This is a huge week for policy choices. The U.S. equity market, at all-time highs boosted by the excitement of artificial intelligence (AI) productivity, will likely bump up against the headwinds of tariffs, though agreements are coming and uncertainty is less than it was.
1. U.S. job growth is slowing but is still positive. As long as job growth is positive, there is no scope for rate cuts this year.
2. Core PCE, the Federal Open Market Committee’s (FOMC) favourite inflation gauge, may tick higher. As long as inflation does not elevate from current levels, the markets can likely handle it. But easy comps suggest higher prices in the coming months.
3. The FOMC will remain on pause, but we could see a couple of dissenters. The dissent could come from some jockeying for the next chairman’s job. Not necessarily that inflation is contained.
4. How will the U.S. Treasury fund US$1 trillion plus in new debt this quarter? If mostly with bills, it could juice equity liquidity.
5. What will the Aug. 1 deadline for tariffs yield? Looks like a China deadline could be kicked down the road again.
U.S. equity markets remain priced for perfection and for the most part, tariffs have not had any material negative for earnings in any meaningful way just yet. The market is trading at 25x trailing earnings and 23.5x forward earnings that are expected to grow at 6.87 per cent in 2025.
The perfection comes in 2026 and 2027 where earnings growth is expected to grow at 12 per cent and 11 per cent respectively. These types of earnings growth forecasts require massive economic growth, which few, if any, are forecasting.
The bulls claim that we can hold multiples at all-time highs in the face of a stagflationary outcome.
The CBO forecasts that if productivity from AI in the coming decade lowers inflation and lifts real GDP, this outcome could happen as the debt to GDP outcome looks more manageable.
I hate being a called Bearman, but markets are getting extremely frothy, and from an historic perspective, it will likely be difficult for markets to keep going unless AI starts to deliver.
The wrong combination of data and decision making on policy this week could cap the current rally for a while, but the AI tailwind is real.
Corrections of 15 per cent plus are more likely given the higher valuation with earnings or growth disappointments, but the AI tailwind is exciting.
Possibly even more exciting that the birth of the internet in the 1990s. There is a speculative bubble forming, but timing it is next to impossible.
The earnings yield of the S&P 500 (inverse of the P/E) relative to the U.S. 30-year yield is now negative 80 bps – the most expensive in decades, but in the 1990s it got much more expensive.
The big difference between the 1990s and now is the inflation outlook. If the CBO alternative scenario plays out, stocks can keep going for years holding higher multiples.
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