AI CapEx Drives Bond Issuance, Shifts Equity Preferences
TL;DR
- U.S. equity valuations appear more justified due to higher corporate profit margins and a favorable policy backdrop of monetary easing, fiscal stimulus, and deregulation, supporting an overweight recommendation.
- AI-driven capital expenditures will create a $1.5 trillion financing gap, leading to an estimated $1 trillion in net investment-grade bond issuance, prompting a downgrade to underweight.
- U.S. stock earnings are expected to broaden beyond a few large companies, with small caps now preferred over large caps due to early-cycle earnings recovery and supportive macro policies.
- Downward pressure on the U.S. dollar is anticipated to persist in the first half of 2026, driven by potential labor market worries, FOMC composition debates, and narrowing rate differentials.
- High-yield corporate bonds are expected to perform better than investment-grade credit due to fewer technical headwinds and declining default rates, supporting a more favorable outlook.
Deep Dive
Investor sentiment for 2026 is shaped by ongoing debates around artificial intelligence's impact on equity valuations, the broadening of market gains beyond a few dominant names, and significant debt issuance needs. Despite concerns of overvaluation, current market conditions, characterized by strong corporate profitability, supportive monetary and fiscal policies, and deregulation, suggest that U.S. equity valuations are more justified than historical comparisons might imply. This favorable environment is expected to support a broader market rally, with small-cap stocks poised to outperform large caps due to early-cycle earnings recovery and supportive macro policies. However, substantial AI-driven capital expenditures will necessitate significant debt financing, creating a technical headwind for U.S. investment-grade corporate credit, leading to a downgrade in this sector, while high-yield bonds are expected to perform better due to more favorable fundamental and technical dynamics. Concurrently, the U.S. dollar is anticipated to face continued downward pressure in the first half of 2026, driven by potential labor market concerns, shifts in Federal Open Market Committee composition, and narrowing interest rate differentials with other major economies.
The justification for current equity valuations hinges on several factors distinguishing the present from past speculative bubbles. Unlike the 1990s, companies in major indices today exhibit higher quality, operate more efficiently, and generate stronger profitability and free cash flow. The increased weighting of technology in indices has pushed net margins to approximately 14%, significantly higher than the 8% seen during the 1990s bubble, making premium stock pricing more tenable. Furthermore, the current policy backdrop is unusually supportive, with expectations of continued Federal Reserve rate easing, potential corporate tax reductions from legislation like the "One Big Beautiful Bill Act," and ongoing deregulation. This rare combination of monetary easing, fiscal stimulus, and deregulation creates an environment that supports valuations, underpinning an overweight recommendation for U.S. equities.
The expectation for a broadening market rally is driven by a new bull market phase characterized by an early-cycle earnings recovery. Supportive macroeconomic conditions, including anticipated Fed rate cuts, growth-positive tax policies, and deregulation, are not only bolstering valuations but also acting as tailwinds for earnings. Leaner cost structures, improving earnings revisions, and AI-driven efficiency gains collectively support a broad-based upturn in earnings. Consequently, U.S. equity strategists project above-consensus earnings growth of 17% for 2026, leading to an upgrade in small-cap stocks, which are now preferred over large caps. Japan is the only other region expected to see above-consensus earnings growth, while Europe and emerging markets are projected to lag, justifying equal-weight and slight underweight positions, respectively.
The substantial AI-related capital expenditure, estimated at nearly $3 trillion from now through 2028, presents a significant implication for credit markets. While hyperscalers will fund half of this through operating cash flows, a financing gap of approximately $1.5 trillion remains, which will be sourced through private credit, asset-backed securities, and U.S. investment-grade corporate credit bonds. When combined with financing needs for an accelerated mergers and acquisitions cycle, this could result in around $1 trillion in net investment-grade bond issuance, a 60% increase from the current year. This substantial increase in supply, despite expected stable credit fundamentals, has led to a downgrade of U.S. investment-grade corporate credit to underweight within a cross-asset allocation framework due to technical pressures. In contrast, high-yield corporate bonds are expected to perform better as they are less exposed to these technical headwinds, and credit teams anticipate declining default rates over the next 12 months.
