Inflation Risks Return | Earnings Explode | AI Boom

Andrew Sarna and Vanessa Hui break down three topics influencing markets:  cautious central banks, surprisingly strong but narrow earnings growth, and massive AI CapEx spending. 

WHAT TO LISTEN FOR

0:25 Why Did All Major Central Banks Hold Rates Steady?

3:06 How Strong Was Q1 Earnings Season?

4:28 Why Are the Magnificent Seven Driving Market Earnings?

6:55 How Big Is the AI CapEx Cycle?

9:28 What Happens If AI Spending Starts to Miss Expectations?

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CONNECT WITH VANESSA HUI

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This podcast is for informational purposes only and does not constitute investment advice. Views expressed are those of the speakers and should not be relied upon for investment decisions.

Transcript

Andrew Sarna (00:04):
Welcome back to Forthlane's Off the Charts podcast where every two weeks we cover three market headlines that matter. I'm Andrew Sarna, portfolio manager.

Vanessa Hui (00:12):
And I'm Vanessa Hui, senior client advisor.

Andrew Sarna (00:15):
Three big things to cover this week, central bank decisions, earnings season, and the AI CapEx cycle that is increasingly driving markets.

Vanessa Hui (00:25):
Okay. Let's start with the central banks. This past week was a rare one where the Bank of Canada, the Fed, the Bank of England, and the Bank of Japan all met. And they all held rates where they are. No cuts, no hikes. Andrew, what should we take away from this?

Andrew Sarna (00:41):
The headlines undersell what's actually happening. The common thread across all four is the same. High energy prices driven by the Middle East causing uncertainty. You still have tail ends of the tariffs. Central banks are now dealing with a world where inflation risks are reemerging. It brings me back to 2022. They know hiking isn't going to reduce energy prices, but the risk is that those energy prices begin impacting goods inflation, which begins pushing wages and you end up in a rising inflationary environment. The Fed held rates as expected, but the internal dynamics are shifting. There's more disagreement than we've seen in years and the messaging was careful. Inflation is still described as elevated and the Fed is firmly in wait and see mode. The easing cycle has effectively paused. For markets, that means borrowing costs stay where they are and the economy stumbles on. Cuts are less earned and markets have less to look forward to.

(01:40):
 The Bank of Canada also held rates flat, reflecting a similar tension. Canada is in a tricky situation where they're exposed to higher energy prices. They could also benefit from those energy prices, but they have to deal with the US trade war as well. The Bank of England may have been the most hawkish of the group. Inflation is the highest of all G7 nations in England, and there are concerns about second order effects impacting wages. And then lastly, you have the Bank of Japan holding rates steady. Japan's stuck in a debt trap and has the highest inflation only behind the UK. So the big takeaway is simple. Central banks are echoing the same cautious stance. Inflation is the risk as oil continues to rise. And you're seeing financial indicators indicate signs of stress. So the US 30 year hit 5%, UK 10 year yields hit 5%.

(02:35):
 Again, yen hit 160 and the Bank of Japan had to intervene. So stress is building in the system. I don't think oil prices and equity markets can rise together in tandem in perpetuity like they did last week. One of these prices is wrong. So you're seeing continued stress build in the system. And it's just a matter of if this war persists, what is going to be the thing that causes the crisis? It's tough to say, but it's clear the stress is building.

Vanessa Hui (03:06):
Onto our next topic, let's turn to earnings. Q1 has been strong, arguably much stronger than expected. Andrew, what are your takeaways following the busiest week of Q1 earnings reporting?

Andrew Sarna (03:19):
Q1 earnings have been incredibly strong. I also think it's very interesting that there's such a disconnect between the macro headlines and earnings. The macro is fairly negative, yet earnings are extremely strong. With about two thirds of companies reported, 84% have beaten earnings estimates and 81% have beaten on revenues. That alone is notable, but the real story is the magnitude of the beats. Earnings are coming in more than 20% above expectations, which is about three times the typical surprise. Earnings growth for the S&P 500 has surged to around 27% year over year, the highest level since 2021, which was a COVID rebound year. What's striking is how quickly estimates have moved. So at the end of March, growth was tracking closer to 13% and has effectively doubled in a couple of weeks, and this has caused markets to rip higher. The driver is fairly concentrated. Last week's results from Alphabet, Amazon, and Meta were responsible for roughly 70% of the increase in overall earnings growth.

