There's ‘a healthy dose of skepticism’ on AI spending, says chief investment strategist

Key Concepts

• AI Skepticism: Doubts regarding the sustainability and valuation of Artificial Intelligence-related investments.
• Long-term Bond Yields: Interest rates on longer-maturity government bonds (e.g., 10-year, 30-year Treasuries), influenced by market expectations.
• Term Premium: A component of bond yields that compensates investors for the risk of holding a longer-term bond.
• Fiscal Spending: Government expenditure, which can influence the supply of government bonds (Treasuries).
• Monetary Conditions: The overall stance of a central bank's policy, including interest rates and quantitative easing/tightening.
• Quantitative Tightening (QT): A monetary policy tool where a central bank reduces its balance sheet by selling off assets or letting them mature without reinvesting.
• Forward PE (Price-to-Earnings Ratio): A valuation metric that uses estimated future earnings to assess a company's stock price.
• Small Cap: Companies with relatively small market capitalization.
• Credit Capacity: The total amount of credit available in an economy.
• Deregulation: The reduction or elimination of government rules and restrictions on businesses.

Current Market Dynamics and Rising Bond Yields

The current market downturn is attributed to a combination of factors: a healthy dose of AI skepticism and an unexpected rise in long-term interest rates globally. Michael Arrone, Chief Investment Strategist at State Street Investment Management, notes that AI skepticism has been reflected in the performance of companies like Oracle and Broadcom.

Regarding long-term interest rates, the 30-year bond yield recently hit a high of 4.867% and is currently at 4.859%, indicating a significant jump over the past couple of days. While the Federal Reserve primarily influences short-term interest rates (like the 2-year Treasury note), long-term interest rates are largely market-driven. Arrone attributes the rise in long-term bond yields to three key factors:

1. Increasing Growth Expectations: The Fed itself has raised its economic growth expectations for the next year.
2. Sticky Inflation: Inflation remains persistent, contributing to higher rate expectations.
3. Term Premium: This "wonky thing" also plays a role. Additionally, structural changes such as the remaking of the global trading system and permanent fiscal spending are expected to result in a significant increase in the supply of Treasuries, further pushing up rates. Currently, these rising rates are not in a cautionary stance; typically, nervousness begins when 10-year Treasuries reach around 4.75%.

Federal Reserve Policy and Economic Outlook

Several Federal Reserve officials have expressed reservations about rate cuts. Austin Goulsby of the Chicago Fed and Jeff Schmid of the Kansas City Fed were against the December rate cut. Beth Hammock of the Cleveland Fed stated that the Fed should pause until inflation retreats significantly from its current 3% to the target 2%.

Despite some of the Fed's public posturing, Arrone argues that the Fed is, in fact, easing monetary conditions. They are cutting rates, have ended quantitative tightening, are buying Treasury bills, and are expanding their balance sheet again. He anticipates a change in leadership at the Fed, expecting further policy easing.

Looking at past market performance, the Dow, S&P, and NASDAQ have experienced "much higher than average gains" for three consecutive years, with the Russell 2000 also showing strength.

2026 Investment Outlook and Growth Drivers

Michael Arrone projects that 2026 has the potential for a fourth consecutive year of solid gains for investors. This optimistic outlook is supported by several key drivers:

• Fiscal Stimulus: Over $400 billion in fiscal stimulus is expected from the "One Big Beautiful Bill Act."
• Easing Monetary Policy: The Fed's actions (rate cuts, ending QT, balance sheet expansion) are creating easier monetary conditions.
• Strong Earnings Growth: Corporate earnings are growing robustly.
• Incremental Tax Refunds: An additional $150 billion in tax refunds is anticipated next year.
• National Celebrations: Events like the 250th anniversary of the signing of the Declaration of Independence and hosting the World Cup are expected to boost economic activity.
• Deregulation: A sprinkle of deregulation could further stimulate the economy.
• Continued AI Spending: Despite skepticism, AI spending is still a factor.

Actionable Investment Opportunities

Arrone suggests a broadening of the investment picture, moving away from the concentrated focus on AI names, which have recently shown signs of investor skittishness (e.g., Constellation Energy Group, Apploving, Broadcom).

His primary recommendation is to invest in financial companies, particularly banks. He highlights that financial companies currently offer similar earnings growth to technology companies but at a "far more attractive valuation." Several tailwinds are expected to benefit financials:

• Market Volatility: A midterm election year in 2026 typically induces trading activity.
• Increased M&A and IPO Activity: Expected to pick up.
• Deregulation: Projected to increase credit capacity by $2.6 trillion next year.
• Capital Returns: Financial companies consistently return significant capital to shareholders through dividends and share buybacks.

He provides specific examples of banks with attractive Forward PE ratios:

• JP Morgan: 15 (cheap)
• Goldman Sachs: 18 (cheap)
• Bank of America: 14 (really cheap)
• City: 14

Another promising area is small cap companies. In the third quarter, small cap earnings surprisingly beat large cap earnings for the first time in 13 quarters. Small caps are poised to benefit from:

• The "One Big Beautiful Bill."
• Easier monetary policy, which should lower interest rates and their cost of capital.
• Increased M&A and deregulation.

These recommendations are predicated on the assumption that the economy will continue to expand and avoid a recession or worse.

Conclusion

Michael Arrone's analysis suggests that while current market jitters stem from AI skepticism and rising long-term bond yields (driven by growth expectations, sticky inflation, and structural changes), the overall outlook for 2026 remains positive. He anticipates a fourth consecutive year of solid gains, fueled by significant fiscal stimulus, an easing Federal Reserve, strong earnings, and various national events. For investors, the key actionable insight is to shift focus from potentially overvalued AI names to undervalued sectors. Financials, especially banks, and small cap companies present compelling opportunities due to their attractive valuations, similar earnings growth profiles to tech, and strong tailwinds from policy, economic activity, and deregulation. The overarching advice is to "don't overpay for things" and seek value in a broadening investment landscape.