The one constant in our world is change. Successful investing means being able to understand and correctly interpret the changes happening around us. Fortunately for equity investors, change driven by rising population and productivity improvement driven by advancing technologies provides a persistent tailwind.
Change doesn’t happen at a constant rate. Nor does it occur in a straight line. Sometimes change is for the worse as when inflation spikes or supply chains break. Too much change can create chaos. Markets don’t like chaos because it increases future variabilities. Too much rapid change can be overwhelming. While I often note that market performance is dominated by changes in earnings and interest rates, it can also be impacted by changes to the pace of uncertainty.
Today, we are witnessing rapid change on three fronts, technological, economic and political. The driver of technological change is generative artificial intelligence. Economic change, normally associated with relatively persistent growth in earnings and GDP, is seeing heightened uncertainty related to tariffs, taxes, and potential changes in government spending. Finally, it is hard to decipher the impact of investments, the economy, and the geopolitical roadmap given the blitzkrieg of Executive Orders from the White House and the DOGE task force.
Yet, despite these tidal waves, the market reaction has been remarkably neutral so far. You wouldn’t know or expect that reading the front page of The New York Times. The task of understanding gets further complicated by 180-degree pivots done routinely and Court interventions.
Let’s take a brief look at the three drivers of change.
• Technology – On the surface we are beginning to see the promises and impact of AI. With a few keystrokes, one can write computer code, complex manuals, and solve a myriad of problems in seconds that used to take weeks. Individuals seeking answers to questions now ask an app like ChatGPT or Gemini rather than swim through a labyrinth of Google searches trying mightily to skip through the ads associated with sponsored responses. In order to answer all queries from all sources, large language models (LLMs) need to use a massive amount of computing power and consume enormous amounts of electricity. Moving down the road, incremental costs should come down rapidly. Future models will also emerge to service vertical markets that don’t require the massive computing power of LLMs. A model forecasting the weather doesn’t need to search who won the Super Bowl (besides, everyone knows that answer anyway!). New technologies attract lots of participants all searching for the magic pot of gold at the end of the rainbow. But few will find the winner’s circle. Look at how many companies tried to make PCs. Go back more than a century and you will find more than a thousand names wanting to be leaders in the emerging auto industry. Some consolidation will come via merger. But more often most that fail to rise to the top will simply die. History doesn’t suggest prior leaders will be future dominators. Winners will include chip manufacturers, LLM builders and a myriad of start up names barely recognizable today. AI isn’t just about computers and components. Innovative ways will have to be found to fortify the electric grid and expand capacity. What we do know about anything AI is that its development will be costly. The payoff may lag the capital costs. “Build it and they will come” applies. But in the near-term big tech names like Microsoft#, Meta Platforms# and Alphabet# will see free cash flow pinched as they redirect the majority of funds to lay the foundation that will support massive growth in the future. What we do know, however, is there isn’t a need for dozens of massive LLMs all trying to do the same thing.
•Political and Economic – The two tie together. With that said, the dominant influencer for both economic growth and the rate of inflation is the Federal Reserve. Donald Trump can rant and attempt to coerce, but at least for now the path (which is the right path) is to let the Fed do its job. As last week’s data shows, inflation has stopped coming down toward the Fed’s 2% target. It is stuck closer to 3%. The difference of a single percentage point may not sound like a lot but it is. The other mandate for the Fed is to maintain full employment. With the unemployment rate at 4%, there is little need for additional stimulus, especially if such stimulus would impact the pace of inflation. Rather than focusing on Fed policy, where markets have become comfortable with a path that won’t seek further short-term rate cuts until the middle of 2025 or later, the focus will shift to deficits, the buildup of debt, the impact of tariffs, and the success of DOGE to lower government spending. There is a strong sentiment that supports the notion that Trump waves the threat of tariffs much more than he actually employs them. So far, the tariffs against Canada, Mexico and our trading partners who tariff us and who have strong balance of payment surpluses in trade with the U.S. have been promised, and then deferred. But Trump loves to quote President William McKinley who was an active supporter of tariffs as a major revenue source in an era before the implementation of income taxes. For now, markets are betting the tariff impact will be modest. But if Trump is to extend all the expiring 2017 tax cuts and add to the bundle tax relief for tips, overtime and Social Security benefits, the only way that can happen is with massive reductions in government spending.
That leads to DOGE, what it wants to do, and what the Courts will allow it to do. That will all unravel over the next several months, but one thing is certain. Whoever loses funding or a job is going to scream bloody murder. They will scream to their members of Congress. It may make sense to some to hold up payments until DOGE can determine what makes sense, what is superfluous, and even what might be fraud. If DOGE is going to make a big dent, stopping support for Sesame Street in Iraq won’t get the job done. Here’s an example. Medicaid funding has increased at an annual rate of over 8.5% since 2019, the year before Covid. If that expense growth had been contained to just 5%, still a level higher than the annualized increased in health care costs over the same time span, the annual difference in 2024-2025 would be $140 billion. Defense is supposed to be sacrosanct. Trump wants to spend $100 billion more on top of roughly $950 billion being spent today. But suppose one asked Secretary Hegseth to present a budget of $850 billion instead. Corporations adjust every day. And despite the Pentagon mantra that says we are living in an ever more dangerous world, can we not defend ourselves for a mere $850 billion? Should the cost of being the world protector be shared more with our partners? These are rhetorical questions of mine. I am not equipped to provide good answers. But any bottom-up analyst would suggest big savings have to come from big buckets, not from USAID alone.
The interplay of tax requests, tariffs, and DOGE savings have to lead to a path of deficit reduction, a topic discussed last week in some detail. There is a wall out there and we won’t know when we are going to hit it until we do. But we don’t want to find out. Right now, Trump is as popular as he has ever been since sitting in the White House. Unless he hits a bullseye with all his programs, he is likely to hit some speed bumps. That is why he wants to move forward as quickly as he can before losing political capital. If he starts to lose capital, member of Congress will get more complaints. They will push back and DOGE will be less successful.
Again, Wall Street so far is willing to give Trump a pass. Collectively, investors like the promises, the game plan, and the unraveling of tortuous regulatory burden. But I suspect that in the months ahead the going will get tougher. There will be early legislative wins on popular issues like border control. Silliness like Mar-a-Gaza, the ending of all birthright paths to citizenship and the confiscation of the Panama Canal and Greenland will take a back seat to the real mission of creating an economic framework that can nurture an accelerated path to growth on the back of the AI revolution. Growing is not the issue alone. Growing with full employment and low inflation is a much trickier path to navigate. We won’t know the answers in just a few months, but we may get a better sense of whether the administration is on the right path or not. Any deviation will create market volatility.
Today, Ed Sheeran is 34. Michael Jordan turns 62.
James M. Meyer, CFA 610-260-2220