently amid intensified concerns about inflation catalyzed by the resumption of hostilities in the Midde East. In other words, per Warsh, the market was able to send signals without the customary jawboning of Fed officials telegraphing their intentions – in other words, without the constant forward guidance the Fed has regularly employed since the aftermath of the 2008 financial crisis. The FOMC can then use these clear market signals as part of their deliberations on when to take policy action.

Fair enough – that is a coherent point of view whether one agrees with it or not. But the delivery was lacking. Peppered with questions by the attending journalists about why the Fed was keeping rates on hold in the face of this persistently above-target inflation, Warsh stumbled and gave roundabout answers about “family fights” and “spirited discussions” and the like. That there were indeed elevated tempers during the FOMC’s deliberations was clear from the outcome – three dissenting votes by Committee members who wanted a quarter-percent rate hike. To the bond market, Warsh’s dissembling sounded like someone who might be thinking more about the political consequences of raising rates than the economic rationale for doing so.

Not a Great Time for Confusion

The outcome of Wednesday’s meeting gives the market one more thing to be concerned about, at a time when there are already plenty of things to be pinning onto your wall of worry. Conditions in the stock market appear fragile, with some eye-popping intraday volatility in the hitherto driving force of the AI trade. When established megacap stocks like Microsoft and Meta experience double-digit percentage swings in a single day (one up, one down), it doesn’t scream “stability.” The CAPE (cyclically adjusted price to earnings) ratio of the S&P 500 is just three points below where it was at the peak of the Internet bubble in 2000. The Middle East turmoil is at risk of turning into a forever war. The total amount of US government debt is about to top $40 trillion, with the debt-to-GDP ratio climbing over 120 percent. That’s a number that will have knives out among those bond vigilantes.

In other words, it is not a great time for the market to be confused about the intentions of the Fed. Again, we have no problem in principle with the idea that the market does not need constant spoon-feeding by FOMC members in order to function properly. But that transition needs to be managed carefully. The Fed is the single most important institution for the bond market, and the bond market is the linchpin of the entire financial system. Kevin Warsh, whatever his own personal ideology, needs to be more attentive to the responsibility he holds as the public face of this systemically important institution.

How quickly it all goes away, like the snows of yesteryear. sms-marketing.gr Just last week, the Bureau of Labor Statistics delivered a cheery inflation report showing that the headline Consumer Price Index had actually fallen – yes, gone down and not up – for the month of June. That pleasant reversal was largely due, of course, to falling energy prices as tempers in the Middle East seemed to be cooling off. mayatoyaworks.com Gas prices were coming down just as the summer travel season was ramping up, a nice change from the usual. Maybe it was even time for a rethink on the likelihood of a Fed rate hike later this year. And then it all went south again. We won’t see the July CPI report for a few weeks, but in the meantime we do know what oil prices are doing in the wake of the Middle East war returning to its hot phase. p3m.pnk.ac.id And interest rates are sending their own very clear message.

Another Strait Heard From

Brent crude oil popped back over $100 per barrel on Thursday and remains in a narrow range on either side of that level today. Thursday also brought another memorization exercise for geography-challenged Americans in the form of the Bab al-Mandab Strait, a narrow body of water off the western coast of Saudi Arabia, through which tankers carrying oil from Red Sea ports like Yanbu and Jeddah must pass in order to get to the Gulf of Aden and onto their export markets in the Indian Ocean and beyond. Two such tankers were struck there by Houthi militants, a Yemeni-based group supported by Iran. So not only is the war back on, but its geographic footprint is expanding. The Houthis have claimed their intention to force closure of the strait in the same way that the Strait of Hormuz, on the other side of the Arabian Peninsula, has complicated passage for the past three-plus months.

As of today (Friday), the situation remains unclear. The US has threatened a massive retaliation in response to the Houthi action and ongoing attacks throughout the region by Iran itself, but whether that translates into action or merely another round of idle bluster is unknown. Some targeted US strikes took place earlier today after the apparent rejection by Iran of a peace deal delivered by the president of Iraq, acting as an intermediary. Markets appear to be mostly in a waiting mode, with not much happening so far today in commodities, interest rates or the stock market.

Tariffs Again, Really?

Amid all of this, it seems slightly surreal that the US administration is apparently pushing ahead with another batch of tariffs, but here we are. This new round of tariffs appear to be an attempt to legitimize the implementation of duties on imports following the Supreme Court’s rejection earlier this year of most of the tariffs implemented last year under the International Emergency Economic Powers Act. The current proposed tariffs, which range from 10 to 12.5 percent and the adverse effects of which appear mostly directed at Asian and Latin American exporters, flow from Section 301 of the 1974 Trade Act.

