Markets get more selective on AI

Hi, I'm Kris Nelson, senior portfolio manager and head of sustainable investing at Russell Investments. And this is Market Week in Review. Equity markets tell part of the story this week. But we got some economic data and a few other things to talk about. So let's get into it. Starting with markets, the S&P 500 rose 1.6% from last Friday's closed through Wednesday, and the Nasdaq gained more than 2% as technology and semiconductor stocks led a rebound. 00:00:30:18 - 00:00:51:17 But Thursday brought a sharp reversal in tech after high profile earnings raised new questions about the cost and the payoff from AI investment. And we saw some divergence across and within industries. And that tells us that the markets are becoming more selective. Let's use a couple of hyperscalers as our example and starting with alphabet. So revenue increased 25%. But the company came in just below consensus expectations, largely because search revenue growth was slower than anticipated. That's notable because overall search volumes grew with their fastest rate in the last five years. And so the issue for Google is monetization. As Google puts more AI generated answers at the top of the page. Users may have less reason to click through the traditional links in blue below, which can reduce the revenue generated from each search. At the same time, alphabet is spending heavily to build out AI capacity, and free cash flow turned negative for the second quarter in a row, and only the second time since their IPO. The market reacted strongly and shares fell more than 12% on Thursday. Microsoft offers the useful counterpoint. Its results showed strong cloud growth, better cash flow generation and revenues and earnings that beat consensus. Shares initially moved higher after market and closed flattish on Thursday. So the market is not questioning the AI investment story across the board, but it is becoming more discerning about who can monetize that investment and how quickly. Let's go from markets to the economy. The US economy grew at a 3.4% annualized rate in the third quarter, and that's an increase from the 2.2% pace in the second quarter. And growth was supported by resilient consumer spending and by business investment. That business investment primarily occurred in technology. Spending on information processing equipment was up 37% year over year. As companies continue to invest heavily in digital infrastructure. Initial jobless claims also remained low, at 194,000, suggesting that there is some strength in the labor market. So the US economy is showing continued momentum and activity and holding up reasonably well, and that's complemented by continued, if a bit more modest, growth from Europe and Asia. And this stronger data helps explain why investors are tolerating relatively high interest rates, even as those rates create a tougher environment for some parts of the economy and markets. Inflation inflation does remain a complication. There's a PC data showed headline inflation up 3.6% year over year in September, and that's slightly higher than the 3.4% year over year increase in August and core PC in September, minus food and energy was up 3.1%. And those numbers remain well above the US Fed's 2% inflation objective. And so that leads us naturally to talk about central banks and what happened in that arena this week. The US fed held steady at 3.75 to 4%. And that was expected. But the decision was not unanimous. Two members voted for a 25 basis point rate hike. And the markets continue to assign a high probability to another increase in December. There was one surprise in the meeting. Kevin Warsh announced a change to the fed meeting structure. Beginning in 2027. One of the eight scheduled meetings will be dedicated to broader monetary policy strategy rather than a rate decision. And in 2028, two such strategy meetings will occur among the eight outside the US. The central bank message was similar this week. Both the Bank of Canada and the ECB cited inflation as a risk to growth, and Canada to raise their rates by 25 basis points to 2.5%, and the ECB held rate steady. The Bank of Japan is also meeting after the time of this recording, and so we'll get another read on how policymakers are balancing inflation against growth from Japan shortly. Lasting dimension remains an important variable. WTI has been above $100 for much of the past two weeks. Equity mid September pricing, but also the sustained period above $100 that we saw last spring. So continue to keep an eye on that. So the story this week in some is really about resilience versus increasingly high expectations, particularly in the AI arena. Economic growth remains solid, inflation remains elevated, and earnings around AI continue to provide support. But with rates still high and adding inflation pressures, the market is becoming more selective about where it is willing to pay for growth. That's it for this week. Thank you for listening. Hope to see you again next week.