The AI Soft Landing Scenario
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For three years the AI build-out has blown through every forecast placed in front of it, with spending growth overshooting consensus so badly that investors, chipmakers and datacenter builders were repeatedly caught flat-footed, scrambling for capacity and components they had not budgeted for. The numbers for 2027 and 2028 suggest that run of upside surprise is ending — gently, if investors are lucky.
Wall Street's base case has hyperscalers' AI infrastructure spending roughly doubling in 2026 to about $800bn, then rising a further 54 per cent to $1.2tn in 2027, before decelerating sharply to just 12 per cent growth, or $1.4tn, in 2028. The rate of change, not the spending itself, is the story: capex is decelerating from exponential to merely large.
That matters most for the "neoclouds," GPU-cloud specialists that lack hyperscaler-grade balance sheets and have leaned on high yield debt to fund buildouts. Bonds issued at a high-single-digit coupon by one prominent neocloud now yield close to 15 per cent, with its credit default swaps trading at distressed levels and the stress rippling across sector equities. Investment grade issuers borrow in an entirely different universe, and that gap could widen into something structural: a well-capitalized operator may find it cheaper to acquire a cash-strained rival than keep underbidding it, seeding consolidation among the weakest high yield names.
Slower neocloud growth also has a hardware angle. 2026's great surprise was the memory squeeze: DRAM contract prices rose roughly 90-95 per cent quarter-on-quarter in early 2026, and spot commodity memory chips went from about $12 to a record $42.50, as datacenters competed with laptops and phones for scarce fabrication capacity. A capex slowdown should let that supply chain exhale.
The rate path is the hinge. Markets currently price at least 50 basis points of further hikes before policymakers contemplate easing, with projections holding rates near 4.5 per cent through 2027 rather than cutting. The optimistic logic: cooler component demand eases a genuine contributor to goods inflation, giving the Fed room to resume cutting in the second half of 2027 into 2028, once those hikes are banked. Lower rates compress credit spreads, easing refinancing pressure on the neoclouds that need it most — and narrowing the window in which they get bought rather than refinanced.
None of this requires the AI trade to end, only to mature. A deceleration from doubling to low double-digit growth sounds dull next to 2026's fireworks, but a maturing cycle should also be a more predictable one, with outcomes landing closer to initial expectations rather than blowing through them. After a year of surprises, markets would welcome nothing more than being right the first time. Investors should position for deceleration, not denial — and for a widening gap between cheap and expensive funders that consolidation, not just credit markets, may ultimately close.
— Peter Wilke, CFA – Head of Tactical Asset Allocation, Global Asset Allocation
THE PRICE OF AI FINANCING – CREDIT MARKETS ARE DRAWING A SHARPER DIVIDE
Interest Rates
Money market conditions remain orderly heading into the fourth quarter, despite a seasonal increase in Treasury bill supply. Net issuance is expected to total approximately $400 billion through mid-December before turning negative. We expect money markets to absorb this supply with only modest upward pressure on bill yields and repo rates. Typical fourth-quarter inflows into money market funds could provide additional demand and further temper pressure on front-end rates.
Repo rates have also remained well contained despite the Federal Reserve’s earlier pause in Reserve Management Purchases of T-bills. This contrasts with the fourth quarter of 2025, when SOFR periodically traded above the upper bound of the federal funds target range. Recent quarter-ends have passed without disruption, suggesting that current liquidity conditions should support an orderly year-end. Lower reserve balances or stronger-than-expected Treasury issuance could nevertheless produce temporary volatility around the turn. We will therefore continue to monitor money market fund flows, reserve balances and repo pricing for indications that supply is placing greater pressure on short-term funding markets.
— Dan LaRocco, Head of Liquidity, Global Fixed Income
- Seasonal T-bill supply is expected to rise heading into the fourth quarter.
- Money market fund demand may limit upward pressure on bill yields and repo rates.
- We expect a relatively calm year-end, while monitoring reserves and issuance for temporary volatility.
Credit Markets
Interest rate volatility and heavy supply weighed on high yield bonds in September. Lower rated debt has continued to underperform this year, creating meaningful dispersion across rating categories. Bonds trading at spreads above 1,000 basis points increased by $6.4 billion in September, reaching $73 billion. They represented 5.2% of the high yield universe, up from 4.5% a year earlier. Distressed pricing can foreshadow defaults as investors increasingly focus on recovery values rather than contractual payments, making the increase worth monitoring.