But wait, there’s more! In addition to those blanket Section 301 tariffs, the administration has delved into an even more bizarre provision – this one from the infamous Smoot-Hawley Trade Act of 1930 – to throw a bunch of duties amounting to 50 percent on specific goods from our eternally patient neighbor to the north, Canada. The Smoot-Hawley Act, as students of economic history know, was a key factor in the malaise that became the Great Depression. Reviving that misbegotten lump of trade policy from the 1930s seems particularly inadvisable amid everything else that is going on today.

The Fed will meet next week, and while the most likely outcome of Wednesday’s policy meeting will be to hold rates steady, this will be what observers call a “live” meeting with the potential for surprises. At the very least, it may suggest what lies in store when the Committee meets again in September, which will be a Summary Economic Projections event and will have access to another two months’ worth of inflation data beyond what we know today. This could be one of those September-October periods with more tricks than treats.

It has been seven weeks since the S&P 500 reached its most recent year-to-date high, closing on June 2 with a 16.9 percent total return. demo.youaddon.com thebereanchurchofgod.org Since then, US stocks have mostly meandered along a sideways pattern in the aggregate, but with some very wide spreads between intraday highs and lows. projectus.com As we head into the typically slow summer doldrums, when light volume can exacerbate movements for any old reason, it’s worth pondering whether what’s going on is just technical positioning based on things happening now, like traders going through the mechanics of adjusting to SpaceX’s arrival on major indexes, or more worrying signs of a major rethink in longer-term outlook.

Lots of Moving Parts

The first meaningful catalyst to pull the market back from its seemingly easy glide up during April and May had nothing to do with SpaceX at all, but rather the monthly BLS jobs report that came out on June 5. That report showed nonfarm payrolls rising by 172,000, well above what economists had predicted. A hot jobs report, while presumably good for participants in the labor market, is not great for anyone (like a bond trader) concerned about the prospect of rising interest rates. The Federal Open Market Committee would be meeting shortly to discuss interest rates, and this jobs report looked set to nudge the thinking in the Eccles Building closer to a consensus around raising rates.

Some of what happened between the June 5 jobs report and the June 17 FOMC meeting (at which rates were held at present levels but with a hawkish tilt) can most likely be ascribed to short-term mechanical tinkering. SpaceX did indeed go public on June 12, amid breathless hype from the top-tier Wall Street firms underwriting the bonanza and passive index managers figuring out how to reallocate their holdings to accommodate the noisy new member. But over in South Korea the KOSPI index, which had become a central player in the latest chapter of the AI story with its concentration of memory chipmakers, started doing some very wild gyrations as investors started to connect the dots between the surging prices of these in-demand memory chips and the more general problem of inflation across all parts of the economy. The heightened volatility on the KOSPI made itself felt in AI spaces elsewhere in the world. After the market close on June 24 Micron, a US-based memory chipmaker, published a blockbuster earnings report showing that the greater part of a 345 percent increase in sales came from higher chip prices. The next morning, Apple announced that it would be raising prices on certain Mac books and iPads in large part due to higher cost pressures from memory chips.

Re-running the Numbers

All this has added to what was already a much more complex set of interwoven threads than the simple moniker “AI narrative” would suggest. These companies – chipmakers of various types of semiconductors, hyperscalers, power suppliers, frontier model platforms and everyone else in the AI ecosystem – interact with each other in a variety of ways as buyer, seller, investor, partner, advisor and a whole lot more. Following the money in this labyrinthine world is no easy feat. And while it does not appear that the market is visibly souring on the economic importance of AI, with few if any signs of demand abating for compute, for data center investment or for the scientific talent to run the models, this stock market pause suggests that some rethinking and repricing is going on.

For the time being, at least, conditions seem top-heavy. Not for the first time or even the sixth time since AI mania got into gear in early 2023. But the market is also not at 2023 valuation levels. The S&P 500’s CAPE (Cyclically Adjusted Price to Earnings) ratio was a bit over 41 when the index registered that June 2 year-to-date high. That is only three points lower than where the CAPE was in March 2000, at the zenith of the dot-com bubble. That is not to say that the market is due for a March 2000-style fall. But it does weigh in on what is going to happen when this sideways pause gives way to another directional trend.

