AI Capital Expenditure Risk Threatens Market Rally, Stagflation Concerns Mount

Bloomberg Surveillance · December 31, 2025 · Listen to Original Episode →

Original Title:

TL;DR

AI capital expenditure may not yield compelling returns, posing the biggest threat to the S&P 500 by potentially causing multiple contraction in a key market segment.
The dominance of large tech in market rallies, driven by superior earnings quality and low volatility, faces a critical test if AI investments fail to deliver expected returns.
A potential "fomo" in C-suites regarding AI, reminiscent of the 1999-2000 tech boom, could lead to narrative rewrites and speculative bets on AI winners and losers.
Below-trend economic growth combined with persistent inflation, termed "stagflation light," is anticipated due to factors like tariffs and labor supply constraints, impacting the US economy.
European equities present a diversification opportunity, outperforming US indices on a currency-adjusted basis due to distinct economic dynamics and potential fiscal stimulus.
The US labor market faces structural shifts from accelerating retirements and slowing immigration, necessitating AI's role in supplementing falling labor supply and potentially offsetting wage pressures.
The expiration of COVID-era healthcare subsidies poses a significant political challenge for Republicans, potentially impacting their electoral prospects in upcoming midterm elections.

Deep Dive

The dominant theme in the market, particularly the outperformance of large tech stocks, is increasingly reliant on artificial intelligence (AI) capital expenditure that may not generate compelling returns, posing a significant risk of multiple contraction for a crucial segment of the market. This reliance on AI spend, while seemingly a driver of growth, presents a critical question about the sustainability of current valuations if the projected returns on invested capital do not materialize, potentially forcing a re-rating of these tech giants and impacting the broader market.

The current AI investment landscape exhibits characteristics reminiscent of the late 1990s tech boom, with companies engaging in frantic spending and deal activity as they attempt to position themselves for the long term. This "fear of missing out" (FOMO) in C-suites could lead to speculative investments and narrative shifts, making it difficult to definitively identify future winners and losers. While the broad tech rally has been supported by strong earnings quality, the free cash flow yields on some major tech stocks are at record lows, indicating a potential disconnect between earnings growth and actual cash generation that could be a precursor to a market correction if returns falter. As a result, diversification away from this concentrated tech theme is becoming increasingly important, with European equities presenting a potentially attractive alternative due to different economic dynamics and potential for stimulus-driven growth, though their valuation may be less compelling than a year prior.

The US economy is navigating a period of "stagflation light," characterized by below-trend growth and persistently high core inflation, exacerbated by factors such as tariffs and labor market imbalances. While the Federal Reserve aims to balance its dual mandate of price stability and maximum employment, the current economic environment presents challenges. Inflationary pressures are likely to persist, particularly in the services sector, driven by a tightening labor supply due to falling immigration and accelerating retirements. This demographic shift, coupled with ongoing labor demand, is expected to keep unemployment rates low and wage pressures elevated, even with moderating job creation. Healthcare is identified as a sector that will continue to see robust hiring due to demographic trends, while other sectors may face challenges. The increasing focus on AI also introduces a new layer of complexity, with potential for both productivity gains and significant job displacement, prompting discussions around regulation and safety nets, which could become a potent political issue.

The expiration of COVID-era healthcare subsidies is set to significantly increase premiums for millions, creating a political challenge for Republicans heading into midterm elections, as healthcare remains an issue where Democrats typically poll better. In Washington, while budget deficit reduction is a recurring talking point, the reality of increased spending and the political difficulty of tax reform suggest that significant deficit reduction is unlikely. Moderate Republicans are expected to distance themselves from the administration to secure re-election, particularly in the face of potential challenges from strong Democratic recruits. The growing discussion around AI regulation and its potential impact on jobs is also emerging as a significant political theme, with Democrats likely to leverage concerns about job disruption and social stability. The Democratic Party's strategic direction for 2026 appears to be influenced by progressive voices, potentially creating friction for moderate Democrats who may need to differentiate themselves from the party's more left-leaning elements.

The Federal Reserve is likely to remain cautious on rate cuts unless the labor market significantly deteriorates, as inflation has stabilized but could creep higher due to ongoing tariff impacts and service sector pressures. Despite strong GDP growth in late 2025, demographic headwinds and a tightening labor supply are expected to keep unemployment rates low, though job creation may moderate. This environment suggests continued consumer spending, supported by accumulated wealth, and potentially lower-than-expected GDP growth forecasts from the Fed. The market is looking for a broadening of gains beyond mega-cap tech, with potential opportunities in financials and industrials tied to data center build-outs and reshoring, though small-cap performance is less certain due to interest rate expectations. Diversification strategies may increasingly look abroad, with emerging markets and Europe offering potential upside, partly supported by a weaker dollar and ongoing fiscal spending. The current wave of AI-related transactions, while showing company investment, is seen as distinct from the speculative dot-com era due to the strong cash flow of participating hyperscale companies, suggesting that the current AI investment cycle may have more sustainable underpinnings for the near term.

