Author: Steven Chiavarone, CFA, Senior Vice President, Chief Investment Officer, Global Equities

October is the month for ghost stories, and the market has no shortage of them. In our last commentary (Still up and to the right), we planted our flag into a bullish outlook for the economy and equity markets heading into 2027. At the same time, we cautioned that the US equity market would likely be haunted by a new set of worries: higher interest rates, Federal Reserve rate hikes, elevated energy prices, a possible slowdown in AI momentum and the midterm elections.

Each of these concerns warrants serious consideration, but none undermines the core of our bullish thesis: we are living through a historically consequential infrastructure buildout that could lead to generational earnings growth.

Higher rates: a new regime, not a crisis

The 10-year US Treasury market recently has sent a chill through investors. Its yield has climbed above 5.2% — its highest level since 2007 — and is up from roughly 1.5% in 2021 and its pandemic-era low of 0.55% in 2020.

Despite this historic rise, equity markets sit at an all-time high this October. This resilience suggests the increase in rates is not just a reaction to the oft-cited fiscal deficits or runaway inflation. If either were the case, we would expect to see some combination of a weaker dollar, unanchored inflation expectations, a significant change in TIPS breakevens, higher credit spreads and more equity market stress. These are the telltale hearts of genuine market worry, and we are not hearing them.

In contrast, we think market behavior reflects stronger nominal growth. The rate debate too often ignores how much the US economy has changed. For roughly a decade after the financial crisis, the economy grew at less than 4% nominally (below 2% real growth and  2% inflation). Real rates were negative, monetary policy was near zero and the 10-year Treasury yield often below 3%.

That world is long gone, even if a similar configuration emerges someday. Nominal growth has been running well above those figures. The Atlanta Fed's tracker points to nearly 7% nominal GDP for the third quarter. Another consideration is the competition for capital. While the AI infrastructure buildout is a driving force behind higher earnings growth, it is also driving significantly more debt issuance. In many cases, investment grade hyperscaler debt offers attractive spreads that are pulling capital away from sovereign issuers, which in turn puts upward pressure on yields.

What deserves our attention is the pace, not the level of yields. September saw the yield on the 10-year Treasury surge 54 basis points. We do not think that tempo is sustainable.

The Fed: hiking modestly, not aggressively

Investors seemed less spooked by the Fed’s September rate hike than expectations for future tightening. Our view is that the market could be getting ahead of itself and jumping at shadows. Growth may be understated, as traditional measures struggle to capture AI-driven productivity gains, while lagging, backward-looking indicators may overstate the persistence of inflation. As Chair Warsh stated, the Fed is not seeking restrictive policy but to remove the accommodation provided last year. We expect one to two more hikes as we move into the first quarter of 2027.

We believe this forward-looking policy is prudent and could extend the economic cycle rather than curtail it.

Energy: Our most legitimate worry, but time may be on our side

The Iran conflict and disruption around the Strait of Hormuz has put crude oil on a harrowing round trip, from lows in the $60s to highs near $120 and back again.

The good news: Transport of oil through the strait is now around 80-90% of pre-war levels. The bad news: prices for refined products remain high. This reflects the loss of refining capacity in Russia/Ukraine and in the Persian Gulf. The ugly: Over the coming weeks, Iranian oil exports are expected to dry up. This will put even more strain on an already weak economy and could push the Iranian leadership to serious negotiations or to desperate attacks on neighbors.

In the meantime, three points keep us from losing sleep:

• Inventories.  While low, they should be sufficient to fuel the US. Europe and Asia would be at greater risk, particularly if supply disruptions extend into late winter.
• Consumer resilience. Spending has stayed solid despite elevated energy prices. The largest drivers of growth, hyperscalers and high-end households, are less sensitive to energy costs than the average consumer.
• Base effects. By March we will lap the inflation spike from when the Iran war began. Even if prices stay elevated, annualized inflation figures may ease or reverse, which could take pressure off the Fed and the long end of the yield curve.

AI: Moderating AI capital spending could be healthy

Calls for a slowdown in AI development emerged after certain industry leaders began highlighting concerns about AI safety. While safety concerns around such a powerful technology warrant serious attention, we do not expect a dramatic slowdown in the frenetic pace of infrastructure build-out.

First, there is the element of self-interest. Not all of the hyperscalers are created equal. The Magnificent Seven have strong business models. to "Investing in AI can expand their moats, increase market share and accelerate their cash flow within their core businesses. In contrast, other hyperscalers are primarily Large Language Model (LLM) providers that lack that diversification. If LLMs become commoditized, they might face an existential threat. As such, they have an incentive to seek regulatory capture to protect their place within the emerging ecosystem.

With so much capital already committed by both the hyperscalers and the chipmakers, AI spending is likely to continue. Witness corporate expenditure (capex) estimates for 2027. They currently exceed $1 trillion, and we expect them to rise. However, we would welcome some moderation. With shortages of power, chips and skilled labor, a modest slowdown might extend the cycle. With price pressures rising, this might also ease inflationary pressures, and improve free cash flow for the biggest spenders. The market likely would celebrate this with higher price-to-earnings (P/E) multiples.

The midterms: noise, not signal

No midterm election has ever ended the world, and this one will not either. We would argue it is among the least consequential elections in a long time. Only two outcomes are likely to  meaningfully change policy: a GOP sweep with much wider margins, or a Democratic wave large enough to produce filibuster-proof and veto-proof majorities. Both appear unlikely.

Historically, the 12 months following a midterm election have been very strong for equities. In fact, it’s been 88 years since the S&P 500 last posted a negative return in the 12 months following a midterm election, with an average return of 14%. One potential explanation is that the president’s party usually fares poorly in the midterm election and then pivots to economic policies that improve their party’s chance of victory in the next presidential election. Ironically, we expect that divided government may once again raise the odds of modestly stimulative policy passing.

What would keep us up at night

Two tail risks could derail our medium-term thesis: AI technology failing to deliver or a major credit event.

On AI, the evidence is fitting our thesis, with capex estimates and adoption rates continuing to climb. Meanwhile, the recent release of agentic tools marks a clear step forward in capability, underscoring the productivity-enhancing potential of this technology. In credit, consumer and corporate balance sheets look healthy, even if financing arrangements around AI remain complex. We do not see any skeletons in the closet at this time.

Government debt has drawn the most attention, and it is elevated. But the deficit has been roughly stable at around 6% of GDP over the past few years, and the US has the deepest capital markets in the world, unmatched innovation and the world's reserve currency. We remain comfortable with the US government's ability to meet its debt obligations. While recent Treasury auctions have exhibited weak spots, they are a risk to watch, not necessarily a thesis-breaker.

Conclusion

October headlines can be frightening, but we think the underlying risks are manageable. Not everything that goes bump in the night is a monster. Looking past the noise, we remain focused on the real opportunities: strong economic growth, the most significant infrastructure buildout since the railroads, and what may be the earnings cycle of our lifetime. We maintain our bias to use weakness as an opportunity to add, and we continue to believe the S&P 500 will climb toward our year-end 2027 target of 10,000.

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