Eventually, the summer dog days will give way to the historically tricky period of the transition from third quarter to fourth quarter. September and October contain a treasure trove of spooky stories from years past for spicing up evenings around the campfire. This might be a good time for a re-examination of prior assumptions and alternative scenarios.

Pay more attention to the bond market than the stock market. paperstrawwarehouse.com That is advice we have been giving our clients for years now. In the world of anthropomorphic Wall Street imagery the stock market – the fabled Mr. thrive.systemadik.com Market of Warren Buffett-speak – is an emotional and unbalanced creature fond of tippling a few back while making rash here-and-now decisions based on his gut. levikingcafe.fr The bond market, by contrast, is an austere and sober gent with only one concern: getting paid in full and on time. The stock market is Pollyanna, full of hopes and dreams and always ready to buy into a too good to be true story. The bond market is Cassandra, the doomsayer of myth certain that dark clouds lie ahead. Consider how each of these investment categories have behaved since the beginning of the war in the Middle East.

Same Magnitude, Different Meaning

On February 27, a day before US and Israeli forces launched an attack on Iran, the benchmark 10-year Treasury yield was trading around 3.9 percent. On May 19 the 10-year hit 4.7 percent, its peak for the year thus far, representing a 20 percent gain (remember that when bond yields go up, bond prices go down). Today the 10-year is fetching around 4.6 percent. Bonds have been in Cassandra mode throughout the period since that initial outbreak of hostilities.

Stocks initially fell as the closure of the Strait of Hormuz threatened to upend the global energy market and disrupt all manner of industry supply chains. But after bottoming out on March 30, around nine percent down from its previous peak, the market went on a tear. From March 30 to June 2 the S&P 500 gained 20 percent. Same magnitude of gain as the 10-year Treasury yield, but with an obviously different  message. Although intraday trading has been volatile on many days recently, the stock market remains close to that June 2 year-to-date high.

Geopolitics, Schmeopolitics

The stock market is famous for its ability to move on past concerns of a geopolitical nature. Yes, the war’s potential to engender higher inflation remains a concern, but investors have largely chosen to focus instead on resilience in corporate earnings. S&P 500 earnings per share for the first quarter, which came out over the April-May time frame, rose by a very robust 28 percent. Information technology was, unsurprisingly, the star performer with a 55 percent EPS gain from the prior year, but consumer discretionary, financials, industrials, materials and communications services all rose by healthy double digits as well. Forward guidance issued by many of these companies suggested that inflation, while higher than desirable, was not yet setting up a doom scenario.

But is that going to change in the coming weeks, when the second quarter numbers start to come out? Analysts have been successively raising their estimates for Q2 earnings, with the current forecast for EPS growth of 24 percent twice as high as the analysts had been predicting at the beginning of the year. This in itself is unusual; typically, analysts start to lower their estimates as the reporting season approaches, which then makes it easier for the companies reporting to produce upside surprises (a somewhat cynical game, yes, but we all live with it). The performance bar is high, particularly for the highest-flying sectors of semiconductors and other AI infrastructure categories.

Meanwhile, Cassandra over in the bond market is not likely to make things easier. Expectations are already baked in for at least one interest rate hike by the Fed before the end of the year. Other central banks, including the European Central Bank, Bank of Japan and Reserve Bank of Australia have already begun raising rates. Inflationary concerns are far from being off the table. With yet another flare-up in the Middle East this week, the stock market may find it harder and harder to cover its ears and scream la-la-la when geopolitical concerns lead the morning headlines. And there have been some recent signs of flagging consumer resilience, such as a dour report on expected back to school sales issued by Deloitte earlier this week, that could complicate some of those optimistic corporate earnings forecasts. It could be a bumpy ride as we get closer to Labor Day. We won’t be taking our eyes away from the bond market.

The second half of the year is underway, and it’s beginning with the market doing a reprisal of one of its favorite schticks, the “bad news good” routine in which what’s bad for Main Street America is good for, well, the market and its myopic focus on whither interest rates. Recall that, following the Federal Open Market Committee’s meeting two weeks ago, the punters were penciling in September as the likely timing for a hike in the target Fed funds rate. Inflationary pressures, exacerbated by the ongoing war in the Middle East, had already taken a long-hoped for rate cut off the table, and the market odds were now on as many as two rate hikes before the end of the year.

