To Be or Not to Be

AI: A Profound Change in the Global Economy

The single most important decision an investor must make is whether, and to what extent, to be – or not to be – in the stock market. At this juncture, we think the answer is to be invested because the United States appears to be entering a major economic transition driven by artificial intelligence. That transition is likely to unfold through several overlapping stages:

1)     Development of the technology;

2)     Distribution of the technology and early profitability;

3)     Widespread adoption and significantly greater profitability;

4)     Restructuring of the workforce around the technology;

5)     Increasing regulation of the technology.

It is clear that we are in the development and early-distribution stages, with still-limited – albeit accelerating – deployment of AI in physical hardware, software, diagnostic tools, research and development, and industrial processes. Early use cases are already visible in areas such as autonomous vehicles, medical diagnostics, drug discovery, software development, robotics, and industrial automation.

AI requires enormous electricity and computing capacity to process large quantities of data, train complex models, and run the infrastructure needed to generate AI outputs at scale. As adoption broadens, demand is extending well beyond the model developers themselves, creating significant needs for datacenters, advanced semiconductors, networking equipment, cooling systems, power generation, and grid infrastructure. In other words, AI is as much a physical-infrastructure story as it is a software story. The pace at which AI can be deployed commercially may therefore depend not only on breakthroughs in algorithms and applications, but also on the ability of the broader economy to supply the energy, hardware, and capital investment required to support it. If you’ve been following the news, you may have seen that Apple is having to pay significantly more for chips for its new iPhone. There simply isn’t enough supply to meet the demand.

The Benefits of Capital Spending for AI

The AI infrastructure buildout is expected to continue for several years and should provide meaningful support to the U.S. economy and corporate profitability, even if its precise contribution to annual GDP growth is difficult to estimate. Datacenter investment, power demand, semiconductor demand, and related infrastructure spending are likely to create a powerful capital-spending cycle that benefits a broad set of companies. As those dollars become revenues and earnings, we expect the buildout to be supportive of the stock market. For this reason, we are moving toward a more fully invested position for clients. That said, the timing and distribution of these benefits will vary, and AI may also alter employment patterns across industries.

The employment impact could be significant, as the computer revolution was over the second half of the twentieth century. We expect many new jobs to emerge as others are displaced, but the net effect on consumer spending is still uncertain.

Infrastructure spending is putting upward pressure on some commodity and power markets. Labor-cost pressures, however, have moderated: BLS reported that nonfarm business unit labor costs rose 1.8% at an annualized rate in Q1 2026, while the Employment Cost Index for civilian compensation rose 3.4% year over year. We view unit labor cost growth below roughly 3% as supportive. With labor-cost growth contained and capital spending strong, investors may be able to look through some of the energy-driven inflation caused by the Iran conflict, as long as inflation expectations remain contained and price pressures do not broaden.

The Iran conflict and the related rise in oil prices are primarily an external supply shock; higher interest rates do little to create more oil supply in and of itself. Rate hikes would become more appropriate if inflation expectations rose sharply or if price pressures broadened beyond energy-sensitive categories. As of the latest CPI release, headline inflation was elevated, energy prices were the main pressure point, and core inflation was lower but still above the Fed’s target. Oil prices have since retreated sharply, and some market indicators now point to more plentiful near-term supply. Gasoline prices near or above $4 in some regions may keep headline inflation elevated for a few more months, but continued declines in energy prices would create more favorable headline inflation readings.

The Federal Reserve

What about the Federal Reserve under Kevin Warsh, who became chair after leaving the Board roughly fifteen years earlier? Warsh has been associated with anti-inflation views while also being viewed as more sympathetic to the Trump administration’s preference for lower rates. Our expectation is that he will be cautious about pushing for higher rates unless inflation expectations or core price pressures require it. Given the decline in oil prices, he may prefer to keep rates steady for longer before following a market-driven decline in rates.

Warsh has signaled that he wants to reduce forward guidance and let incoming data and markets play a larger role in shaping expectations for interest rates. This reminds me of what a senior, very experienced monetary economist remarked some 40 years ago: “No, David, the Fed doesn’t set rates. It follows them!” It now looks as though the Fed may be moving back toward that approach. Continued improvement in the Employment Cost Index would make that easier without stimulating inflation fears.

Profits and Valuations

U.S. corporate profits, as represented by the S&P 500, have exploded in the second quarter, rising an estimated 24%, suggesting that profits for the year will grow 24% year-over-year as well.  Estimates for 2027 range from 10% to 13%.  That puts the S&P 500 Index on a valuation of about 20-21 times 12-month forward earnings of about $366. This is fair value but not bubble territory and explains why the S&P 500 Index stands at 7,499 (as of June 30th). The profits in the 2nd quarter were driven not just by tech earnings but also by energy, i.e. oil company earnings.

RISKS

Slower Profit Growth Due to Bottlenecks

Based on our own use of AI and the ease of rapid adoption, we are less worried about demand for AI as datacenters are built. The larger risk is timing: grid constraints, permitting delays, chip availability, power costs, or integration bottlenecks could delay the point at which new capacity becomes productive. If profit expectations are pushed out, stock prices could fall until those bottlenecks are resolved. The return on hyperscaler investments is still uncertain.

Extension of the War with Iran

An extension of the Iran conflict could once again raise inflation risks. Inflation is already somewhat sticky, and another increase in oil prices – especially without agreement on Hormuz access or Iran’s nuclear program – could create the downside volatility needed to buy stocks at more favorable prices. Sticky inflation plus renewed upward pressure would probably push rates higher and produce a larger drawdown than we currently expect. 

Continued Rise of Interest Rates Because of the Risks

Interest rates could still rise even with a patient Federal Reserve prepared to wait until U.S. economic conditions justify lower rates. The term premium – the extra compensation investors demand for holding longer-maturity Treasuries – is currently estimated at roughly 0.7%, though estimates vary by model. That is still below long-run averages and well within historical ranges. Given the amount of debt issued under both the current and prior administrations, we would expect the term premium to rise from current levels, offset in part by the safe-haven appeal of U.S. assets to foreign investors.

Midterm Elections

Finally, the 2026 midterm elections are approaching. If Democrats were to win both the House and Senate, markets could reassess the durability of the current administration’s pro-business policies. That could have an adverse effect on the stock market, especially in sectors most dependent on those policies.

What to Do

Given the potential importance of AI to the global economy over the next 20 to 30 years – possibly comparable to prior industrial revolutions – we expect the technology sector to remain a concentrated leader in the U.S. economy. Most clients are already exposed to this sector, but we would increase exposure when attractive pricing appears. Some areas, such as software, already present selective buying opportunities.

Most clients also have exposure to housing, which should benefit from any significant decline in interest rates. Long-term housing demand is supported by household formation and the continuing national housing shortage, although affordability remains constrained and inventories have risen in some markets.

We also note that healthcare remains one of the more persistent hiring sectors, even though June hiring slowed relative to its 12-month average. Healthcare could be one of AI’s largest beneficiaries, and we believe promising opportunities exist there. We are looking for beneficiaries of AI as well as producers of AI.

Finally, because of the risks cited above, we are reluctant to own longer-duration bonds for now. We prefer Treasury bills and, at most, intermediate-term notes.

David R. Kenerson, Jr., President

D. Ryder Kenerson, III, Managing Partner

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