K-Shaped Economy: AI Boom, Sticky Inflation, and Divergent Markets - Episode Hero Image

K-Shaped Economy: AI Boom, Sticky Inflation, and Divergent Markets

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TL;DR

  • The "K-shaped" economy bifurcates growth, with large businesses expanding significantly while small businesses face contraction, leading to a stagnant labor market for lower-skilled workers and a widening wealth gap.
  • AI-driven capital expenditures, particularly in data centers and computer equipment, are a significant driver of economic growth, but this is constrained by a tightening labor supply due to immigration policies.
  • Goods inflation is rising due to tariffs and base effects, while services inflation remains sticky around 3.5%, making a return to the Federal Reserve's 2% target challenging.
  • The "Big Beautiful Bill" provides a GDP boost through business investment and consumer tax cuts, but significantly increases the federal debt trajectory as a percentage of GDP.
  • Presidential election cycles historically show choppier market patterns in midterm years, with the third presidential year typically exhibiting a higher percentage of positive market years.
  • The AI boom faces concerns about circularity of financing, echoing late 1990s vendor financing, potentially leading to increased market churn and rotation among tech companies.
  • Investment-grade corporate bonds offer an attractive balance of risk and reward due to improving credit quality and yields at the upper end of their 15-year range, outperforming high-yield bonds.
  • Municipal bonds, despite increased issuance, offer attractive after-tax yields, particularly for higher tax brackets, with opportunities in longer-term bonds for investors with risk tolerance.
  • Treasury Inflation-Protected Securities (TIPS) are attractive due to current elevated inflation, offering protection as their principal value is indexed to the Consumer Price Index.

Deep Dive

The 2026 market outlook signals an unstable economic environment characterized by bifurcations, or a "K-shaped" economy, where distinct segments diverge in performance and stability. This divergence, driven by factors beyond just wealth, presents both headwinds and tailwinds for the labor market and inflation, while a boom in AI-driven capital expenditure offers growth potential. Consequently, investors face a landscape requiring careful navigation of these varied economic forces and distinct asset class dynamics to achieve solid, albeit potentially choppier, returns.

The economy is experiencing significant subsurface churn, masked by headline GDP and unemployment figures. While overall GDP may rebound artificially due to reporting lags and government shutdowns, and unemployment remains low, the labor market reveals stress, particularly for youth, with low rehiring and job-finding rates. This "K-shaped" dynamic is increasingly populated by non-monetary factors, such as youth unemployment, creating stagnation. For 2026, labor is expected to be a mixed force: a headwind due to potential increases in unemployment and slowing payroll growth, but also a tailwind due to downward pressure on labor supply growth from immigration. This could lead to slower wage growth and a moderation in spending, but unlikely a severe recession given continued employment levels. A critical bifurcation exists between large and small businesses; large corporations with over 500 employees show strong employment growth, while businesses with fewer than 50 employees have seen payrolls decline, exacerbated by tariffs that disproportionately squeeze smaller entities.

Inflation remains a sticky concern, split between goods and services. Goods inflation is showing upward pressure, partly due to tariffs and base effects, with core goods prices historically high. Services inflation, a larger component of the economy, is hovering around 3.5%, making a return to the Federal Reserve's 2% target challenging. Concurrently, a boom in AI-related capital expenditure is a significant driver of economic growth, particularly in data centers and computer equipment, with spending up by nearly 40% year-over-year. This capex cycle could lead to broader downstream impacts, but its full potential may be constrained by the aforementioned labor supply pressures. The "Big Beautiful Bill" is projected to boost GDP by approximately 0.7%, but at the cost of a significantly higher federal debt trajectory as a percentage of GDP.

The equity market outlook for 2026 anticipates solid returns but with increased choppiness, influenced by factors like the presidential election cycle which historically shows more volatility in midterm-adjacent years. A notable divergence exists between consumer sentiment: expectations for rising unemployment are dour, while expectations for stock prices are robust, reflecting different survey respondent bases. The obsessive focus on the "Magnificent Seven" is expected to fade as only a few of these stocks are outperforming the broader S&P 500. There is a growing participation and broadening within the market, with a higher percentage of S&P 500 constituents outperforming the index, indicating a healthier market under the surface. Favorable sectors include healthcare, communication services, and industrials. Earnings outlook remains healthy, with consensus expecting growth to exceed 2025, though multiple expansion is unlikely to drive significant gains, meaning earnings growth will need to carry the market.

Fixed income is expected to deliver solid returns, though potentially less robust than 2025, as there is less room for rates to decline significantly. The Federal Reserve has limited room to cut rates due to inflation remaining near 3% and substantial supply issues from both government deficits and corporate issuances. The yield curve is expected to steepen, with long-term rates staying elevated while short-term rates fall, and 10-year Treasury yields likely to struggle to fall much below 4% without further inflation reduction. Within the taxable bond market, a preference for higher-quality investment-grade corporate bonds is advised due to a better balance of risk and reward compared to high-yield bonds, where spreads are tight and compensation for risk is low. Preferred securities offer potential tax advantages for taxable accounts, while TIPS are attractive for inflation protection, as their principal is indexed to the CPI.