Jobs Blow Hot, Then Cool

Inflation was not the only factor driving rate hike expectations. The labor market, which had been all over the place late last year with alternating declines and advances in monthly nonfarm payrolls (NFPs), found its footing in the second quarter of this year with three successive barnstormers of a BLS report in April, May and June. The June report, containing data for May showing 174,000 payroll gains, arrived at the FOMC’s doorstep just in time to unleash a spate of hawkish Fedspeak by Committee members and chairman Warsh himself ahead of, during and following the June meeting.

Hence the market’s relief this morning when the BLS report containing June data came out well shy of the 100,000 NFPs economists had predicted. And the modest 57,000 payroll gains for June was not the only treat in the bag, as the BLS revised down the previous two months’ worth of payroll gains by 74,000. Those 174,000 jobs from the previous month got hacked down to 129,000. That suggests a jobs market that is cooling – but far from going into deep freeze. In 2025 the average monthly gain in nonfarm payrolls was just 9,670. For the first six months of 2026 the comparable number is 92,000, even after the downward revisions.

Apocalypse Not Now

Economists have spent the last year trying to figure out what the jobs numbers tell us about the threat of AI to result in widespread layoffs and permanent job losses. To be perfectly honest, they have come up with few compelling insights – other than to say that nothing in the current cache of data suggests an immediate “jobs-pocalypse.” Yes – it’s rough going for recent college grads dealing with the vagaries of AI hiring tools and resumes that disappear into the black holes of online employment sites. The monthly layoff data provided by Challenger, Gray and Christmas have also trended bleak recently. But the national overall unemployment rate remains relatively low – 4.2 percent in today’s BLS report. And average hourly wage growth of 3.5 percent over the past year has, it would seem, more or less kept up with inflation.

One might think that this sets up a bullish picture for the market in these early days of the second half. A cool, but not cold, labor market along with subsiding tensions in the Middle East (maybe) sounds like a buy recipe. But not necessarily. Even in the brief time it has taken to write this report, the S&P 500 has retreated into negative territory for the day (hence the two, not three, cheers in the title above). Volatility in the AI trade, as we discussed at length last week, is not taking a summer break. As always, there are plenty of ways for things to go pear-shaped. But at least from the standpoint of the macroeconomic picture, things could look worse.

Like any good complex organism, the AI narrative is splitting into multiple versions of itself, each reacting in different ways to the daily flow of information that feeds its life support systems. Time was when this was a simple, one-celled story. Buy AI! The collective wisdom of the market came up with a catchy name for the trade – the Magnificent Seven, mega-cap companies close enough to this emergent technology to be considered viable proxies. We were always a bit dubious about the logic underpinning the Mag 7. Nvidia – sure, its graphic processing units are essential for powering the large language models that put generative AI capabilities at the fingertips of the human user base. Microsoft, Alphabet and Amazon are the hyperscalers, supplying cloud computing space for the models to run on. We saw a less compelling case for the other three names in the Mag Seven – Apple, Tesla and Meta – to be fundamental cogs in the AI story. But hey, whatever – the market needed a go-to trade, and these are the tech industry’s leading behemoths, so why not?

Memory Is Not What It Used to Be

There were at least three mutating sub-narratives among the Mag Seven during the Thursday trading session this week. After the market close on Wednesday, memory chipmaker Micron released a blowout earnings report showing a 15-times surge in quarterly profits and a year-on-year revenue growth rate of 345 percent. These memory chips, long regarded as among the least sexy bits of tech architecture, are essential parts of the AI infrastructure value chain, and they are in hot, hot demand. So much demand that Micron’s gross profit margin more than doubled from a year ago to around 85 percent. That’s a level more befitting a luxury goods maker than a semiconductor shop.

Good news for Micron, not so good for anyone who has to buy these memory chips. Like, say, Apple, which announced some sizable price increases for its iPads and Macbooks, specifically citing the cost pressures arising from memory chips. Or Microsoft, which, let us remember, also sells products alongside its newer, jazzier business line of cloud computing. Or, let’s be honest, any mega-cap tech company whose sky-high capital expenditure outlays have increasingly been drawing analysts’ scrutiny.

Buy This, Sell That

As investors consider reapportioning their AI investments into new hot-demand names like Micron or South Korea’s SK Hynix – the latter seemingly single-handedly powering the Korean Kospi stock index to triple-digit gains this year – the question arises as to where the funds for these new momentum-chasing investments are going to come from. Mr. Market seems to have an answer – the Mag Seven! So another sub-story that may be going on here is selling pressure on stocks like Nvidia and Amazon as investors redirect funds out of those companies to be on what they think is the right side of the memory trade.

