One thing we’ve learned this year is that AI winners and losers seem to change places every few weeks. After a rocky first half of the year, many of the big AI names have come roaring back. The Mag 7 recovered, hyperscalers have regained momentum, and recently software stocks have outperformed semiconductors. Value stocks were pulled into the AI trade as well. Earlier this year, much of value’s performance was driven by the same AI infrastructure themes that have dominated growth for the last few years. Then the index rebalance reshuffled exposures, leadership rotated, and some of the companies that had been hurting performance turned around and became major contributors. Another great reminder of the importance of diversification.
Advantages
- Earnings growth: The S&P 500 is currently tracking nearly 47% year-over-year earnings growth this quarter (compared with a long-term average of approximately 7% to 8%).
- AI momentum: Ongoing investment in artificial intelligence, data centers and infrastructure remains a strong tailwind for earnings and productivity.
- Strong economy: Corporate investment, consumer spending, expansion in services and manufacturing activity and low unemployment continue to fuel growth.
- Innovation across industries: Opportunities are emerging in financials, health care, consumer sectors and enterprise software.
Disadvantages
- Stubborn inflation: Energy, wages, transportation costs and tariffs continue to keep price pressures elevated.
- Higher-for-longer rates: The Federal Reserve may keep interest rates elevated, creating headwinds for both stocks and bonds.
- Geopolitical risks: Ongoing tensions in the Middle East, Ukraine and Israel are contributing to market volatility and energy price uncertainty.
- Midterms ahead: Markets do not like uncertainty, and history suggests volatility may increase as elections approach this fall.
Economic backdrop
GDP is not showing the same explosive growth as earnings results, but Q3 forecasts are coming in healthy. Real GDP remains around 2% supported by business investment. We may see upside revisions as more data becomes available and AI investment projects move forward.
The unemployment rate came in at 4.1% which remains historically low, but labor force participation has declined. Fewer workers competing for the same number of jobs can reduce the unemployment rate.
Inflation has moved higher in recent months, driven in part by energy prices and lingering tariff impacts, keeping the Fed cautious about lowering interest rates too quickly.
Equity markets
Equity markets took a breather after the rapid growth seen in April and May. June and July were bumpy, but remained largely flat for most indexes. This may not sound like good news, but technically it allows the moving averages in the market to catch up to the massive upward movements seen in late spring.
In the early part of August, markets returned to all-time highs. The S&P 500, Dow and Russell 2000 reached all-time highs. The NASDAQ is only a few percent away from the top as well. International markets are holding on to their mid-summer gains, led by emerging-market exposure to memory chips and tech.
The breadth of the market is perhaps the most comforting development. Over the last few years, market returns have come mainly from the Magnificent Seven. This year, however, the remaining 493 stocks in the S&P 500 have also shown strength.
Fixed income and inflation
Fixed income has faced more pressure. Persistent inflation and expectations of a “higher for longer” Fed policy have weighed on bond prices, keeping U.S. Treasury yields elevated.
Energy-driven inflation concerns have added another layer of uncertainty about whether and when rate cuts will begin. However, the income generated from bonds is still quite attractive, and the buffer provided by fixed income in a portfolio is valuable if and when equity markets have corrections or pullbacks.
Looking ahead
The economy is neither booming nor struggling. Growth remains positive, unemployment remains low, earnings are strong, inflation is still elevated, and AI continues to be one of the most important forces shaping markets and corporate investment.
In many ways, today's environment resembles the early stages of the internet revolution. Most investors recognized the opportunity, but identifying the long-term winners proved much more difficult. AI may follow a similar path.
As always, markets are rarely linear. Leadership will likely continue to rotate, volatility will come and go, and investor sentiment will shift. For long-term investors, maintaining diversification and focusing on fundamental business strength remains the most reliable path forward.