In the municipal bond market, high issuance levels in 2025 are expected to continue into 2026, driven by infrastructure costs and voter-approved debt. While this increased supply could pressure prices, strong demand from mutual funds and ETFs may provide support. Opportunities exist in municipal bonds due to their tax-exempt nature, offering attractive after-tax yields, particularly for investors in higher tax brackets. Longer-term municipal bonds may also offer higher yields for investors with sufficient risk tolerance. Credit quality in the municipal market remains stable, with states generally holding healthy savings accounts. Investors are advised to stay within the investment-grade segment of the municipal market due to tight spreads in the high-yield segment, and to generally maintain an intermediate-term duration, balancing interest rate and reinvestment risks.

Action Items

  • Audit economic bifurcations: Analyze 3-5 segments of the economy for divergence and potential convergence in 2026.
  • Track small business employment: Monitor payroll growth trends for companies with fewer than 50 employees to assess economic stress.
  • Measure AI capex impact: Quantify the downstream effects of AI-driven business investment on consumer spending and labor market supply.
  • Evaluate fiscal stimulus trade-offs: Calculate the GDP boost from the "big beautiful bill" against its impact on federal debt trajectory.
  • Assess equity market disconnect: Measure the correlation between consumer expectations for unemployment and stock price increases across 3-5 surveys.

Related Episodes

Key Quotes

"I think that the really interesting point about this k shaped nature of the economy is you know it's i think a lot of people initially thought about it -- and certainly we were in the same camp -- you know a few years ago of the upper part of the k just being people that made a lot of money and then the lower part being people that didn't make a lot of money or wealthy individuals and asset owners versus less wealthy individuals and asset owners but what's interesting is that it's being populated more by things that don't just have to do with with money so I think about you know the youth unemployment situation in America that's sort of an example where you know there's a lot more stress now at the bottom part of the k and it's harder for people to be able to find jobs we know that the rehiring rate is very low the job finding rate is very low."

Kevin Gordon explains that the "K-shaped economy" is evolving beyond a simple wealth disparity. Gordon highlights that factors beyond income, such as youth unemployment, are increasingly contributing to the bifurcation seen in the economy. This indicates a more complex set of challenges affecting different segments of the population.

"The other piece of an area of opportunity in the muni market is for those investors that want to get a little bit more tactical and i think there's an opportunity with longer term municipal bonds now again we're not suggesting everybody go out and buy 20 30 year municipal bonds but the slope of the yield curve like the corporate curve is positively sloped so you are getting a higher yield the further out you go also the difference between the yield on a municipal bond and that of a treasury after adjusting for taxes begins to increase further out the yield curve you go."

Cooper Howard suggests that longer-term municipal bonds may present tactical opportunities for investors. Howard notes that the positively sloped yield curve, similar to corporate bonds, offers higher yields for longer maturities. He also points out that the tax-adjusted yield difference between municipal bonds and Treasuries increases at longer durations.

"Our main concern is the extra yield that we as investors are earning to take those risks today so we're not saying you need to avoid the riskier parts of the market but we are focusing more on those higher quality investment grade rated corporate bonds because that's where we see a better balance of risk and reward."

Colin Martin expresses a preference for higher-quality investment-grade corporate bonds due to a better risk-reward balance. Martin indicates that the current extra yield offered for taking on higher risks in the market is not sufficiently compensating investors. He advises focusing on investment-grade bonds where the potential reward aligns more closely with the associated risks.

"The other piece that i'd point to is that yes municipalities can generally hang their hat on stable credit quality and that's because most of the municipalities out there the starting point in terms of credit quality is very high to begin with so if you look at the bloomberg municipal bond index which is a very big broad index of kind of many different municipal issuers that are out there on average about seven out of 10 of the issuers in that index are either triple a rated or double a rated those are the two top rungs of investment grade credit quality."

Cooper Howard emphasizes the stable credit quality of municipal issuers. Howard explains that this stability is due to the high starting credit quality of most municipalities, with a significant portion of issuers holding top investment-grade ratings. He highlights that this strong credit foundation provides a reliable basis for municipal bonds.

"The consensus expectation is for growth that exceeds calendar year 2025 and that the majority of sectors are expected to have earnings growth greater in 2026 than 2025 but my guess is that the bar is set on the higher side and that what all of a sudden done at the end of the year we probably don't see estimates exceed the original expectations to the same degree as what was the case in 2025."

Liz Ann Sonders discusses the earnings outlook for 2026, anticipating growth that surpasses 2025 levels. Sonders suggests that while earnings growth is expected to be positive across most sectors, the original estimates might be set too high. She anticipates that the actual results may not exceed expectations as significantly as they did in the previous year.

Resources

External Resources

Books

  • "The Big Beautiful Bill" - Mentioned as a source of fiscal stimulus with a projected boost to GDP and an increase in federal debt.