Action Items

Audit AI capex spending: For 3-5 key AI initiatives, project ROI and free cash flow yields against current market lows.
Analyze European equity performance: Compare P/E ratios and growth prospects of European indices against US counterparts for diversification.
Track US labor market dynamics: Monitor wage growth, immigration trends, and retirement rates to assess inflationary pressures.
Evaluate AI regulation discourse: Identify key arguments for and against AI regulation from administration and opposition viewpoints.
Measure economic growth drivers: Assess the impact of tariffs and consumer spending on US GDP growth projections for 2026.

Key Quotes

"Michael Purves of Tallbacken Capital Advisors writing the biggest threat to the S&P next year is that AI spend will be considered not to generate compelling returns. This means multiple contraction for a key part of the market."

Michael Purves argues that a significant risk for the S&P 500 in the upcoming year is the potential for artificial intelligence (AI) related spending to fail to yield strong returns. Purves suggests this outcome could lead to a contraction in market multiples, particularly affecting companies heavily invested in AI.

"Michael Reid, Senior US Economist at RBC, writing we maintain our view that tariffs will weigh on the labor market and put upward pressure on inflation reinforcing that the US economy is experiencing stagflation light."

Michael Reid of RBC Capital Markets maintains the view that tariffs will negatively impact the labor market and contribute to rising inflation. Reid characterizes this economic condition as "stagflation light," indicating a scenario of below-trend growth combined with persistent inflation.

"George Pollack, Senior US Policy Analyst at Signum Global, weighing in on the expiration of Covid-era healthcare subsidies."

George Pollack of Signum Global highlights the expiration of COVID-era healthcare subsidies. Pollack points out that this expiration will lead to significant premium increases for millions of Americans, impacting healthcare coverage.

"Barbara Doran, CEO & CIO at BD8 Capital, gives her market outlook for the year ahead. Barbara Doran wrote the Fed could be stingy on rate cuts unless labor market takes a big dive."

Barbara Doran of BD8 Capital suggests that the Federal Reserve may be hesitant to implement significant interest rate cuts. Doran indicates that the Fed's decision will likely depend on a substantial downturn in the labor market, implying a cautious approach to monetary policy.

"Michael Purves also stated, 'I think there it does remind me of a little bit of 1998, 1999, 2000 when telecom and tech were converging and and frantically there was frantic deal activity and frantic cap x activity as well there and of course there were some ultimately great winners and there were some a lot of write offs as well.'"

Michael Purves draws a parallel between current AI investment trends and the late 1990s tech boom. Purves notes that this period saw intense merger and acquisition activity and capital expenditure, ultimately resulting in both significant successes and substantial losses for companies involved.

Resources

External Resources

Books

"The Fourth Turning" by William Strauss and Neil Howe - Mentioned as a framework for understanding generational cycles and societal shifts.

Articles & Papers

"The Biggest Threat to the S&P Next Year is That AI Spend Will Be Considered Not to Generate Compelling Returns" (Tarbuck and Capital Advisors) - Discussed as a perspective on the potential downside risk for the S&P 500 due to AI spending not yielding sufficient returns.

People

Michael Purvis - Mentioned as an analyst from Tarbuck and Capital Advisors discussing AI spend and market returns.
Michael Reed - Mentioned as an analyst from RBC Capital Markets discussing tariffs, inflation, and the US economy.
Barbara Duran - Mentioned as an analyst from BDA Capital discussing the Federal Reserve's approach to rate cuts and the labor market.
George Pollack - Mentioned as an analyst from Signal Signum Global discussing healthcare policy and political strategy.
Ron DeSantis - Mentioned as a Republican governor discussing AI.
Spencer Cox - Mentioned as a Republican governor discussing AI.
Bernie Sanders - Mentioned as a Senator discussing AI and its potential impact on jobs and data center construction.
Zoran Mamdani - Mentioned in relation to an inauguration event and its potential significance for the Democratic party.
AOC - Mentioned in relation to an inauguration event.
Laura Gille - Mentioned as a tri-state Democrat facing a tough re-election.
Tom Suozzi - Mentioned as a tri-state Democrat facing a tough re-election.
Marie Gluesenkamp Perez - Mentioned as a Democrat in Washington.
Jake Auchincloss - Mentioned as a Democrat in Massachusetts.
Jared Golden - Mentioned as a Democrat in Maine.
David Sachs - Mentioned in relation to criticism of the administration's embrace of AI.
Matt Miller - Mentioned in relation to celebrating Hogmanay.
Lizzie Burden - Mentioned as a source of information from London.