The scale and concentration of distress temper that warning. The distressed balance remains roughly half its June 2022 level and a fraction of the March 2020 peak. Seven issuers account for 41% of distressed debt; excluding them brings the distressed ratio closer to 3%. While this does not rule out broader deterioration, it supports our expectation that defaults will remain concentrated and issuer-specific rather than develop into a broad cycle. Continued dispersion should create opportunities for managers able to identify mispriced securities through fundamental credit research.
— Ben McCubbin and Sau Mui, Co-Heads of High Yield, Global Fixed Income
- Interest rate volatility and heavy supply weighed on high yield bonds in September.
- Distressed bonds underperformed performing high yield by more than 12 percentage points year to date.
- Distress remains concentrated, supporting our view that defaults should remain primarily issuer-specific and create opportunities for credit selection.
Equities
U.S. equities face a more demanding valuation backdrop as rising bond yields erode their relative appeal. The 10-year U.S. Treasury yield climbed roughly 50 basis points in September as markets repriced toward renewed Federal Reserve tightening. By mid-October, it stood near 5.1%, slightly above the S&P 500 Index’s forward earnings yield. The resulting earnings-yield gap is in the bottom few percentiles of observations since 2010, leaving earnings growth to do more of the work in supporting current valuations.
A narrow premium, by itself, is not a market-timing signal: historical outcomes have varied with earnings growth and the direction of interest rates. The greater challenge is the expectations embedded in equity prices. Following an exceptionally strong second quarter, third-quarter results and guidance will need to meet a high bar. Strong earnings can sustain further gains, but a meaningful Treasury yield leaves less room for disappointment. Earnings delivery and regional valuation differences should therefore become more important, with wider cushions in markets such as Europe warranting consideration.
— Jordan Dekhayser, Senior Equity Client Portfolio Manager and Daniel Kim, Associate Equity Client Portfolio Manager
- The S&P 500 Index earnings yield has fallen slightly below the 10-year U.S. Treasury yield.
- Higher yields leave earnings delivery with less room for disappointment.
- Regional valuation differences are becoming more relevant, with Europe offering a wider cushion.
Real Assets
Diesel spot prices climbed sharply in September, outpacing crude oil as crack spreads reached historically elevated levels. The move reflected acute tightness in refined product markets rather than crude scarcity alone. Disrupted Middle East energy flows, reduced transit through the Strait of Hormuz, Russian refinery outages and export restrictions, and sustained global inventory draws constrained distillate supply. Refiners were already operating near capacity, limiting their ability to increase diesel production quickly despite elevated margins.
Looking ahead, diesel prices are likely to remain elevated in the near term given low inventories and continued vulnerability to geopolitical disruptions or refinery outages. However, we see increasing scope for prices to moderate. Elevated refining margins incentivize higher output where capacity is available, while higher prices should eventually restrain demand. If Middle East tensions ease and trade flows normalize, diesel cracks could narrow materially, potentially causing diesel prices to decline faster than crude oil prices. We affirm our neutral weight to global natural resource equities.
— Jim Hardman, Head of Real Assets, Multi-Manager
- Diesel prices surged as refinery constraints, low inventories and supply disruptions tightened distillate supply.
- Low inventories provide near-term support, but easing disruptions and increased refinery output where capacity is available could narrow crack spreads.
- We affirm our neutral weight to global natural-resource equities.
Unless noted otherwise, data in this piece is Sourced from Bloomberg as of October 2026.
Peter Wilke, Senior Vice President – Head of Tactical Asset Allocation
The Bloomberg 1 – 3 Month U.S. Treasury Bills Index is a sub segment of the Bloomberg U.S. Treasury Bill Index that tracks the market for treasury bills issued by the U.S. government. U.S. Treasury bills issued in fixed maturity terms of 4-, 13-, 26- and 52-weeks. The U.S. Treasury Bill Index is a component of the U.S. Short Treasury Index along with U.S. Treasury notes and bonds that have falled below one year to maturity. It is not possible to invest directly in an index.
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IMPORTANT INFORMATION
The information contained herein is intended for use with current or prospective clients of Northern Trust Investments, Inc (NTI) or its affiliates. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust Asset Management’s (NTAM) and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, its accuracy and completeness are not guaranteed, and is subject to change. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.
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