Strains Beneath the Exuberance

During the second quarter, easing tensions in the Middle East prompted a strong rally in risk assets, supported by strong earnings and artificial intelligence (AI) investment spending.

Meanwhile, spending on data centers and AI infrastructure relative to GDP now exceeds the dot-com peak, funded primarily out of operating cash flow and, increasingly, debt issuance.² This current rate of growth seems difficult to sustain, in our view. Further, this spending has also produced frictions in the real economy, pushing up prices on inputs ranging from copper to dynamic random-access memory (DRAM) and serving as an inflationary impulse to the economy as a whole.

Although financial conditions in the US are pretty much the easiest they've been in the last couple of decades excepting the Covid-19 period, we have also seen a pronounced shift higher in US interest rate expectations of late even as those for other major economies generally moderated. In part due to the perceived credibility of new Fed Chair Warsh, two-year Treasury yields and the US dollar have risen as gold de-rated.³ That said, the Federal Reserve’s ability to increase interest rates meaningfully is constrained by the government’s need to continually roll over its very large primary deficit at prevailing higher interest rates.