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ECONOMIC WEEK AHEAD: October 26-30
The S&P 500 fell 0.5% last week, and the Nasdaq dropped 0.7%, both posting second straight weekly losses. The Nasdaq’s 2.9% slide on Thursday was its biggest one-day drop since June, as concerns flared over the cost and availability of financial capital for AI investment. The price of WTI crude topped $100 a barrel amid US-Iran conflict concerns, while the 10-year Treasury yield fell to 5.0%. The FOMC meeting (Wed) is the focus this week, alongside the release of Q3 GDP and September's PCED inflation report (Thu). San Francisco Fed President Mary Daly and St. Louis Fed President Alberto Musalem speak on Friday. A heavy week of Q3 earnings reports rounds out a packed calendar. Here’s more: (1) FOMC. The FOMC’s two-day meeting concludes Wednesday, followed by Fed Chair Kevin Warsh’s press conference. The CME FedWatch Tool puts the odds of a hike this week at 9% and the odds of one in December at 84%. Federal funds futures imply 2.7 rate hikes over the next 12 months and 1.4 over the next six (chart). We believe the committee should hike on Wednesday but won't because the midterm elections are so close. (2) GDP & PCED. The first estimate of Q3 GDP (Thu) follows Q2’s third estimate of 2.2% saar, with the GDP price index up 6.1%. The Atlanta Fed’s GDPNow model estimates Q3 growth at 3.5% as of October 20, led by a 17.8% jump in business equipment spending (chart). September’s core PCED (Thu) follows August’s 3.0% y/y. That was well below September’s 4.6% pace of core PPI final demand for personal consumption and above the core CPI’s 2.6% (chart). The Cleveland Fed’s Inflation Nowcasting model projects September’s core and headline PCED at 3.1% and 3.6% y/y, up from August’s 3.0% and 3.4%. (The model’s m/m rates are 0.28% and 0.47%.) CPI computer software and accessories rose 28.4% y/y in September and PPI electronic components 26.8%, while PCED computers and peripheral equipment rose just 8.4% in August. September’s PCED will show whether that gap starts to close. (3) ADP & unemployment claims. ADP’s weekly employment reading (Tue) follows a drop in the four-week average to 18,500 for the week ended October 3, down from 26,000 the prior week (chart). That’s still more than double July’s low of 8,250, pointing to a solid October payrolls report. Initial jobless claims (Thu) follow last week’s 194,000, below expectations and near the lowest level since the late 1960s. The four-week average stands at 197,800 (chart). Continuing claims rose to 1,728,000 for the week ended October 9, up from 1,710,000, while their four-week average edged down to 1,708,000. (4) Regional business surveys. The Richmond Fed’s manufacturing index (Tue) follows September’s -2 reading. The regional M-PMI business activity index slipped to 13.4 in September from August’s 18.7, while the national M-PMI eased to 54.5 from 54.6 (chart). (5) Earnings. The earnings reporting season heats up this week, with 36% of the S&P 500 companies set to report. Boeing, Seagate, and Corning report on Tuesday. Alphabet, Microsoft, SK Hynix, and GE Vernova follow on Wednesday. Samsung, Intel, Eli Lilly, SanDisk, and Amazon report on Thursday. Exxon Mobil reports on Friday. Analysts’ consensus estimates imply Q3-2026 operating EPS growth for S&P 500 companies of 24.1% y/y, slightly up from last week (chart). Q4 estimates have also risen. (6) Global central banks. Both the Reserve Bank of New Zealand and the Bank of Canada (Wed) are expected to hike by 25bps. The markets are pricing in 88% odds that the RBNZ will lift its official cash rate to 3.00% and an 85% chance that the BOC will raise its policy rate to 2.50%. The European Central Bank (Thu) and the Bank of Japan (Fri) are set to hold their policy rates at 2.50% and 1.25%, respectively (chart). December is the focus for the latter pair. The markets are pricing in 75% odds of an ECB hike in December and a 74% probability of a BOJ hike. Guidance from ECB President Christine Lagarde and BOJ Governor Kazuo Ueda will show whether those odds hold.