But there is more to this “source of funds” story than memory. Anthropic, which many observers now believe is the leading AI model company, is due to go public sometime in the second half of this year (Anthropic’s main competitor, OpenAI, m ay also go public in this time frame but has expressed some hesitation recently, possibly due in part to the recent rocky post-IPO price path of SpaceX). There’s the pure AI play, a company without non-AI legacy baggage like Microsoft or Amazon. Funds will be needed for these investments as well.

Anthropic’s looming presence is not just a funding redirection story, but also a manifestation of a talent war. Yet another sub-narrative this week was the announcement by Alphabet of some key personnel departures, including members of some of its most high-profile AI projects who have decamped for Anthropic and OpenAI. The competition for talent in the AI space is intense, and Alphabet’s losses in this area are seen as key factors in the decline of about seven percent in the company’s stock this week.

A Pandora’s Box of Open Source

But there are yet more complexities to the story for investors weighing the merits of pure play investments in Anthropic and/or OpenAI. China’s DeepSeek briefly knocked established AI names for six last year when it launched what appeared to be a competing platform on par with ChatGPT but much more cost-effective. Now DeepSeek is ramping up its latest models and benefitting in part from cheaper energy sources powering its data centers in Inner Mongolia. Other model developers in China and Japan are touting the benefits of open source systems, which could ultimately throw a wrench into the business models and price projections of the established US players.

All of which is to say that the AI story is vastly more complex than it was a year ago, and chances are that it will be more complex still a year from now. The complexity is breeding uncertainty, and uncertainty is showing up in the very volatile day-to-day price movements in this sector. The fundamentals remain strong when we consider the traditional metrics of growth, profitability and asset quality. But we can safely say that the days of simply buying the Magnificent Seven and buckling in for the ride are over.

Anyone who had been paying attention to the US monetary policy conversation in the past few weeks knew, within a very tight margin of error, what was actually going to happen at this week’s Federal Open Market Committee meeting. Nothing, as in, no change to the current Fed funds target rate range of 3.5 – 3.75 percent. Yes, but what was the new chairman of the Fed, Kevin Warsh, going to say about the decision to do nothing? What were the vibes going to be? How would this FOMC meeting be different from every other FOMC meeting? Well, we got answers to all those questions and more.

The War on Excess Verbiage

The first clear sign of the new sheriff’s handiwork came precisely at 2:00 pm Eastern time, with the publishing of the FOMC statement. Those of us who have been reading these statements for years on end did a collective double-take upon countenancing the abrupt change in style, format, content and (especially) length of this statement from previous FOMC releases. In the past, these documents changed very little from meeting to meeting, typically running in the neighborhood of 350-ish words and using lots of tendentious filler language like “in assessing the appropriate stance of monetary policy” to lead the reader to the substance of what was happening. By contrast, yesterday’s statement came in at a terse 132 words, did away with just about any word that did not absolutely need to be there, and entirely did away with any language that could be interpreted as forward guidance, i.e., suggestions as to whether the Committee was leaning towards easing or tightening as it looked ahead. “Here’s what we did today. See you in six weeks” was the blunt substance of Wednesday’s report.

Dot Plots for Thee, Not for Me

The second item of note was the Summary Economic Projections – the fabled “dot plot” containing the Committee members’ best estimates as to where the Fed funds rate might be headed in the months and years ahead. Given Kevin Warsh’s well-publicized dislike of any kind of forward guidance, the fact that there actually was a dot plot was itself a revelation. But it was missing one dot, because Warsh himself declined to provide his own estimates. So the number of dots fell from 19 to 18. The subject came up at the post-meeting press conference, in which Warsh managed to simultaneously support his colleagues’ continuation of the dot plot guesses and convey his own belief in the silliness of the exercise.

There is a certain logic to his thinking. The world is going through substantial changes on many fronts – socially, economically, geopolitically – and today’s best guess about interest rates is likely to be upended by the events that unfold tomorrow. Back in March, the median (out of the 19 separate estimates) for where the Fed funds rate would be at the end of 2026 was 3.375 percent, implying a rate cut from the current level. Those estimates were made just shortly after the war in the Middle East had begun. Yesterday’s dot plot produced a median estimate of 3.875 percent, implying the likelihood of a rate hike this year. Nine out of the 18 Committee members providing estimates expect a rate hike. But that is as of today. Who knows what that will look like in six weeks when the FOMC meets next?

