Wall Street Earnings Season Peaks: Can the AI Trade Withstand Fed Pressure?

Wall Street has just been through a turbulent week, with investors worried about surging oil prices and AI-related corporate spending, actively seeking out defensive sectors as a haven from tech stock volatility.

In the coming week, the market will face multiple tests from a heavy batch of earnings reports and the Federal Reserve's interest rate policy meeting. Capital will continue to weigh the soaring costs of AI investment and the risk of unclear return timelines, while the approach of the midterm elections is another potential source of turbulence.

The Fed may hit pause

This week's main U.S. data continued to show an economy expanding but with high price pressures.

The S&P Global October purchasing managers' index (PMI) showed that U.S. private sector growth slowed, but hiring increased, with selling prices rising at the fastest pace since August 2022. Chris Williamson, chief economist at S&P Global, believes the data show the U.S. economy continued to boom in early the fourth quarter, with the output trend matching annualized GDP growth of 5%, the strongest level of growth since early 2015 excluding the pandemic shock; however, corporate order backlogs posted their largest increase since May 2022, and worsening supply chain bottlenecks and labor shortages pushed corporate selling prices up by the sharpest margin in four years, which will further raise inflationary pressure going forward.

The University of Michigan consumer survey showed that U.S. consumer confidence fell in October to its lowest level in five months, while inflation expectations rose to their highest since May. One-year inflation expectations stood at 4.7%, and 5- to 10-year long-term inflation expectations at 3.5%, showing that neither short- nor long-term inflation expectations have fallen at all, and that inflation stickiness far exceeds the Fed's previous policy targets, further fueling market concerns that "inflation is easy to raise but hard to bring down."

Bob Schwartz, senior economist at Oxford Economics, said in an interview with Yicai: "Consumers' assessments of current conditions deteriorated due to higher gasoline prices. Respondents generally believe the economy is worse now than in early summer, and the risk remains that higher energy costs could feed through into overall inflationary pressure, which we expect will prompt the Fed to maintain a hawkish stance in the coming months."

With the Fed meeting set to convene next week, the prospect of further rate hikes has also become a focus. According to London Stock Exchange Group (LSEG) data, after the Fed raised rates in September for the first time since 2023 to control above-target inflation, the probability of another hike this month is only about 10%. However, the market leans toward a hike at the next meeting in December, with futures showing about an 80% probability of a move then.

PIMCO, the world's largest bond asset manager, believes the Fed will hold steady next week while retaining a clear tightening bias and will not release any dovish signals, clearly conveying to the market that "further rate hikes remain possible." With long-end U.S. Treasury yields currently elevated, this has already partly offset the easing of financial conditions brought by the strong U.S. stock market, so the Fed can first observe the transmission effects of higher rates on the economy before deciding its next move; at the same time, as the AI industry's boost to aggregate demand continues to exceed expectations, the Fed will not easily abandon its tightening stance, and the most likely next move is a 25 basis point hike in December.

Schwartz told Yicai: "Even if the Fed does not act next week, we still expect an additional 50 basis points of tightening—most likely in December and March next year. However, the risk is that, because the economy has become less sensitive to rising rates, the central bank may have to hit the brakes harder than expected." He believes monetary tightening will only deepen the obvious divergence in traditionally rate-sensitive sectors of the economy. The housing market is going from bad to worse, while corporate investment is benefiting from artificial intelligence, military spending and other positive factors. This divergence is not expected to disappear anytime soon.

When will the market stabilize?

This week, the three major U.S. stock indexes diverged, with tech stocks dragging the Nasdaq lower, the S&P 500 posting a second straight weekly decline, while the Dow rose 0.4% for a third consecutive weekly gain.

Dow Jones market statistics show that the past week's declines were concentrated in four of the S&P 500's 11 sectors. Communication services fell 6.2%, industrials dropped 1.9%, and technology and materials also edged lower. On the upside, energy and health care led gains, rising 1.55% and 1.45%, respectively. Real estate, utilities, financials, consumer discretionary and consumer staples also edged higher.

Investors pulled out of the AI trade after Meta, Tesla and Netflix reported earnings, pushing two-year, 10-year and 30-year Treasury yields lower. BMO said in a report: "The fading heat of the AI trade triggered broad market rotation." Financial institution D.A. Davidson believes investors continue to assess the recent selloff in AI-related stocks and are worried about the enormous capital needs in the sector.

Next week, market focus will remain on earnings season, with strong corporate profit growth underpinning this year's gains in major stock indexes. According to London Stock Exchange data, S&P 500 companies' third-quarter earnings are expected to grow more than 32%. About one-third of S&P 500 companies will report quarterly results over the next five trading days, including Alphabet, Microsoft and Amazon, and the capital expenditure forecasts of these three AI hyperscalers will be closely watched by Wall Street.

JPMorgan global market strategist Nikolaos Panigirtzoglou's team noted that hedge funds have sharply cut equity risk exposure, the long positions that previously drove the AI rally have largely been closed out, and momentum investors' position adjustments are nearing completion, so the pressure for further concentrated selling has clearly weakened and the risk of a near-term crash has fallen substantially. The current performance of the semiconductor sector is the core bellwether for market risk appetite, with the sector accounting for 21% of hedge funds' related risk capital, and its earnings performance will directly determine the strength of next week's tech stock rebound; even if some small and mid-sized cloud providers face financing pressure, it will not shake the entire AI industry's growth cycle, and leading tech companies are fully capable of absorbing the related computing demand.

Bank of America, meanwhile, advises investors to maintain a tactical risk-off stance until mid-November. Michael Hartnett, BofA's chief strategist known as "Wall Street's most accurate analyst," judges that profit anxiety surrounding the AI trade and uncertainty over the U.S. midterm elections will continue to weigh on market sentiment, and that U.S. stocks will likely extend a choppy, weak pattern next week, with a clear reversal window only arriving after risks are fully released in mid-November. He particularly noted that global investors' tech stock exposure has now reached its highest level since August 2020, with capital still flowing continuously into the tech sector, but the market has yet to complete the switch from "chasing the AI rally" to "a full retreat from AI," and if next week's tech giant earnings disappoint, it could easily trigger concentrated profit-taking.