A Market Ahead of Its Economy

The market is unusually disconnected from today’s economy. The market is focused on the future of AI rather than the near-term economy. Most of the market’s value is a claim on a future economy. Markets are reacting asymmetrically. The war’s end mattered to markets; its continuation did not, since it has little effect on the future success of AI. Index labels cannot tell the two economies apart. Growth and value indices must split the market by construction, but a market dominated by growth forces future-economy companies into value indices. Popular diversifiers are exposed to AI. Emerging markets, value indices, and even REITs sold as alternatives to U.S. technology hold AI components. Own both economies deliberately. The future economy will arrive in some form; today’s economy will adapt and hold value within it. Diversified exposure to both is the answer.

Today’s market does not represent today’s economy. The ratio of market value dependent on future economic activity versus present activity has never been higher. These companies have earnings now, but those earnings stem from investments in the future, not present consumption. This is the most future-weighted market in history. Even at the height of the dot-com bubble, valuations were at least aspirationally tied to virtual businesses participating in the real economy. Today, valuations are tied to an economy that does not yet exist. The technological limits of AI are still unknown, and its ultimate success will depend on its own properties. Its pace depends on investment and informed application, but the future value of AI is little affected by even dramatic global events. It is no wonder markets ignore significant military action unless it threatens to slow the buildout of the AI future. The question for investors is how much of their wealth to invest in this vision of the future economy and how much in today’s. There is little doubt that AI will change the future, and even less that much of today’s economy will adapt to that future and continue to have value in it. We want diversified exposure to both.

For all the drama in prices, the underlying economy had an unremarkable quarter. Growth remained mixed and labor markets were muted, and the war impacted inflation: May headline/core PCE remains above the Fed’s target at 4.1%/3.4%. This plateau will likely prove sticky because inflation is asymmetric: prices rise quickly and fall slowly. For instance: Apple raised prices this quarter as memory prices surged with AI demand, but will not lower them when prices fall. Tariffs raised prices last year while the rebates from the Supreme Court's ruling became corporate profit. The future economy is taxing the present one: AI demand for chips has raised the price of phones, cars, and everything that computes. Investment in the future is showing up as inflation today.

Deglobalization continued beneath the headlines. Countries keep investing in independence across energy, defense, manufacturing, and technology. These transitions reverse specialization and are inherently inflationary, while the resulting policy divergence makes international markets more valuable as diversifiers. Trade policy has decreased in magnitude and frequency since the Supreme Court struck down the tariff regime in February. Less inflationary and less uncertain is an improvement on both counts, and markets favor it. Fiscal policy remains stimulative.

The most significant economic force remains AI capital expenditure. Once again, expectations of massive investment were exceeded; AI is proving to have an insatiable appetite for computational infrastructure. The buildout is creating shortages in energy, grid, and above al...