ECONOMIC HIGHLIGHTS

• The U.S. economy keeps expanding, but growth is now more investment-driven than consumer-driven. Business investment, technology spending, data center construction, and AI-related capital expenditures are key drivers.
• Corporate capital spending remains a strong economic sector, with nonresidential fixed investment, capital goods orders, technology infrastructure, and data center projects trending higher despite uncertainty.
• The labor market has cooled but remains healthy. July payrolls declined slightly, unemployment dropped to 4.1%, claims are low, and demographic trends imply fewer jobs are needed to sustain stability than in previous cycles.
• Inflation remains the main challenge for policymakers. Despite softer June inflation and contained wage pressures, energy prices, tariffs, and supply disruptions pose ongoing inflation risks.
• Federal Reserve officials seem more focused on inflation than employment. Labor market conditions are stable, and markets debate whether the next move will be a rate hike or cut.
• Earnings growth remains strong with second-quarter S&P 500 earnings surpassing expectations, driven by healthy profit margins, productivity gains, and tech-sector leadership.
• AI investment remains a key driver of economic growth and profits, with data center construction, semiconductor demand, cloud infrastructure, and tech spending accelerating globally.
• Market leadership expands beyond a few mega-cap tech stocks. Financials, industrials, value sectors, and small-cap equities show increased participation, supporting a healthier market.
• International growth is mixed but generally positive. Taiwan, South Korea, Japan, and other tech economies benefit from strong demand for semiconductors and AI, while China shows relative weakness.
• Credit conditions remain favorable, not indicating recession stress. Lending standards are improving, commercial lending is expanding, and investment-grade credit markets stay stable despite rising geopolitical uncertainty.
• Key risks include persistent inflation, energy shocks, Middle East tensions, high market expectations, and potential profit peak after a strong earnings cycle.

China Remains the Most Notable Area of Weakness:  China continues to lag most major economies. While inflation has stabilized, consumer demand remains subdued, business confidence remains weak, and economic activity continues to underperform developed-market peers. China continues to face headwinds from subdued consumer demand and weak business confidence, with 2026 GDP growth consensus at approximately 4.6% — below its historical trend. While China is investing heavily in AI infrastructure domestically (a reported $295 billion five-year data center buildout), its participation in the global AI investment cycle has been more insular and less integrated with the broader technology supply chains driving growth in Taiwan, South Korea, and Japan.

Bottom Line: Economic conditions remain consistent with continued expansion. Business investment, technology spending, manufacturing improvement, and resilient consumer activity continue to support growth despite moderating labor conditions and elevated geopolitical uncertainty. The global economy is increasingly being driven by AI-related capital spending, while inflation and energy markets remain the primary variables that could alter the outlook.

Inflation Risks Remain Unresolved:  Inflation pressures have moderated from earlier peaks, but the Fed is not yet in a position to declare victory. Energy prices remain sensitive to developments in the Strait of Hormuz, tariffs remain a potential source of goods inflation, and global supply disruptions continue to complicate the inflation outlook. Strategas’ central point is that shocks need to end, not merely pause, to be considered transitory. Oil, tariffs, and geopolitical risk have each eased at times, but none have been fully resolved. That keeps the Fed cautious even when individual inflation reports look more benign.

Fed Pause Remains Likely, But Hike Risk Has Increased:  The near-term base case remains a Fed pause, particularly at the September meeting. However, the policy path has become more asymmetric as inflation risks linger and several Fed officials appear more willing to consider additional tightening. Futures markets now assign roughly a one-in-three probability of a rate hike by December, rising to approximately 40% by March 2027 — a meaningful shift, but not yet a base-case expectation. The policy path has become more asymmetric, and markets should not assume the next move is automatically a cut.

Less Forward Guidance May Be a Form of Tightening: Chair Warsh’s communications approach appears to be intentionally less dependent on forward guidance. One could make the case that less guidance may itself tighten financial conditions by shifting more uncertainty onto markets and making each Fed meeting more “live.” This approach forces investors to rely more heavily on incoming data rather than policy promises. In practice, reduced guidance can increase rate volatility and keep short-term yields from falling as quickly as they otherwise might when inflation data soften.