US MARKETS CALL: Still Proceeding Cautiously
On September 15, we advised investors to proceed with caution. We pushed out our 8,400 S&P 500 target from year-end 2026 to mid-2027 and set 7,900 as our new year-end target. On October 14, we reiterated our caution. Sure enough, the stock market has been turbulent since mid-September, with AI-related stocks falling sharply. We are seeing some buying opportunities, but better ones are likely after the November 3 midterm elections. Our main concern is a likely escalation of the Middle East war. That could push oil prices above their $120 peak earlier this year. I. Stock Market Performance The S&P 500 is still up double digits ytd at 11.4% (chart). XMAGS is up 13.1%, while MAGS is up only 6.2%. The gap has widened again in recent weeks as MAGS rolled over. Meta led the latest leg down, falling 9.4% last week after reporting earnings. Breadth remained on the weak side. Only 37.8% of S&P 500 companies are outperforming the index on a y/y basis (chart). Rotation was notable last week. The S&P 500 Energy and Health Care sectors led with gains of 1.5% each (chart). Communication Services fell 6.2%, and Industrials dropped 1.9%. As bad as the week felt, the S&P 500 was down only 0.5%. II. S&P 500 Earnings S&P 500 forward earnings per share rose to a record $414.41 during the week of October 22 (chart). It is converging on the analysts’ 2027 consensus estimate of $424.56, up from this year's estimate of $365.94 (chart). The 2026 consensus is closing in on our $375 per-share forecast (chart). The consensus for 2027 matches our $425 forecast. The 2028 consensus is already $493.32, well above our $450 forecast for that year and almost at our $500 target for 2030! If the analysts are right, the S&P 500 could rise to 10,000 by the end of next year. We are sticking with that target for the end of 2029. We think the analysts are too bullish on earnings. Forward earnings for the S&P 400 and S&P 600 are also at record highs (chart). III. Valuation Valuation multiples continue to compress despite strong earnings (chart). The Magnificent-7's forward P/E is 22.8, down from a 2026 peak of 28.5. The S&P 500, S&P 400, and S&P 600 trade at 18.4, 14.5 and 14.0, respectively. The big valuation story is that for the S&P 500 Information Technology sector. Its forward P/E dropped from 26.5 at the end of 2025 to 19.0 now (chart). The S&P 500 has fallen from 22.2 to 18.6. The S&P 500's forward earnings is up 31.0% ytd (chart). The index is up 11.4%. The forward P/E is down 13.5%. Stocks have gotten significantly cheaper this year. IV. Bonds The 10-year Treasury yield is back in the “old normal” range of 4.00%-5.00% (chart). It peaked at 5.35%, attracting many buyers. It is now at 4.96%. Some of that decline reflects safe-haven buying during the recent risk-off selloff in the stock market. But market-based measures of long-term inflation expectations remain subdued. Bond investors seem to expect inflation to subside. We agree. The 13-week change in the 10-year yield tends to track the Citigroup Economic Surprise Index (CESI) (chart). Recently, the yield's change overshot the index, as it has done before. Now, the 10-year yield is up 27bps over the past 13 weeks, down from over 80bps a few weeks ago. Corporate credit default swap spreads are breaking out again (chart). The widening reflects credit-quality concerns about companies like Oracle and CoreWeave. The Bond Vigilantes are regulating credit in the AI ecosystem. That's healthy. We aren't particularly concerned.
AI Credit Crunch?
