The three major U.S. stock indexes closed higher for the week. Investor positioning in large-cap technology stocks, supported by corporate earnings proving that AI capital spending is generating commercial returns, offset the pressure from rising Treasury yields. However, long-end U.S. Treasury yields hit new multi-year highs, with market concerns that rising oil prices could reignite inflation, potentially applying valuation pressure to growth stocks.
Meanwhile, a wave of chip company earnings is on the horizon, setting the stage for a new round of tests on the AI narrative. Expectations for a Federal Reserve rate cut have receded. This week saw a flurry of economic data, headlined by the U.S. Q2 GDP and the June personal consumption expenditures (PCE) price report. Driven by lower energy prices, the headline PCE price index fell 0.1% month-over-month in June, marking its first decline in four years. On an annual basis, it rose 3.7%, below the expected 3.8%. Excluding food and energy, core PCE rose 0.1% month-over-month and 3.3% year-over-year, below the expected 3.4%.
The U.S. economy grew at an annualized rate of 1.5% in the second quarter, significantly missing the 2.1% consensus estimate as the trade deficit widened. However, a pickup in consumer spending, coupled with increased business investment in AI-related infrastructure, revealed the economy's underlying resilience. If not for the drag from trade and inventories, growth would have exceeded 3%. These components can temporarily distort GDP readings but have a limited impact on the medium-to-long-term economic fundamentals. The labor market remains stable, with initial jobless claims rising by 9,000 to 197,000 for the week. Continuing claims fell by 7,000 to a seasonally adjusted 1.782 million, below the 1.795 million estimate.
The Atlanta Fed's GDPNow model projects Q3 GDP growth at an initial estimate of 5.0%. Bob Schwartz, senior economist at Oxford Economics, commented that the Q2 GDP figure understated the true resilience of the U.S. economy. He noted that consumer spending, the primary driver of growth, benefited from a rebound after Q1's extreme weather disruptions and support from fiscal stimulus. However, he cautioned that persistently high gasoline prices could cool consumption momentum in the second half of the year. A positive sign was that investment outside of the AI sector is starting to recover, posting its largest gain in three years, with the recovery expected to broaden to more industries in coming quarters.
Last week, the Fed held its benchmark interest rate steady in the 3.50%–3.75% range. Compared to the June statement, the only new language reiterated the committee's commitment to continuing its policy operations while maintaining ample reserves in the banking system. Despite the hawkish tone, Chair Warsh and the majority of members chose to pause rate hikes, leading the market to believe the Fed's tightening might be less aggressive than anticipated. Fed funds futures pricing shows the implied probability of a rate hike at the September meeting has fallen from nearly 100% last week to 67%. Further out, pricing is unchanged: the market expects two 25-basis-point rate hikes by the Fed before the March meeting, consistent with last week.
Deutsche Bank, in an email commentary, stated its base case remains unchanged: the Fed will hike a total of 50 basis points this year, with 25-basis-point increases in both September and December. Warsh believes reducing forward guidance helps better capture market sentiment. However, judging by the market reaction following the latest press conference, the FOMC is unlikely to be pleased with this outcome: nominal yields across the Treasury curve rose sharply, while real yields gave back most of the gains made since the June meeting. Schwartz told media that the Fed's July meeting achieved a hawkish hold, with Warsh appearing content to let financial markets perform some of the tightening work on the Fed's behalf. The Fed's core assessment remains that the economy and labor market are resilient, keeping the short-term policy focus on inflation. With inflation expectations stable, this could lead the Fed to view the current oil price shock as a one-off disturbance and opt for a longer pause.
The rebound faces multiple challenges. As global tech giants maintained or raised capital expenditure forecasts in their latest earnings reports, the AI spending spree shows no sign of cooling, helping U.S. stocks stabilize and rebound late last week. According to Dow Jones market data, the consumer discretionary sector posted the highest weekly gain at 8.3%, followed by communication services (up 5.4%) and consumer staples (up 1.2%). Utilities (-4.2%), real estate (-2.2%), and materials (-1.7%) were the laggards. This week, the six major tech companies that have reported earnings saw a combined market cap swing of nearly $2 trillion. Amazon, Microsoft, and Alphabet, parent of Google, saw their market caps surge, driven by strong cloud business growth, leading the market to believe that companies are getting closer to realizing returns on their hundreds of billions in AI investment. Last week, Microsoft's market cap increased by over $600 billion, while Amazon and Google each added more than $400 billion.
On the other hand, Meta's stock price plunged after its earnings report as investors questioned its AI investment strategy, wiping out about $85 billion in market cap last week. Apple's losses were even steeper, with its market cap shrinking by over $450 billion due to a memory chip shortage weighing on its outlook. Tesla's cash flow turned negative, and with increased spending anticipated, its market cap fell by about $7 billion. This earnings season shows capital is actively filtering AI winners, with a clear divergence in the stock performance of tech giants. Refinitiv data shows analysts generally expect S&P 500 earnings for Q2 to surge 48% year-over-year, with AI-related stocks contributing the bulk of the increase. Strong earnings expectations, combined with the recent stock price correction, leave the S&P 500 trading at a forward P/E of about 20 times, slightly above the 10-year average of 19 times.
Charles Schwab noted in a market commentary that after the FOMC meeting, the bond market experienced significant volatility, but the stock market held up under pressure. The intense volatility in tech and AI stocks over the past month was largely due to high leverage and crowded positions, coupled with fears of excessive AI spending and the difficulty of turning business models into profits. Amazon and Microsoft provided evidence of AI commercialization, with both stocks surging over 15% after their earnings reports. Looking ahead, the firm believes the rebound could have further upside early next week, but warns of tail risks. The main risk points are a lack of substantive progress in U.S.-Iran negotiations and continued upward pressure on long-term Treasury yields. Rising bond yields have a tightening effect, compressing equity risk premiums and making stocks less attractive relative to high-yielding fixed-income assets, prompting capital to flow from stocks to safer bonds. Additionally, historical seasonal patterns suggest that stocks tend to weaken in August and September. Although August has just begun, this risk warrants attention. Furthermore, earnings from chip companies like SanDisk and Western Digital will serve as a reference for the market's assessment of the AI narrative.
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