And that is the core of Warsh’s argument against forward guidance. In an environment of rapid change and high uncertainty, best guesses about the future are likely to have very limited usefulness as a predictive mechanism. The case against Warsh, though, is that this exercise of forward guidance provides transparency into the Committee’s thinking. A regular diet of Fedspeak, through the SEP as well as the frequent public events in which Committee members share their views with members of the public, can also help shape a consensus for markets, with the potential for fewer surprises that catch investors off guard and result in wilder price swings.

The Times Are A-Changin’

How is all this going to translate into, not just a change of style at the Fed, but of substance as well? We will know more about that later this year. At the post-meeting press conference, Warsh unveiled plans for five new task forces to address a wide range of issues, from communications to data sources, the Fed balance sheet, productivity, inflation and the jobs market. He expects to have many of the findings from these task forces ready by the end of this year. Reading between the lines, some of those findings are likely to result in significant changes to the Fed’s current communications practices (quite possibly the end of the dot plot era), more insight into possible relationships between inflation, jobs and artificial intelligence, and even questions about the specific metrics used for data insights, such as the core Personal Consumption Expenditures index as the Fed’s preferred inflation gauge.

The Warsh Fed, in other words, is likely to look very different in meaningful ways from the somewhat abstemious collegiality of the Bernanke, Yellen and Powell Feds. But on one other important matter Warsh very capably, in our opinion, established his commitment to the independence of the central bank. Anyone who thought he was going to come in as a paid spokesman for the White House with a sweeping push for easy money will have been swiftly disabused of that notion. Markets were, in fact, a bit taken aback by the discernable hawkish sentiment, not just in the higher dot plot estimates for the Fed funds rate but in Warsh’s oft-repeated comments during the press conference about the primacy and urgency of bringing inflation under control.

So concerns about an imminent loss of central bank independence can, we believe, be pushed off the list of top-level worries. It remains to be seen whether all these forthcoming institutional changes to the Fed will be for better or for worse. For now, we are inclined to give the benefit of the doubt to the new sheriff in town. Institutional change is hard, but sometimes change is necessary for the institution to maintain strength, integrity and relevance. We will be watching these developments closely as they unfold.

As of this past Wednesday’s market close, the S&P 500 had retreated by around 4.5 percent from its recent all-time high, set on June 2. The Nasdaq, home to a bevy of the AI-related names central to the market’s fortunes this year, had given up 7.1 percent from its most recent high water mark. There’s nothing particularly unusual about a drawdown of these magnitudes after a sustained run upwards. We make a note of every time the S&P 500 loses five percent or more followed by a recovery of at least that much, something which has happened 90 times since the beginning of the twenty-first century. As always there are multiple factors at play. Stretched valuations have caused another round of second-guessing on the AI narrative, as we discussed in our commentary next week. barbarossaleatheroverstock.com The SpaceX IPO and subsequent (expected) debuts by Anthropic and OpenAI could add more third-guessing and fourth guessing to this space, with near-term risks both to the upside and downside. ksa.yadawi.org What concerns us more broadly, though, is the specter of inflation that has been looming over everything for the past several months. On Thursday the European Central Bank became the first of the G7 central banks to raise interest rates following the recent cycle of monetary easing, citing higher inflationary risks and also revising its growth estimates down. beijingxiantour.com That sets up a challenge that the Fed will face when the FOMC meets next week.Shades of 2022

The stock market has been impressive (some might say complacent) in its efforts to ignore that the war in the Middle East is still going on, three and a half months after it started, without an obvious path to conclusion. Investors do seem to have wised up enough, though, to stop engaging in rapturous cartwheels every time Axios comes out with yet another “deal is just around the corner” headline. Inflation had been sticky before the war started, but it has since gone from sticky to uncomfortably higher.

Energy, of course, has been the main influencing factor pushing prices skyward as both the headline consumer price index (CPI, in green) and producer price index (PPI, in crimson) show. But core CPI (blue), which excludes energy as well as food prices, has also trended up since the war started. Producer (wholesale) prices in particular are rising by more than any time since 2022-23, at the peak of the post-Covid inflationary spike. Higher energy prices mean higher input costs for pretty much any business, and either those costs will get eaten by the business itself (lower profit margins) or get passed onto the consumer (higher prices for you and us).