I. AI Jitters Investors have worried that AI companies are spending too much on data centers. These companies' once ample free cash flows have turned negative, forcing them to borrow. Concerns have mounted that they are driving up financing costs and won't generate sufficient returns to justify their huge investments. Now, another concern is moving to the forefront: Does enough capital even exist to finance everyone's ambitious AI spending plans? Meta's earnings announcement on Wednesday brought these concerns to the fore. Despite revenues rising 26% y/y to $64.6 billion, the company reported negative free cash flow of $2.1 billion. It raised the lower end of its 2026 capital expenditure guidance to $135–$145 billion and announced a new class of non-voting shares to facilitate future capital raising. Investors interpreted the move as a sign that even hyperscalers may be rushing to secure financing before competitors absorb the available capital. Indeed, the Meta report stated: "Recent significant capital raises from peers like Alphabet and SpaceX, alongside anticipated fundraising from Anthropic and OpenAI, have created an increasingly challenging fundraising environment." Several industry leaders have confirmed this concern. Broadcom CEO Hock Tan recently warned that capital could become the biggest constraint on AI development. BlackRock CEO Larry Fink said that competition for capital was the fiercest he had witnessed in his career. On Thursday, Nvidia CEO Jensen Huang warned that neocloud demand is "off the charts" but capital is scarce. As AI companies compete for capital, rising financing costs increase the returns required to justify investments, amplifying the original worry about whether all that spending will pay off. Today’s market action showed how these concerns are playing out across stock and bond markets: (1) AI stocks got a shellacking. Meta's shares plunged 7.0% today after yesterday's announcement, leading a broad selloff in AI-related stocks. Nvidia fell 4.4%, CoreWeave fell 10.1%, and Lam Research fell 11.8%. SOXX dropped 6.8% (chart). The Nasdaq dropped 2.6%, its worst day in four months (chart). (2) Investors rotated. The market broadened away from technology stocks today. The equal-weighted S&P 500 edged up 0.7%, outperforming its market-cap-weighted counterpart, which fell 1.2% (chart). MAGS fell 3.4% today, while XMAG edged down 0.5% (chart). The latter is still outperforming the former so far this year: 14.3% versus 10.5%. The Dow edged up 0.02%, while the Russell 2000 gained 0.11% (chart). Rather than abandoning equities, investors rotated away from the AI trade into other sectors. (3) The bond market's reaction was a happy one. Treasury yields declined across the yield curve, with the 2-year falling sharply to 4.64% but remaining well above the effective federal funds rate (chart). The 10-year Treasury yield fell below 5.00% for the first time in nearly a month, returning to what we consider its old-normal range of 4.00%–5.00% (chart). The Treasury market rally suggests that investors are increasingly concerned that tightening access to capital could slow the AI buildout, one of the economy's most important growth engines. (4) Our take. We view market-driven tightening access to capital as healthy for the AI boom, resulting in more efficient capital allocation and reducing over-investment risks. Importantly, we expect the key players to retain financing access. The five major hyperscalers (Amazon, Alphabet, Meta, Microsoft, and Oracle) alone are projected to spend almost $780 billion in 2026. Over each of the following four years, from 2027 through 2030, that figure is expected to exceed $1 trillion annually. Their strong cash flows, balance sheets, and market access should allow them to continue investing in AI. II. The Middle East Wild Card Another development amplifying risk-off sentiment today was escalating geopolitical tensions in the Middle East. The New York Times reported that the US and Israel have developed plans for possible renewed strikes against Iran following the November 3 midterm elections. Meanwhile, intensifying Houthi attacks on Saudi infrastructure prompted the US to order nonessential diplomatic personnel and their families to leave Saudi Arabia, while Saudi Aramco evacuated staff from its Dhahran headquarters. The price of Brent crude oil jumped to $113.17 per barrel Thursday, while West Texas Intermediate crude rose to $103.95 (chart). That sent XLE, which we've recommended overweighting, to a new record high today. Yet, Kpler data cited by The Wall Street Journal showed Middle Eastern oil exports averaging more than 24 million barrels per day during the week through October 18, exceeding prewar levels of 23 million. Prices remain elevated partly because of higher shipping costs, but more importantly because of a geopolitical risk premium, reflecting concerns that such flows may not be sustained. The bottom line is that the Middle East conflict remains a wild card. However, we expect US consumer spending and business investment to remain robust, while federal deficits of roughly 6% of GDP (during a solid economic expansion) provide additional economic stimulus. We expect the US economy will continue to pass the latest stress tests originating in the AI ecosystem and in the Middle East. III. Miscellaneous We expect to see lower bull-bear ratios next week after today's drubbing (chart). If they fall low enough, that might set the stage for a year-end rally. Then again, there might be a better opportunity to buy the dip when and if bombs start falling again in the Middle East. Gold sold off on today's commotion even though interest rates fell (chart). We are expecting that the retest of $4,000 per ounce might hold and be a good entry point following this year's correction (chart).
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