Regarding foreign exchange, the downward pressure on the U.S. dollar is expected to persist in the first half of 2026. This trend, which began with expectations of U.S. growth weakness and questions about the dollar's global role amid rising trade barriers, is supported by several factors. Potential near-term worries about the U.S. labor market and debates surrounding the future composition of the Federal Open Market Committee could increase the dollar's negative risk premium. Additionally, a compression in U.S. versus rest-of-the-world interest rate differentials is projected to reduce foreign exchange hedging costs, incentivizing dollar selling and hedging activities. These dynamics suggest continued dollar weakness, with projections of EUR/USD at 1.23 and USD/JPY at 140 by the end of the first half of 2026.
Action Items
- Audit AI CapEx financing: Analyze $1.5 trillion financing gap for data centers, assessing private credit, ABS, and investment grade bond issuance impact.
- Track 3-5 AI-driven companies: Measure AI-driven efficiency gains and their impact on earnings revisions and cost structures for 2026 growth.
- Evaluate equity valuation adjustments: Compare U.S. equity multiples to historical data, adjusting for profit margins and index composition changes.
- Analyze U.S. dollar pressure: Assess factors like labor market concerns and Fed FOMC composition for potential dollar weakening in H1 2026.
- Measure small-cap earnings growth: Track U.S. small-cap earnings growth against consensus expectations for 2026, comparing to large caps.
Key Quotes
"First of all, I think companies in major equity indices are higher quality than the past. They operate more efficiently. They deliver strong profitability, and in general pretty solid free cash flow. I think we also need to consider how technology now represents a larger share of the index, which has helped push overall net margins to about 14 percent compared to 8 percent during that 1990s valuation bubble."
Serena Tang explains that current equity market valuations are more justified than historical parallels, such as the 1990s bubble, due to improved company quality and efficiency. Tang highlights that technology's increased index share has led to higher net profit margins, making premium stock prices more reasonable.
"And I think this combination, you know, monetary easing, fiscal stimulus, deregulation. That combination rarely occurs outside of a recession. And I think this creates an environment that supports valuation, which is by the way why we recommend an overweight position in U.S. equities, even if absolute and relative valuation look elevated."
Tang argues that a rare confluence of supportive policies, including monetary easing, fiscal stimulus, and deregulation, creates an environment favorable for equity valuations. This unique combination, according to Tang, underpins Morgan Stanley's recommendation for an overweight position in U.S. equities, despite potentially elevated absolute and relative valuations.
"Yes. We are expecting U.S. stock earnings to sort of broaden out here and it's one of the reasons why our U.S. equity strategy team has upgraded small caps and now prefer it over large caps. And I think like all of this -- it comes from the fact that we are in a new bull market. I think we have a very early cycle earnings recovery here."
Tang anticipates a broadening of U.S. stock earnings growth, leading her team to upgrade small-cap stocks over large caps. This outlook, as explained by Tang, is rooted in the belief that the market is in an early-stage bull market with an earnings recovery underway.
"Now, part of it will be via private credit, part of it would be via Asset Backed Securities. But some of it would also be via the U.S. investment grade corporate credit bond space. So, add in financing for faster M&A cycle, we forecast around [$]1 trillion in net investment grade bond issuance, you know, up 60 percent from this year."
Tang forecasts a significant increase in U.S. investment-grade bond issuance, projecting approximately $1 trillion in net issuance, a 60% rise from the previous year. This surge, as detailed by Tang, is driven by AI-related capital expenditures and an accelerated M&A cycle, requiring substantial debt financing through various credit channels.
"I think in the first half of next year that downward pressure on the dollar should still persist. And you know, as you said, we've had a very differentiated view for most of this year, expecting the dollar to weaken in the first half versus G10 currencies. And several things drive this. There is a potential for higher dollar negative risk premium, driven by, I think, near term worries about the U.S. labor markets in the short term."
