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AI Scare Raises Growth Fears and Lowers Bond Yields
I. Treasury Yields US Treasury yields fell sharply today, extending Wednesday's retreat from intraday highs. The 10-year yield dropped 9bps to 5.10%, while the 30-year fell 10bps to 5.43% (chart). Even the 2-year yield declined slightly to 4.77% (chart). Remarkably, this broad-based decline occurred despite two hotter-than-expected inflation reports. Normally, such surprises would push Treasury yields higher as investors priced in a more hawkish Fed. So, what's going on? We think the bond market is focusing on the sustainability of the AI investment boom. That issue came to the fore this week as CoreWeave's bonds plunged below 80 cents on the dollar and debt financing major data center projects also tumbled. A new Gartner report estimates AI data center operators will need $8.5 trillion in revenues through 2030 to cover costs and earn healthy returns, versus projected revenues of "just" $3.6 trillion. Why does this matter? The AI buildout has become a major engine of US economic growth. But doubts about future returns are pushing up borrowing costs, potentially constraining access to capital and ultimately slowing investment spending. As a result, investors may be lowering their economic growth expectations amid concerns that the AI boom could slow, pushing Treasury yields lower. This reinforces our longstanding view that the earlier surge in Treasury yields largely reflected stronger-than-expected nominal GDP growth (chart). We are nowhere near ready to write off the AI investment boom. Demand for compute continues to outpace supply, while rising adoption should fuel further investment. Indeed, just five hyperscalers (Amazon, Alphabet, Meta, Microsoft, and Oracle) are expected to spend a combined $892 billion this year and $1.1 trillion next year. Their strong balance sheets and cash flow generation make their spending plans relatively insensitive to higher borrowing costs. While heavily indebted AI infrastructure providers may struggle, we expect the hyperscalers to keep spending and the Roaring 2020s to keep roaring. II. Inflation Let's take a closer look at September's hotter-than-expected PPI report and what it tells us about inflationary pressures in the pipeline. (1) PPI for final demand. September's PPI final demand surged 1.3% m/m, largely reflecting a 10.8% spike in energy prices. However, even excluding the volatile food, energy, and trade services components, producer prices still rose 0.5%, suggesting that inflationary pressures remain broad-based. On a y/y basis, core PPI final demand rose to 5.0%, with services and goods prices rising 5.0% and 5.2%, respectively (chart). (2) PPI for consumption. The PPI for personal consumption, a key input into the Fed’s preferred PCED inflation gauge, surged by 1.3% m/m in September (chart). Excluding food and energy, it was up 0.6%. Core PPI personal consumption rose to 4.6% y/y and remained well above both core PCED and core CPI inflation, suggesting that upside risks to consumer inflation remain elevated (chart). (3) Supercore inflation. The PPI supercore inflation rate rose to 4.6% y/y in September (chart). (4) Core PCED. With September CPI and PPI now in hand, most forecasters expect core PCED inflation to rise 0.3% m/m in September, which would lift the y/y rate from 3.0% to 3.1%. The Cleveland Fed’s Inflation Nowcasting model projects 0.28% m/m and 3.05% y/y, respectively. III. Booming Economy For now, the US economy shows no signs of slowing down. Consider the latest data points: (1) Jobless claims. Initial jobless claims edged up slightly to 199,000 in the week ended October 10, the fifth straight week below 200,000. That is the longest streak since 1969! Continuing claims declined to 1.71 million, dragging down the 4-week moving average to the lowest level since April 2023 (chart). (2) Retail sales. September retail sales rose 0.8% m/m, partly driven by a 6.4% surge in gasoline station sales amid elevated pump prices (chart). Still, eight of the 13 major categories posted gains. Sales at food services and drinking places, the only services category and a key discretionary spending indicator, jumped 1.1% m/m, their eighth consecutive monthly gain. They rose 7.0% y/y, the strongest increase since March 2023. (3) GDP. Reflecting today's retail sales report, the Atlanta Fed’s GDPNow model estimates Q3 real GDP growth at 3.6% (saar), unchanged from October 8 (chart). Consumer spending is projected to rise 3.6%. AI-related demand is boosting business equipment investment (17.6%), fixed business structures (7.0%), and intellectual property investment (6.6%). Final sales to private domestic purchasers are expected to grow 4.7%.
On Bank Earnings & Defending Data Centers
Investors have been worried about the major banks, particularly given fears that leveraged AI data center operators will cause a deterioration of corporate credit quality. But if a reckoning is coming, it’s a future concern. Life for the big banks is currently sweet. That’s Jackie’s takeaway from the stellar Q3 earnings reports of JP Morgan and Bank of America, which enjoyed expanding loan portfolios and net interest income last quarter. … Also: Amid all the spending hyperscalers are doing to build AI infrastructure, they may have ignored an important detail: How to protect data centers if they are attacked.
