AI Wobbles. Treasuries Step Up.

by Rick J. Polsinello, Christian J. Galipeau of Franklin Templeton, 10/27/26

AI Wobbles. Treasuries Step Up.

Macro

  • Economic growth remains strong in the United States. We expect 2026 real GDP growth to come in at 2.5% (based on our Global Investment Management Survey). That is above the Bloomberg consensus of 2.2% and the 2.3% median response from the Federal Reserve’s (Fed’s) most recent Summary of Economic Projections (SEP), or “dot plot.” The Atlanta Fed’s volatile GDPNow (“nowcasting” model) projects 3.5% real GDP growth in the third quarter (Q3).
  • Consumers remain resilient. We have heard this on most earnings calls the past couple of weeks. The main takeaway has been that the consumer is healthy and is supported by a strong labor market, even amid higher gas prices in Q3. Retail sales for September increased 0.8% month-over-month (m/m), versus market expectations of 0.3%, bringing the year-over-year increase to 6.3%.
  • Initial jobless claims, reported on Thursday, came in slightly below expectations again, and the four-week average remains below 200,000. This data supports our belief that the labor market remains strong. The September unemployment rate (reported on October 2) was 4.2%.
  • Inflation remains hot. Two reports last week came in above expectations. The headline Consumer Price Index rose 0.6% in September, an increase from 0.4% in August and 3.7% year-on-year. The core (excluding food and energy) rose 0.3% and 2.6% annually vs. expectations of 0.2% and 2.5%, respectively. Producer Price Index (PPI) final demand rose 1.3% m/m, its largest increase since March of 2022. The core PPI rose 0.7% vs. 0.3% expected, also the largest in four years.
  • The two-year Treasury yield fell 10 basis points (bps) on the week to 4.70%. The 10-year fell below 5% for the first time in nearly a month and now yields 4.99% after falling 9 bps. The yield curve has continued to bull-flatten.
  • Fed funds futures have dropped meaningfully. Current pricing implies only a 10% chance that the Fed hikes next week, and an interest-rate hike by the Fed’s last meeting in December is not fully priced in. The market now expects less than three rate hikes over the next year.
  • Tech companies have increasingly issued debt to fund their spending plans. Each of these factors may have helped push rates higher over the past year. Changes in the artificial intelligence (AI) spending narrative, even small ones, seem to have repercussions in the bond market.

See more: RIA AI Adoption Is Showing Up in the Filings

Equities

  • Some cracks have started to show in areas of the AI trade. Since the start of October, the Nasdaq 100 Index is down more than 4%, the Philadelphia Semiconductor Index (SOX) is down 14%, the neocloud company Coreweave has shed 37%, and the Korean Stock Exchange Index (KOSPI) is down 19%.
  • The selloff comes amid questions surrounding the ability of some companies to meet their massive spending commitments over the coming years, their ability to refinance at potentially higher interest rates, and elevated stock prices for AI-related names.
  • Readers of this note will know that while we are constructive on equities overall (our S&P 500 target range is 7400-7800, based on our Global Investment Management Survey), we also believe we may currently be in a volatility window. We know that historically, markets have been volatile after the Fed begins a new tightening cycle. The median three-month S&P 500 return after the initial hike in the six previous tightening episodes was -3.3%. Despite each period having a drawdown of at least 7% in the year after the first hike, the median 12-month return was 8.1%. The periods with the worst returns were the ones where the Fed moved most aggressively. We do not believe we are entering an aggressive cycle. All indications are the Fed will be deliberate here, in an attempt to not break something.
  • The key theme from our team dating back to January of last year is “broadening.” We believe it is prudent today to stay diversified across size and style in the United States, and that there are opportunities in emerging markets and Japan. Given strong fundamentals in each of these areas, we believe corrections will present opportunities to add exposure to the broadening trade at relatively more attractive valuations.
  • Earnings have driven the S&P 500’s 12% rise this year. Earnings estimates have increased while the forward price-to-earnings multiple has contracted from 22x to 20x year-to-date. Q3 earnings kicked off last week with most of the big banks. Reports were mixed on the headlines and showed strength underneath, with banks benefiting from strong capital markets and a resilient consumer.
  • The earnings calendar shifted to a cyclicals and industrials theme this week, with major reports coming from aerospace/defense, rail and airline companies. Overall, it was a bit of a mixed bag. Although aerospace/defense and rail reports were mostly positive, airline companies continue to face strong headwinds, mostly due to elevated fuel costs. Next week will be the big one, with a slew of hyperscaler and tech companies reporting, as well as the October Federal Open Market Committee meeting on Wednesday.
  • The two major risks we have been flagging for equities are earnings coming in below expectations and the Fed aggressively raising rates. AI capex expectations, while related to earnings, have also come more into focus for equity investors. We repeat our thinking on the current environment: Stay diversified and stay disciplined.