Tang expects continued downward pressure on the U.S. dollar in the first half of the upcoming year, a view consistent with Morgan Stanley's differentiated stance. Tang attributes this projection to potential negative risk premiums associated with short-term concerns about the U.S. labor market and investor debates surrounding the Federal Open Market Committee's composition.
Resources
External Resources
Articles & Papers
- "Cross asset outlook for 2026" (Morgan Stanley) - Referenced as the basis for discussions on investor debates and market outlooks.
- "The potential for nearly 3 trillion of ai related capex spending over the next few years" (Morgan Stanley) - Discussed in relation to debt issuance for AI-driven capital expenditures.
People
- Michael Zezas - Global head of fixed income research and public policy strategy at Morgan Stanley.
- Serena Tang - Morgan Stanley's chief global cross asset strategist.
Organizations & Institutions
- Morgan Stanley - Publisher of the "Cross asset outlook for 2026" and source of market analysis.
- FOMC (Federal Open Market Committee) - Mentioned in the context of investor debates regarding its likely composition and impact on monetary policy.
- US (United States) - Referenced as a leading economy with a favorable policy backdrop supporting valuations.
- Japan - Mentioned as a region with expected above-consensus earnings growth in 2026.
- Europe - Mentioned as a region with below-consensus earnings growth expectations for 2026.
- EM (Emerging Markets) - Mentioned as a region with below-consensus earnings growth expectations for 2026.
Other Resources
- AI (Artificial Intelligence) - Discussed as a driver of capital spending, market valuations, and potential debt issuance.
- US Investment Grade Corporate Credit - Downgraded to underweight within cross-asset allocation due to technical backdrop of debt issuance.
- High Yield Corporate Bonds - Expected to perform better than investment grade due to fewer technical headwinds and anticipated lower default rates.
- US Dollar - Discussed in relation to its weakening trend, potential for continued downward pressure, and impact on FX hedging costs.
- Euro Dollar - Projected to reach 1.23 by the end of the first half of 2026.
- Dollar JPY - Projected to reach 140 by the end of the first half of 2026.
- Monetary Easing - Expected from the Fed, contributing to a supportive policy backdrop for valuations.
- Fiscal Stimulus - Expected from the "one big beautiful bill act" to lower corporate taxes, supporting valuations.
- Deregulation - Continued priority in the US, contributing to a supportive policy backdrop for valuations.
- Equity Valuations - Discussed in relation to AI's impact and comparisons to past bubbles.
- Profit Margins - Higher in current equity indices compared to the 1990s, justifying premium stock pricing.
- Free Cash Flow - Strong generation by companies in major equity indices.
- Net Margins - Approximately 14% in current indices, compared to 8% during the 1990s valuation bubble.
- Small Caps - Upgraded by Morgan Stanley's US equity strategy team, now preferred over large caps.
- Large Caps - Less preferred than small caps by Morgan Stanley's US equity strategy team.
- Earnings Recovery - Expected to broaden out across US stocks, indicating an early cycle phase.
- Earnings Revisions - Improving, supporting a broad-based earnings upturn.
- AI-driven Efficiency Gains - Contributing to a broad-based earnings upturn.
- Data Center Related Capex - Expected to reach nearly another 3 trillion by 2028.
- Hyperscalers - Expected to fund half of the AI-related capex spending from operating cash flows.
- Private Credit - One of the channels for sourcing financing for AI-related capex.
- Asset Backed Securities - One of the channels for sourcing financing for AI-related capex.
- M&A Cycle - Forecasted to be faster, contributing to increased net investment grade bond issuance.
- Default Rates - Expected to come down over the next 12 months, supporting high yield bonds.
- Risk Premium - Potential for higher dollar negative risk premium driven by worries about the US labor market.
- Labor Markets - Near-term worries about the US labor markets contributing to a potential dollar negative risk premium.
- Rate Differentials - Compression in US versus rest of the world rate differentials expected to reduce FX hedging costs.
- FX Hedging Costs - Expected to decrease due to compression in US vs. rest of the world rate differentials, incentivizing hedging activity and dollar selling.