Last week equities took a bit of a breather entering the heart of earnings season. Sitting here today, we at Cornerstone remain more positive than negative about stocks throughout this month though.
Still, we think two macro data points are worth quickly addressing.
The first is tariffs.
Of course, right after sending out last Monday’s post that referenced the tariff deadlines of July 9, the White House extended them to August 1, albeit with firm statements that they would not be extended further. Unsurprisingly, the current popular narrative is one of worry over potential tariff impacts.
But this is in stark contrast to what the bond market is saying, even after the projected $2.4 trillion deficit addition over the next decade due to President Trump’s policy agenda bill. At the moment, the U.S. is collecting roughly $240 billion annualized in tariff revenues. Over 10 years, that roughly offsets the deficit projection.
As always, we’ll rely on data. Most importantly, even the high yield market hasn’t seen widening spreads. Thus, it’s not currently pricing in additional risk from future economic weakness, tariffs negotiations, higher deficits, and the like:
Second, the Federal Reserve’s consumer survey was positive overall and indicated consumers aren’t currently suffering from tariffs.
According to the Fed survey, one-year inflation expectations fell, more people think their finances will improve, fewer people are worried about jobs, and less people feared over tightening conditions:
Taking all this data together, it’s quite encouraging, especially in conjunction with how the one-year inflation expectation is back to pre-February tariff levels:
In other words, this suggests the Fed will be more likely to cut rates in the back half of the year as long as June and July’s inflation metrics are benign. If all this data continues positively going forward, it’s increasingly more powerful for forward-looking equity markets.
And when considering that six years and six “Black Swan” events later, the price-earnings ratio for the equal-weight S&P 500* is lower today than it was before COVID, it runs strongly contrary to the popular bear-ista narrative of late that the market is over-valued:
Understanding this current valuation is objectively not overextended, let’s turn to what will likely be the primary topic in the upcoming earnings commentary: AI. It wouldn’t surprise to see AI provide further tailwinds to markets over the next handful of years.
Secular Game Changer
As AI begins to drive broader productivity gains across the economy, its impact will be felt across all sectors. AI is a bullish macro overlay and a secular game changer. Heading into this earnings season, let’s talk about what's driving AI, how quickly it'll invoke change, and the long-term macro implications.
Back in February, many thought the AI trade was stale. But then on earnings calls, the largest companies in the world reminded everybody that AI isn't a trade, but a structural reshaping of technology, capital allocation, and the nature of competition.
Consequently, we’ve seen investment only continue to increase. The current 11 largest companies already have confirmed their 2025 AI capital expenditures would rise to a record $392 billion:
Big tech is already showing that translating AI investments into revenue growth and margin expansion is no longer a theory. Firms have shifted from experimentation to monetization across their platforms.
Some might argue this is focused on one sector. But look to investing great Warren Buffet, who said, “A rising tide lifts all boats.”
Yes, tech firms are the big adopters now. But it’s already becoming clear that productivity improvements will spread far and wide. For example, only last quarter AI was cited on earnings calls by over 40% of S&P 500 corporations:
We think that rate will significantly rise this earnings season.
Efficiency benefits from AI will contribute to stronger growth and productivity across all sectors, not just tech. Examples include automation of repetitive and time-consuming tasks, AI where robotics can automate physical tasks across industries, pharmaceutical development, and more.
Doubters of AI-driven productivity gains need only look at how productivity grew 2.7% in 2024 alone. What’s more, Goldman Sachs estimates generative AI will raise annual U.S. labor productivity growth by about 1.5% per year over the next 10 years:
If we look for historical context, it's reasonable to expect iterative labor productivity booms similar to those that followed the emergence of innovations like the electric motor and personal computer. These two time periods offer key lessons.
The exact timing of the productivity rocket is difficult to predict. But in both cases, it began about 15 years after the initial tech breakthrough, when about half of U.S. businesses adopted the technology.
Next, in both cases labor productivity growth rose by about 1.5% per year for a decade. This suggests the early stage of labor productivity gains can be substantial.
This type of productivity growth provides a huge tailwind for equity markets as it’s a long-term, secular trend that will unlock increased equity valuations. We’re already seeing more positive earnings guidance going into this earnings season.
We think that will continue. Interestingly, going into this earnings season, the number of companies issuing positively increased guidance is above both the five-year and 10-year averages.
It’s been clear over the past two quarters how rising productivity has been boosting S&P 500 net profit margins. In fact, the latest expectation for net income margin is a near-record 13.5%.
Thus, earnings have followed suit. It’s the main reason why P/E valuations today are lower than they were six years ago, even as we touch record highs:
We only must look at the technology sector’s 26% margin expansion to see what we can expect for companies in every sector when their margins begin to expand (i.e., profits rise and valuations increase).
At the end of the day, we know stocks follow earnings. Looking at markets since 1950, you can see big gains in years following top-quartile productivity acceleration like we’re just beginning to experience:
This all provides the foundational support for why AI gains are a secular game changer that’s just beginning. If we use this data to look forward to what is to come, we remind ourselves to, “Don't let yesterday use up too much of today.” Thank you, Will Rogers.
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