It could be worse. Oil prices, while higher than before the war, are lower than some of the worst-case scenarios being spun after the Strait of Hormuz closed, which had crude oil prices pushing up past $150 per barrel. That hasn’t happened for several reasons, including a dramatic decrease in oil imports by China, which has been relying on other sources including inventories and alternative energies to meet its needs. But the longer the war persists, the more households and businesses will build higher inflationary expectations into their budgeting plans. Once these expectations become structural, they are very hard to dislodge – this is how inflation turned into a decade-long problem in the 1970s.

The Jobs Puzzle

But inflation is not the only macro variable putting pressure on the near-term outlook for stocks. Last Friday’s jobs numbers went over like a lead balloon. Meaning, of course, that the BLS report itself was upbeat, with 172,000 nonfarm payroll gains versus 100,000 expected, and the unemployment rate staying put at 4.3 percent. This was one of those time-honored “good news is bad news” events, as the Fed is even less likely to take a dovish position on rates when conditions in the labor market are healthy.

But are things actually all that great for jobs? Layoffs keep happening in large numbers. The May report on layoffs by Challenger, Gray and Christmas was up 16 percent from April and the highest number of layoffs for any May since 2020 (when pandemic-related layoffs were in full swing). The job market for recent college graduates is in terrible shape, with AI-generated resumes getting ghosted by AI hiring algorithms and nary a human to be found in the process. So far the evidence is anecdotal, but some concerning signs are evident. Additionally, the upbeat BLS May jobs report is thought to be due in no small part to one-off hiring in areas like hospitality and leisure ahead of the World Cup, which began this week.

So, we have lots more questions than answers. Again, we see the potential for near-term risks skewing either up or down. Uncertainty can cut both ways. But inflation seems set to remain a problem, potentially beyond the rest of this year, and we would very much like to be proven wrong on this front.

You would have needed a pole vault to get over that bar. The expectations bar, that is. On Wednesday after the market close, US chipmaker Broadcom released its sales and earnings report for the second quarter (second fiscal quarter, corresponding to the first calendar quarter ended March 31). kantarawichai.mahasarakham.police.go.th Broadcom’s sales rose 48 percent year-on-year, and the company’s forward guidance for the quarter to come topped consensus estimates. The Palo Alto-based chipmaker is smack in the middle of the hottest story – arguably the only story – driving US stock market growth this year. Pretty good results, one might have thought. But one would have been mistaken, at least in the context of what occupies the mind of the market. Broadcom shares plunged more than 12 percent yesterday, one of the biggest single-day losses on record, as investors apparently decided that even though the forward estimates beat the median forecast, they didn’t beat the most optimistic estimates. The freefall is continuing in the early hours of trading today, and the stock is now around 17 percent off where it started yesterday. ppid.pnk.ac.id demo.youaddon.com

Here We Go Again with Productivity

The eye-popping magnitude of the Broadcom drop notwithstanding, the context around it is something we have seen time and again ever since OpenAI introduced ChatGPT to the world back in the latter months of 2022. Every now and then, the furious pace of investment in AI infrastructure and compute – the so-called “tokens” that are the basic units of AI brainpower – has been popped by a counternarrative questioning whether all this money was ever going to produce something genuinely productive and business-enhancing for its end users. There was a Goldman, Sachs research piece asking that exact question all the way back in the summer of 2023. Last year we had an MIT report in which 95 percent of companies using generative AI in some form claimed that their pilot programs were not delivering a clear financial return. And just last week, the chief operating officer of Uber introduced “tokenmaxxing” to the large swath of humanity unfamiliar with that term, noting that it was increasingly difficult to justify the amount being spent on AI tokens relative to their measurable effect on productivity. Just in time, perhaps, to frame the debate into which that hapless Broadcom earnings report came out this week.

Another False Rotation?

Whenever the AI counternarrative manages to score a hit against the dominant momentum, the inevitable question comes into play: to wit, is this now the moment when all the dishwater-dull laggards come out from behind the rocks and take charge? A look at recent history would suggest caution when debating whether to go pedal to the metal on any such rotation, because they have shown themselves to be short-lived. The chart below shows the performance of low-volatility versus high-beta (beta is a measure of relative volatility) stocks for the past 14 years, going back to the beginning of 2012 (the ETFs shown here were incepted in the middle of 2011). We think the high-beta / low-vol comparison is better for this purpose than, say, the old metric of value versus growth, because the AI trade has been pretty much entirely a high-beta story, while the waters are a bit muddier in the value / growth differential.