Articles & Papers

  • JOLTS (Job Openings and Labor Turnover Survey) data - Discussed as an indicator of labor market conditions, specifically noting a fall in the hiring rate to a cycle low.
  • ADP data - Referenced for insights into employment growth segmented by business size.
  • Refinitiv Labs data - Mentioned in relation to slowing payroll growth.
  • Bloomberg visual on AI financing circularity - Used to illustrate concerns about the sustainability of financing in the artificial intelligence sector.
  • Joint Committee on Taxation estimates - Cited for projections on the GDP boost from "The Big Beautiful Bill."
  • Congressional Budget Office estimates - Cited for projections on the GDP boost from "The Big Beautiful Bill."
  • Tax Policy Center estimates - Cited for projections on the GDP boost from "The Big Beautiful Bill."
  • Bloomberg U.S. Corporate Bond Index - Referenced for data on investment-grade corporate bonds, including the share of triple B rated bonds and average credit quality.
  • Bloomberg Municipal Bond Index - Referenced for data on municipal bonds, including average yield and credit quality.

People

  • Mark Regepy - Mentioned as head of the Schwab Center for Financial Research.
  • Liz Ann Sonders - Co-host of the "On Investing" podcast and a speaker on market outlooks.
  • Kathy Jones - Co-host of the "On Investing" podcast and a speaker on market outlooks and fixed income.
  • Kevin Gordon - Mentioned as head of macro research at Schwab, discussing the economic outlook.
  • Colin Martin - Colleague on the fixed income team, discussing taxable bond markets.
  • Cooper Howard - Colleague on the fixed income team, discussing municipal bonds.
  • Kevin Powell - Mentioned as a guest discussing NFL analytics.
  • Fed Chair Powell - Mentioned in the context of potential changes at the Federal Reserve due to retirement.

Organizations & Institutions

  • Schwab Center for Financial Research - Mentioned as the origin of the "Financial Decoder" podcast.
  • Charles Schwab - The organization that produces the "On Investing" podcast.
  • Federal Reserve (Fed) - Discussed in relation to monetary policy, interest rates, and inflation targets.
  • National Football League (NFL) - Mentioned in the context of sports analytics.
  • New England Patriots - Mentioned as an example team for performance analysis.
  • Pro Football Focus (PFF) - Mentioned as a data source for player grading.
  • OpenAI - Mentioned in the context of artificial intelligence financing circularity.
  • Nvidia - Mentioned as a central company in the context of artificial intelligence financing circularity.
  • Oracle - Mentioned in the context of artificial intelligence financing circularity.
  • AMD - Mentioned in the context of artificial intelligence financing circularity.
  • Moody's - Mentioned in relation to credit rating upgrades and downgrades.
  • Standard & Poor's - Mentioned in relation to credit rating upgrades and downgrades.
  • The Conference Board - Mentioned for its consumer confidence index.
  • University of Michigan - Mentioned for its consumer sentiment index.
  • Joint Committee on Taxation - Cited for estimates on the GDP boost from "The Big Beautiful Bill."
  • Congressional Budget Office - Cited for estimates on the GDP boost from "The Big Beautiful Bill."
  • Tax Policy Center - Cited for estimates on the GDP boost from "The Big Beautiful Bill."

Websites & Online Resources

  • schwab.com/learn - Referenced as a source for detailed perspectives, charts, graphs, and written reports on market outlooks.

Other Resources

  • K-shaped economy - Discussed as a framework to understand economic bifurcations and stress.
  • AI (Artificial Intelligence) - Mentioned as a factor influencing capital spending and economic growth.
  • Fiscal stimulus - Discussed in relation to "The Big Beautiful Bill" and its impact on GDP, deficit, and debt.
  • Presidential election cycle - Mentioned as a factor that can influence market choppiness.
  • Magnificent Seven group of stocks - Discussed as a focus of attention in the equity market, with a suggestion that this focus may fade.
  • Qualified dividends - Mentioned in the context of preferred securities and their tax treatment.
  • TIPS (Treasury Inflation-Protected Securities) - Discussed as an investment to protect against inflation, with principal values indexed to the Consumer Price Index.
  • Consumer Price Index (CPI) - Mentioned as a measure of inflation and used to adjust the principal value of TIPS.
  • Personal Consumption Expenditures (PCE) - Mentioned as a main inflation index.
  • Rainy day fund - Referred to as a savings account for municipalities.
  • Investment grade corporate bonds - Discussed as a preferred investment due to a balance of risk and reward.
  • High yield bonds - Discussed with caution due to low compensation for risk.
  • Preferred securities - Mentioned as a hybrid investment with potential tax advantages.
  • Bank loans - Discussed as a riskier investment compared to high yield bonds.
  • Municipal bonds - Discussed in terms of issuance, tax benefits, and credit quality.
  • Treasury yields - Discussed in relation to the Federal Reserve's policy and inflation.
  • Yield curve - Discussed in terms of its slope and implications for interest rates.
  • Interest rate risk - Mentioned as a factor for investors to consider, particularly with longer-term bonds.
  • Reinvestment risk - Mentioned as a factor to balance with interest rate risk.
  • Default risk - Discussed in relation to bond investments and credit quality.

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