MARKET VOLATILITY RISES AMID AI AND POLICY UNCERTAINTY
Summary
Last week’s sharp market selloff has renewed concerns about how long the AI investment boom can last. Investors appear to be reassessing the sustainability of the AI trade, with crowded positioning and forced selling likely amplifying the recent volatility.
The Federal Reserve faces an increasingly difficult balancing act as economic growth remains resilient and inflation stays elevated. Stronger-than-expected job growth and persistent underlying inflation have increased the likelihood of another interest rate hike.
The midterm elections have produced a divided government, but history suggests the political outcome is unlikely to determine the market’s long-term direction. Since 1950, stocks have risen in the twelve months following every midterm election, although meaningful pullbacks were common along the way.
Our microcast™ model also recently downgraded to a defensive allocation. Taken together, our tactical risk models suggest a more cautionary backdrop for the stock market at this time.
THE AI TRADE HAS BECOME MORE UNCERTAIN
Last Thursday’s market decline was among the most severe in recent years. The S&P 500 fell 4.4%, its worst day since the April 2025 tariff shock, while the Nasdaq 100 plunged more than 6%, its largest decline since March 2020.
The selloff came two days after the midterm elections, as investors weighed the risk that a Democratic Congress could slow the pace of the AI buildout, raising a familiar question: Is the artificial intelligence investment boom finally beginning to unravel? While concerns about AI spending are legitimate, we believe the magnitude of last week’s decline reflects both genuine uncertainty about AI’s payoff and the unwinding of an increasingly crowded investment trade.
As we’ve discussed in previous Market Musings, AI spending has become a major driver of economic growth and corporate earnings. But AI spending affects the companies writing the checks very differently from the companies cashing them. If the pace of AI investment slows, the AI suppliers (semiconductor manufacturers and data center developers) could face weaker demand, while the AI spenders (Microsoft, Alphabet, Amazon, and Meta) could benefit from improved cash flow as their enormous spending budgets moderate.
That distinction was evident last week. Major chipmakers suffered substantial losses, while several of the technology companies funding the AI buildout held up considerably better (chart from 3Fourteen, through Nov 10th):
Market positioning likely amplified the decline. After years of extraordinary gains, AI-related stocks have become some of the most widely owned investments among hedge funds and other institutional investors. When prices fall sharply, investors using borrowed money can be forced to sell to meet margin requirements or reduce risk, triggering additional declines.
There are indications that this contributed to Thursday’s selloff, although the extent of forced selling remains uncertain. The conclusion, in our view, is that a sharp decline driven partly by investors reducing risk does not necessarily reflect a major decline in corporate fundamentals.
None of this eliminates the legitimate concerns surrounding AI. The scale of investment is extraordinary, and its ultimate profitability remains uncertain. However, AI-related revenues continue to grow, corporate earnings remain healthy, and there is little evidence that spending has come to a sudden halt.
In our view, the market is becoming more selective about which companies will ultimately benefit from AI and whether their valuations justify the risks. That adjustment may create further volatility, but it does not necessarily signal the end of the AI investment cycle.
THE FED FACES AN INCREASINGLY
DIFFICULT BALANCING ACT
While attention has focused on the election and technology selloff, recent economic reports have complicated the Federal Reserve’s policy path. In September, the Fed raised interest rates for the first time in three years, and it held rates steady in October. Economic updates since then reflect an economy that remains strong enough to make interest rate cuts difficult to justify, while inflation remains persistent enough to raise the possibility of further tightening.
October’s employment report showed 165,000 new jobs, considerably more than expected, while unemployment remained relatively low at 4.1%. Monthly employment figures can be volatile and subject to substantial revisions, but the broader labor market continues to demonstrate resilience.
Inflation remains more challenging. Consumer prices increased 0.4% in October, following a 0.6% rise in September. Core inflation, which excludes food and energy, rose 0.3% for the third consecutive month, suggesting price pressures extend beyond the higher oil and gasoline prices tied to the war with Iran. If core prices kept rising at that pace for a year, core inflation would run at roughly 3% to 4%, well above the Fed’s 2% target (data from St. Louis Fed):
This combination leaves the Fed in a difficult position. Strong employment and economic growth support corporate earnings, but they also give policymakers less reason to lower interest rates while inflation remains above target. Markets are increasingly anticipating another rate increase in December, and a small chance that the hike could even be .50% instead of the typical .25%.
However, a Fed rate hike is not inherently bearish for stocks. As we discussed in September, markets have frequently advanced during periods of rising rates when economic growth and corporate earnings remained healthy.
The greater concern would be higher borrowing costs accompanied by deteriorating earnings, rising unemployment, or widespread financial stress. For now, that is not our base case. The Fed faces a difficult balancing act, but the underlying economic expansion remains resilient.
HOW SHOULD INVESTORS THINK ABOUT
THE MIDTERM ELECTION RESULTS?
The midterm elections delivered a significant change in Washington, with Democrats winning control of both chambers of Congress. The result creates a divided government for the remainder of President Trump’s term and raises questions about what the new political landscape means for investors.
As we emphasized last month, stocks have performed well under virtually every combination of political control. Elections can influence taxes, spending, and regulation, but economic growth and corporate earnings have historically been much more important drivers of market returns.
A divided government generally makes sweeping legislative changes more difficult. Investors have often welcomed this kind of political gridlock because it reduces the likelihood of major policy shifts. However, disagreements over federal spending, government funding, and the debt ceiling can still create volatility.
The election could also have implications for specific industries, particularly AI. Proposed restrictions on data-center development could affect investment spending, although significant federal legislation would face potential presidential opposition. Meanwhile, many executive powers, including substantial authority over trade and foreign policy, remain with the White House.
Rather than attempting to predict every political development, history offers a more useful perspective. Since 1950, the S&P 500 has finished higher in the twelve months following every midterm election, with a median gain of approximately 14.5%. That includes elections producing substantial changes in congressional control (data from Bluekurtic):
Those positive returns did not come without volatility. Over the following twelve months, the market experienced drawdowns ranging from approximately 4% to 33% (the high end reflects the October 1987 crash, an outlier), with a median decline of just over 10%. History suggests a favorable period for stocks, not necessarily a smooth one.
Ultimately, investors have historically been better served by focusing on economic fundamentals and following their long-term financial plan rather than making portfolio decisions based on election outcomes. Political developments will undoubtedly influence specific industries and create periods of uncertainty, but the direction of the economy and corporate earnings remains far more important for long-term returns.
In summary, recent market volatility reflects growing uncertainty around AI spending, persistent inflation, and a changing political landscape. Investors are becoming more selective about AI-related stocks, and the Fed may raise rates again, but corporate earnings and economic growth remain healthy. History also suggests a favorable period for stocks following midterm elections, even if volatility persists. The risks have increased, but the economic backdrop remains constructive.
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