(04:28):
 Some of that was supported by non operating factors. The big tech companies have benefited from the investments in some of the AI labs on their balance sheet, but nonetheless, they continue to drive earnings higher. In fact, the blended earnings growth rate for the Magnificent Seven companies increased to 61% today from expectations for 22.4% earnings growth on March 31. This compares to mid teens growth for the rest of the index. That explains why markets can feel strong even though underlying breadth is mixed. It's not the whole market driving performance, it's a handful of these big companies, but the more important story is what's happening with revisions. Typically, analysts lower estimates at the start of every quarter. And essentially what is happening is analysts set their expectations and they want these companies to beat so it looks good. But what's actually happening this time is analysts are revising earnings higher.

(05:26):
 So Q2 earnings estimates revised up by more than 2% in April and full year 2026 estimates were revised up over 3% in a single month. And again, normally earnings are revised down. Those revisions are being driven by two forces really, AI and energy. On the AI side, the data is increasingly clear. Tech earnings growth is running at roughly 50% with semiconductors and cloud infrastructure leading the way. It is showing up directly in earnings, margins, and revenue growth. Demand continues to exceed supply and earnings are benefiting. Energy is also chugging along. Q2 energy earnings estimates have been revised up by more than 45% and full year estimates by 27%. Really, this is just a beneficiary of elevated energy prices driven by the conflict in Iran. The catch and the thing that I'm a little bit worried about is S&P 500 valuations are really continuing to be priced to perfection.

(06:29):
 The market is trading at about 21 times forward earnings, which is above five and 10 year averages. So there isn't really room for error if earnings are revised down. So the takeaway from earnings season is straightforward. It's not broad based earnings growth, but in these few concentrated pockets of the market, earnings have been outstanding.

Vanessa Hui (06:55):
Now onto our last topic, AI CapEx. This is quickly becoming one of the most important forces in markets today. We're talking about hundreds of billions in hyperscaler spending, large enough to move growth, earnings, and market leadership. How should we be thinking about the sustainability of this cycle?

Andrew Sarna (07:15):
Hyperscaler CapEx is truly difficult for our brains to comprehend. Estimates have it in the $700 to $800 billion range in 2026. This is roughly 2.4% of US GDP. It's enormous. And for context, the rest of the S&P 500, the S&P 493, they're expected to spend just under a trillion dollars. So essentially, a handful of companies are spending the same amount on CapEx as 493 companies. AI infrastructure spending is now large enough to move not just growth, it's also powering earnings. Real GDP growth in Q1 was around 2%, and estimates have about half of that was AI CapEx. That suggests the underlying economy is not that strong, especially when you consider that the US is running a 6% deficit, and this is all the economy can muster. The bigger question is whether this level of spending is sustainable. Markets like to price in that this level of spending is just going to continue on in perpetuity, but the reality is this is likely to be cyclical in the upfront buildout of the infrastructure.

(08:29):
 I mean, think about railroads as an analogy. We didn't just continue to build railroads and railroads and railroads across the country. You do the one large infrastructure spend upfront, and the infrastructure's largely in place, and then it's just maintenance after that. So the question is, what does ongoing sustainable CapEx look like? And then what is the impact on markets once we get through this initial buildout? Chips, data centres, and cloud providers, and power infrastructure are all seeing strong demand, and there's just so much money flowing into such a narrow part of the market that earnings are exploding higher. Margins expand as capital flows into the system, but eventually it's going to slow. We are seeing early signs of that sensitivity. Not saying that we're anywhere near that ending. I don't know how long this infrastructure build is going to take. It could be another six months before it peaks.

(09:28):
 It could be five years. But last week we saw OpenAI miss certain internal targets that led to stocks across the AI complex declining. Companies like Oracle are heavily tied to OpenAI being able to hit their targets, and if they aren't able to hit those commitments, companies like Oracle could be in big trouble as they're making a huge bet on single companies. So the key question is not whether the AI buildout is real. It clearly is. The question is whether the current spending is sustainable and what happens when the spending normalizes. And then, when does it peak? Is it months or is it years? But what is clear? Right now, it's where the money is being made, just so much money flowing into such a narrow segment, you're seeing stocks that benefit from this go parabolic.

Vanessa Hui (10:20):
So putting it all together, the three topics for today, central banks are on pause as inflation risks reemerge. Earnings are strong, but concentrated in a small group of companies. And lastly, AI CapEx is acting as a major driver of both growth and market performance.

Andrew Sarna (10:41):
That's it for this week's Off the Charts. Thank you for listening. Thank you for your time. Let me know your thoughts on the podcast. Shoot me an email. Leave a rating and a review and share with somebody.