Why are markets becoming more selective on AI?
Our Senior Portfolio Manager and Head of Sustainable Investing Kris Nelson sees a market still supported by economic and earnings strength but becoming more discerning about the returns companies can generate from artificial intelligence investment.
The S&P 500 rose 1.6% from the previous Friday through Wednesday, while the Nasdaq gained more than 2% as technology and semiconductor stocks led a rebound. However, Thursday brought a sharp reversal following several high-profile earnings reports.
Alphabet (GOOGL) provides one example of the changing market reaction. Revenue increased 25%, but came in slightly below consensus expectations, with search revenue growth slower than anticipated.
While their search volumes themselves remained strong, the challenge is monetization. As Google places more AI-generated answers at the top of search results, users may have less reason to click traditional links, potentially reducing the revenue generated from each search.
At the same time, Alphabet continues to invest heavily in AI capacity, while free cash flow turned negative for a second consecutive quarter. Shares fell more than 12% on Thursday.
Microsoft (MSFT) offered a contrasting picture, reporting strong cloud growth, better cash flow generation and revenue and earnings above expectations.
Kris explains that the message from markets is becoming clearer. Investors are not rejecting the AI investment story. They are becoming more selective about which companies can monetize that spending, and how quickly.
How strong is the U.S. economy?
The economic backdrop remains supportive. The U.S. economy grew at a 3.4% annualized rate in the third quarter, up from 2.2% in the second quarter, supported by resilient consumer spending and business investment.
Technology remains an important part of that investment story. Spending on information-processing equipment increased 37% year-over-year as companies continued to build digital infrastructure.
The labor market also remains relatively firm, with initial jobless claims at 194,000.
Taken together, the data suggest that U.S. economic activity continues to hold up well, complemented by more modest growth in Europe and Asia.
Kris highlights that the resilience helps explain why markets have been able to tolerate relatively high interest rates, even as those rates create a more challenging backdrop for some companies and consumers.
What does sticky inflation mean for the Federal Reserve?
Inflation remains the complication. Headline PCE inflation increased 3.6% year-over-year in September, up from 3.4% in August. Core PCE inflation, which excludes food and energy, rose 3.1% year-over-year.
Both remain well above the Federal Reserve’s 2% inflation objective. The Fed held its policy rate steady at 3.75% to 4% this week, as expected. However, the decision was not unanimous, with two policymakers voting for a 25-basis-point increase.
Markets continue to assign a high probability to another rate increase in December. Kris notes a surprise, with Fed Chair Kevin Warsh having announced a change to the meeting structure beginning in 2027, with one of the eight scheduled meetings dedicated to broader monetary policy strategy rather than a rate decision.
How are global central banks responding to inflation?
The challenge of balancing inflation against growth extends beyond the U.S. The Bank of Canada raised rates by 25 basis points to 2.5%, while the European Central Bank held rates steady. Both highlighted inflation as an important risk to the economic outlook.
The Bank of Japan was also due to meet after the time of recording, providing another indication of how policymakers globally are approaching that same trade-off.
Energy prices remain another variable to watch. WTI crude has traded above $100 per barrel for much of the past two weeks, keeping energy-driven inflation pressure in focus.
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