Balance Sheet Policy Becomes More Important: It is increasingly important to the Fed’s outlook. The Fed’s reserve management T-bill purchase program provided some accommodation earlier in 2026. Still, that program has now been wound down — the Fed announced it will conduct no reserve management purchases through mid-September. Chair Warsh has formed a task force to review the $6.7 trillion balance sheet, and Wall Street expects outright shrinkage to begin as early as Q1 2027. The key issue remains whether policymakers can begin removing liquidity without destabilizing funding markets.

Long-Term Yields Reflect More Than Fed Policy: The rise in long-term Treasury yields should not be viewed solely as a referendum on Fed credibility. Strategas notes that long bond yields are also being affected by Iran-related risks, oil prices, fiscal concerns, Treasury supply, and currency market volatility. Japan’s yen weakness and related intervention are also important because severe yen pressure could increase the risk of Japanese investors selling Treasuries. US support through the FIMA repo facility has been proposed as a mechanism to reduce Treasury selling risk — Treasury Secretary Bessent has urged the Fed to expand the facility — but Japan has not yet utilized it. Japan reportedly has alternative liquidity tools available that would not require outright Treasury sales.

Bottom Line: The Fed is likely to remain on hold in the near term, but the policy backdrop has become more complicated. The labor market has cooled, yet not enough to force a policy pivot. Inflation risks tied to energy, tariffs, currency volatility, and supply shocks remain unresolved, keeping the Fed tilted toward caution. The most likely outcome remains a September pause, but markets should continue to take seriously the possibility of renewed tightening later this year or in early 2027 if inflation pressures persist.

Earnings Estimates Remain Elevated: The usual downward progression in forward earnings estimates has not materialized this year. Consensus expectations for 2026 and 2027 remain elevated, with 2026 earnings growth still projected at an unusually strong pace and 2027 estimates also remaining constructive. This reflects a favorable profit backdrop, but it also raises the hurdle for future upside surprises. If expectations have already outpaced fundamentals in parts of the market, even strong results may not be sufficient to support further price gains.

Profit Margins Remain Strong, But Breadth Matters: Corporate profit margins remain one of the most important supports for the current expansion. Market-cap-weighted margins continue to rise, aided by mega-cap technology and communication services companies.  Margin beats in Q2 2026 were broad, with 80% of companies beating on margins and the median company beating by 54 basis points. Elevated margins remain a critical cushion against tariffs, energy costs, labor expenses, and other input-cost pressures.

AI Investment Continues to Support Results: Artificial intelligence remains a major driver of revenue growth, capital spending, and earnings. Semiconductor demand, cloud infrastructure, software integration, data center construction, and power infrastructure continue to support corporate activity. At the same time, investors have become more selective. Companies linked directly to AI infrastructure continue to attract capital. Still, markets are increasingly focused on whether AI-related spending produces measurable returns rather than simply rewarding the scale of spending.

Productivity Gains Are Helping Offset Cost Pressures:  Productivity has improved as the AI investment cycle continues, and rising productivity can help offset wage and input-cost pressures. Trend productivity remains well below prior productivity booms, but recent improvement is important because stronger output per hour can limit unit labor cost growth and support margins. This is particularly important in an environment where wage growth, energy costs, tariffs, and transportation costs remain potential risks to profitability.

Credit Conditions Remain Supportive:  Corporate credit markets continue to signal confidence in fundamentals. Credit spreads remain historically tight, lending standards have eased, and commercial lending growth remains positive. While issuer differentiation is emerging and higher financing costs bear watching, current credit conditions are not consistent with broad recessionary stress. Stable credit markets remain an important source of support for capital investment, refinancing, and shareholder returns.

Peak Profit Risk Bears Watching:  The central risk is not that corporate profitability is weak, but that profit growth may be approaching a cyclical peak after an exceptionally strong period. High earnings expectations, record-level margins, elevated input costs, and increased scrutiny of capital spending create a narrower margin for error. Corporate profitability remains highly supportive of economic expansion, but future market gains may require continued earnings delivery rather than additional valuation expansion.

Bottom Line: Corporate profitability remains a major pillar of support for the economy and markets. Earnings growth has exceeded expectations, margins remain elevated, AI investment continues to support revenues and productivity, and credit conditions remain constructive. The key question is whether profit growth can continue to exceed already high expectations as input costs, capital-spending scrutiny, and peak-margin concerns become more important.