The AI Spending Trap: Why the Fed Can't Cut Rates

Key Concepts

• Cyclical Economy: The 20% of the economy comprised of residential fixed investment, durable goods consumption, and business equipment investment.
• Leading Indicators: Economic metrics (money supply growth, yield curve slope, building permits) that signal future economic health.
• Corporate Profit Margins: The ratio of profit to revenue; currently at historic highs (~22% pre-tax).
• Interest Rate Sensitivity: The degree to which sectors or income streams are affected by changes in the Fed funds rate.
• Fiscal Transfers: Government payments (Social Security, Medicare, Medicaid) that are largely immune to interest rate fluctuations.
• Credit Spreads (OAS): The difference in yield between corporate bonds and risk-free Treasuries; a key indicator of market stress.

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1. The State of the Cyclical Economy

Eric Basmajian of EPB Research emphasizes that the economy should be viewed as a sequence of events rather than a collection of headlines. While headline GDP growth remains resilient (around 3%), this is heavily skewed by a narrow segment: business equipment investment, specifically computer equipment.

• The "Cyclical Pie": This 20% of the economy is the primary driver of booms and busts.
• Sector Performance:
  • Residential Investment: Weak for the past three years, currently in a renewed downtrend.
  • Durable Household Goods: Flat trend.
  • Business Equipment: Explosive growth (75–80% annualized), which is masking weakness in other cyclical areas.
• The "Stripping Out" Effect: If computer equipment is removed from the cyclical calculation, the cyclical economy is actually in a mild contraction.

2. Valuation and Corporate Profits

Basmajian argues that traditional valuation metrics (like the S&P 500 P/E ratio) must be viewed through the lens of record-high profit margins.

• Margin Expansion: Corporate profit margins have risen from ~8% during the dot-com era to ~22% today.
• Structural Shift: The rise of monopoly/oligopoly-style companies and the increase in interest-rate-insensitive fiscal transfers suggest that higher P/E ratios may be justified compared to historical averages.
• The Risk: If profit margins revert to the mean, the market faces significant valuation risk.

3. The Fed’s Conundrum

A major theme is the growing disconnect between interest-rate-sensitive sectors and the rest of the economy.

• Insensitivity: A larger share of household income now comes from government transfer payments, which are unaffected by Fed policy.
• Policy Pressure: Because more of the economy is "immune" to rate hikes, the Fed must apply disproportionate pressure on interest-rate-sensitive sectors (like housing) to achieve its inflation targets. This creates a political and economic conflict, especially as legislative efforts attempt to boost housing supply while the Fed restricts demand.

4. The "Playbook" for Future Market Stability

Basmajian identifies the labor market as the ultimate "tell" for systemic risk.

• The Employment Trigger: Credit issues (private credit, corporate debt) will remain "headline stories" rather than systemic crises as long as unemployment remains low.
• The Cascade Effect: Job losses typically begin in cyclical sectors (construction/manufacturing).
• Data Point: We have seen roughly 100,000–200,000 job losses in these sectors since 2024. Basmajian suggests that an additional 200,000 losses are likely required to trigger a broader, downstream economic cascade.
• Monitoring: Investors should watch for a re-inversion of the yield curve and widening credit spreads (e.g., BofA Triple B OAS) as indicators that cyclical weakness is spreading to the broader economy.

5. Notable Quotes

• "If there is no major employment cycle... then all of the credit issues that people are calling out... will amount to almost nothing. It's the job losses that create the credit issues." — Eric Basmajian
• "The Fed will have to probably put even more pressure on sectors like housing than they otherwise would have to offset [interest-rate-insensitive spending]." — Eric Basmajian

Synthesis

The current economic environment is characterized by a "bifurcated" reality: a headline economy bolstered by explosive AI-driven computer equipment spending, and a cyclical economy that is fundamentally weak and contracting. While large-cap equities remain resilient due to record-high profit margins, the stability of the market depends entirely on the labor market. If job losses remain contained, the "extend and pretend" cycle of credit can continue. However, if cyclical job losses accelerate, the current valuation premiums and credit conditions will likely face a significant correction.