As the chart shows – and what should probably strike you as intuitive – is that in periods where things go sour, those high-beta stocks can fall much farther. A brief China shock in 2015, rising interest rates in 2018 and 2022, and the initial Covid shock in March 2020 all depict such periods. But the recovery from each downturn has tended to be quick, and over the entirety of the period the performance gap is notable, with the high-beta index returning nearly double its low-vol counterpart. Makes sense, right? Higher risk needed to obtain higher returns (though that Finance 101 tenet has always had its share of challengers, which is how “low volatility” offerings got to be a thing in the first place).

We will not be surprised if the stocks affected by the latest AI blowback turn around in the very near future, given that – tokenmaxxing chatter aside – there isn’t much evidence yet of any meaningful reversal to demand for all things infrastructure and compute. The buy-the-dip impulse among punters seems to be more frenetic than ever these days. But we will continue to take the counternarrative seriously, too, because it really still is an open question as to how all of this translates into measurable productivity. And we have some potentially major structural disruptions ahead, with both Anthropic and OpenAI on track to enter the public markets in the coming months. Not to mention the unwieldly behemoth SpaceX, about which we will no doubt have to share our opinions at some point in the not too distant future, whether we want to or not. In other words – both the narrative and the counternarrative are going to require close scrutiny in the weeks ahead.

The American consumer is the stuff of legend. Resiliently spending her way through the best and the worst of times, the consumer is the iconic emblem, the longstanding growth machine of the great US economy, accounting for nearly 70 percent of total gross domestic product year in and year out. Small wonder, then, that economists and other students of the market closely follow the minutiae of consumer data, from retail sales to personal consumption expenditures to household sentiment surveys.

Struggling to Keep Up

Many of these data points have been holding up better than expected recently. But there are some growing signs of pressure that may bode for a troubled summer ahead. Data recently released by the New York Fed shows that 90-day credit card delinquencies for the first quarter of this year rose to just over 13 percent, the highest figure recorded since the immediate aftermath of the global financial crisis. The savings rate, meanwhile, has fallen to its lowest level since 2022. Other data show that a growing number of households are dipping into retirement savings and taking out more debt as they struggle to keep up with rising inflation. The inflation rate was sticky even before the war in the Middle East began two months ago, and it has been trending up steadily ever since.

In the above chart we see the surge in energy prices producing a jump in the headline Consumer Price Index (CPI, crimson line), but also the steady rise in the core Personal Consumption Expenditure (PCE) index, the Fed’s preferred metric (blue line) which excludes the food and energy categories, and the core CPI number (green line) for good measure. The core PCE index is at its highest level since 2023, and it suggests that inflation is now about more than just higher gas prices, but is starting to make itself felt in a wider range of goods and services. Consumers are very much aware of this. In the latest Conference Board Consumer Confidence index, published earlier this week, two-thirds of respondents said that they will be cutting back on spending in the next six months due to higher prices, with the biggest cutbacks coming in discretionary and big-ticket items.

The Fed’s Dilemma

Consumers aren’t the only ones concerned about higher prices. A bevy of Fedspeak this week reflected a growing sense among the nation’s monetary policy stewards that a continuation of the present inflation trend could make the next change in interest rates a hike rather than the long-awaited cut. Investors are already pricing in a likely rate hike of 0.25 percent by the first quarter of next year. When the Federal Open Market Committee reports next on June 17, we will see whether the market’s outlook is matched by the Summary Economic Predictions that will accompany the FOMC’s press release. As of the prior SEP, a couple months ago, the median expectation was still for two rate cuts this year. We do not think that assumption will hold. To add to the drama, this will be the first FOMC chaired by Kevin Warsh, and may be an indication of changes afoot as the new Fed chair attempts to make his mark on the proceedings.

We do not expect to see rates move either up or down at the June meeting. There is still much that we don’t know about how structural the current inflationary trend will be, or how long it will take for the disruptions caused by the crisis in the Strait of Hormuz to work themselves out. One encouraging sign from that Consumer Confidence report cited earlier was that households’ inflationary expectations, while elevated, did not rise measurably from the previous month. In the 1970s, it was the wage-price spiral driven by expectations that produced the structural inflation of that decade – a feedback loop that went off the rails until the dramatic monetary policy actions of the Paul Volcker Fed at the end of the decade. We are nowhere near those levels today, and hopefully we won’t be there tomorrow. Meanwhile, we will need to keep a close eye on the consumer-facing data as they come in over the coming weeks.