Continue To Proceed With Caution
I. Risk Off Is Back On September 15, we advised our readers to "Proceed With Caution." We postponed our year-end S&P 500 target of 8,400 to mid-2027. Our concern isn't earnings; it's stock valuations. We remain bullish on the economy and earnings, expecting no recession through the end of the decade in 2029. Accordingly, we haven’t lowered our 2027 S&P 500 earnings forecast of $425 per share, which is only slightly above the industry analysts' current consensus of $423.08 (chart). Instead, we lowered our year-end forward P/E forecast from 19.8 to 18.6; that’s what reduced our year-end S&P 500 target to 7,900. So far, our caution has been warranted. The S&P 500's forward P/E has been moving toward our targeted valuation multiple (chart). Risk-off sentiment was on full display in the stock market today for most of the reasons we flagged in mid-September. The S&P 500 fell 1.1% to 7,718.94, while the Nasdaq Composite and Russell 2000 both dropped 1.9%. Selling pressure was particularly pronounced among technology stocks, with the SOXX tumbling 4.5% (chart). Interestingly, IGV fell 3.0%, while MAGS was down only 1.9%. The AI trade is getting sloppy amid intensifying competition and doubts about returns on massive AI investments. Shares of heavily indebted neocloud provider CoreWeave plunged 16% today amid growing concerns about its ability to service its debt (chart). Furthermore, today's CPI was hotter than expected, raising the odds of two Fed rate hikes over the rest of this year. A cargo ship sank in the Strait of Hormuz after hitting an Iranian mine. Meanwhile, the risk-off sentiment we anticipated may be helping Treasuries find their footing. On Saturday, we suggested that the 10-year Treasury yield might stabilize around 5.25%. So far, that call is holding up despite mounting fears of further Fed tightening today (chart). That's partly because Treasuries offer attractive real returns, with the 10-year TIPS yielding around 2.90% (chart). Our worry list remains long, including more partisanship after the midterm elections and a re-escalation of the war in the Middle East. We expect risk-off sentiment to persist, further compressing valuation multiples. That's why we still recommend proceeding with caution. On the other hand, buying opportunities are increasing, and Santa could still deliver a year-end rally up to 7,900. II. Inflation Is Back Too Today's September CPI report fueled bets on further Fed tightening. The probability of an October rate hike jumped from 21% to 36%, briefly reaching 45%. Meanwhile, the 2-year Treasury yield surged as much as 13bps intraday before closing 3bps higher at 4.79%, roughly 95 bps above the midpoint of the federal funds target range (chart). Here's more: (1) CPI inflation (m/m). The headline CPI jumped 0.6% m/m in September, its biggest increase since March, led by a 9.3% surge in energy prices (chart). But inflationary pressures were broad-based, with the core CPI rising 0.3%, including gains of 0.3% in core goods and 0.4% in core services. Indeed, 52% of CPI categories recorded inflation above 3% y/y, with 70% above 2%. Durable goods prices jumped 0.9% m/m in September (chart). Notably, prices of computers, peripherals, and smart home assistants rose 1.3%, pushing this three-month moving average inflation rate to a record high. That reflects surging semiconductor prices driven by the AI investment boom. Tariffs are also adding to inflation, with prices of other household equipment and furnishings jumping 2.1% m/m. Nondurable goods prices jumped 1.4% m/m in September, led by a 9.3% surge in motor fuel prices (chart). The services sector also showed broad-based inflationary pressures, with prices rising 0.4% m/m (chart). Higher energy costs are passing through to transportation and travel services, while robust aggregate demand is sustaining pricing power. (2) CPI inflation (y/y). Both headline and core inflation accelerated on a y/y basis in September, marking the 67th consecutive month that inflation has remained above the Fed's 2% target (chart). Both goods and services inflation rose in September (chart). With durable goods deflation unlikely to return soon, services inflation must fall more to bring inflation back to target. However, services inflation remains stubbornly elevated. Supercore CPI inflation rose to 3.2% y/y in September, underscoring the persistence of underlying price pressures (chart). III. The Fed's Beige Book The Fed's October Beige Book, which summarizes economic conditions across the 12 Federal Reserve districts, reinforced the September CPI report's message that inflation remains troublesome. Half the districts reported robust or accelerating price pressures, compared with broadly stable inflation in September. Four districts reported accelerating inflation, while three characterized price growth as robust, up from one previously. Higher energy costs, tariffs, and insurance premiums were the main drivers, with diesel costs passing through via freight surcharges (chart). Expiring hedges and contract renewals threaten further increases. Meanwhile, economic activity remains robust, supported by strong manufacturing demand from AI data centers, defense, and energy.
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