Organizations & Institutions

JP Morgan Asset Management - Mentioned for its active fixed income ETFs and exploring opportunities in the US public bond market.
JP Morgan Chase Co - Mentioned as the parent company of JP Morgan Asset Management.
JP Morgan Distribution Services Inc - Mentioned as the issuer of a communication regarding JP Morgan Asset Management.
FINRA - Mentioned as a member organization for JP Morgan Distribution Services Inc.
Okta - Mentioned for securing AI agents' identities and providing a layer of control and trust.
Adobe Acrobat Studio - Mentioned for its AI-powered PDF capabilities, including generating insights from market research and tailoring report tones.
Chase Sapphire Reserve for Business - Mentioned as a credit card offering rewards and benefits for business owners, including points on travel, social media, and search engine advertising.
JP Morgan Chase Bank, N.A. - Mentioned as the issuer of Chase credit cards.
FDIC - Mentioned as a member organization for JP Morgan Chase Bank, N.A.
Bloomberg Audio Studios - Mentioned as the producer of the Bloomberg Surveillance podcast.
Bloomberg Television - Mentioned as a platform where the Bloomberg Surveillance show is broadcast.
Bloomberg Terminal - Mentioned as a platform where the Bloomberg Surveillance podcast is available.
Bloomberg Business App - Mentioned as a platform where the Bloomberg Surveillance podcast is available.
Tarbuck and Capital Advisors - Mentioned as the source of a perspective on AI spend and market returns.
RBC Capital Markets - Mentioned as the source of a perspective on tariffs, inflation, and the US economy.
Signal Signum Global - Mentioned as the source of a perspective on healthcare policy and political strategy.
BDA Capital - Mentioned as the affiliation of Barbara Duran.
Public - Mentioned for its platform to build multi-asset portfolios, including generated assets based on AI prompts.
Open to the Public Investing Inc - Mentioned as the provider of brokerage services for Public.
Public Advisors LLC - Mentioned as the provider of advisory services for Public.
Lenovo - Mentioned for offering deals on business PCs, including Thinkpad and Yoga models.
FedEx - Mentioned as a partner for businesses using a smart platform to navigate supply chain issues.
My Policy Advocate - Mentioned for its platform that reads insurance policies to identify vulnerabilities.

Tools & Software

AI Agents - Discussed as a technology requiring identity verification for trust and security.
Adobe Acrobat Studio - Mentioned for its AI-powered PDF features.
Chase Sapphire Reserve for Business Card - Mentioned as a financial tool for business owners.
Public Platform - Mentioned for building multi-asset portfolios and creating AI-generated assets.
Lenovo PCs - Mentioned as business computing tools.
FedEx Platform - Mentioned for managing supply chains.
My Policy Advocate Platform - Mentioned for analyzing insurance policies.

Websites & Online Resources

jpmorgan.com/getactive - Mentioned as a website to learn more about JP Morgan Asset Management's active fixed income ETFs.
chase.com/reservebusiness - Mentioned as a website to learn more about the Chase Sapphire Reserve for Business card.
public.com/market - Mentioned as a website to learn more about Public's platform and transfer portfolios.
adobe.com/dothatwithacrobat - Mentioned as a website to learn more about Adobe Acrobat Studio.
public.com/disclosures - Mentioned for complete disclosures related to Public's services.
mypolicyadvocate.com - Mentioned as the website for My Policy Advocate.
lenovo.com - Mentioned as the source for exclusive deals on Lenovo business PCs.

Other Resources

Passive Fixed Income ETFs - Mentioned in contrast to active fixed income ETFs.
Active Fixed Income ETFs - Mentioned as a way to capture more of the US public bond market.
Identity (for AI Agents) - Discussed as a crucial element for trusting AI agents.
AI-Powered PDF Spaces - Mentioned as a feature of Adobe Acrobat Studio.
Generated Assets (on Public) - Mentioned as a way to turn ideas into investable indexes using AI.
Tariffs - Discussed as a factor weighing on the labor market and putting upward pressure on inflation.
Stagflation Light - Described as below-trend growth with uncomfortably high inflation.
Dual Mandate (of the Fed) - Mentioned in relation to the Federal Reserve's focus on low prices and stable employment.
Demographics - Discussed as a factor impacting labor supply, with an aging population and accelerating retirements.
Healthcare Sector Hiring - Mentioned as a significant area of job growth due to demographic trends.
Mag 7 Stocks - Mentioned as a dominant theme in the market, with discussion on their continued strength and potential for profit-taking.
European Equities - Mentioned as an area for potential rotation and diversification.
SX5E (European Continent SPX) - Mentioned as an index that has outperformed US indices.
Fiscal Stimulus (in Germany) - Discussed as a significant economic force.
US Cyclical and Value Trade - Mentioned in the context of market rotation and sentiment.
PE Expansion - Discussed as a driver of recent market rallies.
Emerging Markets - Mentioned as an area for diversification with potential opportunities.
Hogmanay - Mentioned as the Scottish New Year.
Rate Cuts (by the Fed) - Discussed in relation to the Fed's focus on the labor market and inflation.
Jobless Claims - Mentioned as a leading indicator for the labor market.
CPI (Consumer Price Index) - Mentioned in relation to inflation data.
ADP Number - Mentioned as a jobs report.
GDP (Gross Domestic Product) - Mentioned in relation to economic growth.
Small Cap Performance - Discussed as a trade that may not continue.
Interest Rates - Mentioned in relation to small cap performance and Fed policy.
Emerging Markets Earnings - Mentioned as being better and more stable.
Dollar (USD) - Discussed in relation to interest rates and Fed policy.
Brain Injuries (in Football) - Mentioned as a reason for declining participation in youth football.
Lacrosse and Field Hockey - Mentioned as sports that may be perceived as safer alternatives to football.
Hogmanay - Mentioned as the Scottish New Year.