Equity markets displayed steady confidence throughout the 3rd quarter with the S&P 500 index up 8% amid modest volatility. Equity returns have jumped more than 30% off the April tariff lows and are now up more than 14% for the year. This is a remarkable outcome given all the global macroeconomic shocks, geopolitical angst, and following the strong market returns experienced in 2023 & 2024.
We have discussed the major concerns threatening investment returns this year; but we manage our client accounts by focusing our attention on the underlying earnings fundamentals and future potential at each firm in our client portfolios. Earnings growth for the 2nd quarter was better than expected with many companies raising expectations going forward. We expect positive earnings trends to continue for the balance of 2025 recognizing that analysts are also forecasting another strong earnings year in 2026.
In addition to higher earnings and cash flows from companies, it now appears the Federal Reserve Bank’s monetary policy will likely seek to lower short term interest rates over the next year. The balance of risks between inflation and unemployment has shifted with the Fed now incented to support employment by lowering interest rates. This is positive for employment, economic growth, and valuations; the old adage “Don’t fight the Fed” is once again a very reasonable explanation for the markets’ steady confidence.
It is not the only explanation. A very important driver of global economic growth and market strength has been the elephant in the room, artificial intelligence. Capital investment for AI infrastructure has exploded to the upside over the past few years by several hundreds of billions of US$. These outlays are primarily coming out of the cashflows of the hyperscalers (GOOGL, MSFT, META & Amazon) rather than financed by debt. AI infrastructure spending is expected to continue at a torrid pace for at least the next few years; and while there may be some concerns about overcapacity, it may still be very early in the investment cycle.
AI infrastructure demand positively impacts several industries both directly and indirectly. Additional power, electrification, storage, cooling, construction and computing capacity have benefitted many companies already and backlogs have swollen to several years. Currently, it is the AI infrastructure spending that has generated all the economic growth; actual AI product/service revenues remain low in comparison. There are real concerns about AI’s revenue-generating potential and whether relatively weak revenue growth trends will slow the infrastructure spending. Some debt and vendor financing has also crept into some data center infrastructure spending which also raises risks.
We believe there is real value in the infrastructure that is being put in place because of the productivity and efficiency improvements that the computing capacity provides. We are cautiously invested in the industry leaders who also happen to be the most profitable companies this year. We are also looking across industries to find value in companies whose products and services can be enhanced through AI, or companies whose R&D costs can be significantly improved using AI. We see significant opportunity for value creation.
Just as with the introduction of the internet, now that AI is available there is no turning back. The steady confidence displayed by investors during Q3 may reflect longer term views on the potential value of AI.
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