From AI Euphoria to AI Skepticism
Global financial markets have experienced important transitions over the past thirty days. The dominant narratives shifted away from energy-driven inflation shocks to geopolitical stability. While simultaneously, investors pivoted from artificial intelligence (AI) euphoria to capital expenditure skepticism. Although much regarding market fundamentals remains unchanged, market leadership and investor expectations evolved considerably in a relatively short period.
Diplomacy to reopen the Strait of Hormuz, where as much as twenty percent of the world’s energy supply was previously trapped, was a significant development that occurred in early June. Iran and the US tentatively agreed to peace and an agreement to restore global energy supplies, which released tens of millions of oil barrels back into global markets. Oil prices reacted sharply, decreasing by about $30 per barrel almost instantaneously, as investors removed geopolitical risk premiums that spiked energy prices in early spring.
Declining energy prices quickly altered the broader economic story. The energy price declines softened expectations for inflation, eased financial burdens placed on consumers and businesses, and improved the outlook for global trade. Manufacturing activity also strengthened across several export-focused economies that helped rebuild global supply chains, as global shipments accelerated. Most notably, South Korea reported record exports led by semiconductor demand, while China posted historically strong exports of AI-related hardware and a large importer of advanced semiconductor equipment.
In equity markets, investors thought cautiously about the next phase of AI investment. Throughout much of the past year, companies were rewarded for their AI adoption. However, by late June, investors grew more concerned over the earnings growth needed to justify the enormous capital expenditures that the AI buildout has cost. Several large technology companies have experienced increased volatility as of late, as investors have questioned the timing and magnitude of future returns from AI, which has led to a rotation towards more traditional sectors, including financials and industrials. Despite the changing backdrop, equity markets remained remarkably resilient during June. Broadly speaking, equity indexes continued to break previous record highs, supported by better geopolitics, lower energy costs, and robust earnings growth. Even foreign markets have benefited from technology production and related exports that are driving economic expansions.
“Investors are evaluating whether AI infrastructure can be converted into sustainable AI profits.”
As the third quarter begins, investors may focus on a different set of questions than they faced only a month ago. Rather than worrying about energy-induced inflation shocks, investors are evaluating whether AI infrastructure can be converted into sustainable AI profits. Even though geopolitical risks have lessened for now, the durability of economic growth, the pace of AI monetization, and the forward path of interest rates will likely drive market performance between now and the rest of this year.
Geopolitical
In June, the US and Iran reached a temporary memorandum of understanding that paused most direct military hostilities, reopened the Strait of Hormuz to commercial shipping, and created a 60-day window for negotiations over Iran’s nuclear program and broader regional security. However, that agreement has largely unraveled over the past week.
Military operations have unfortunately resumed. The US has carried out additional strikes against Iranian targets, saying they were in response to Iranian attacks. Iran has responded with retaliatory attacks and threats. The ceasefire is effectively no longer holding. Both sides accuse the other of violating the June agreement, particularly regarding shipping in the Strait of Hormuz and sanctions relief.
The US has announced it will reinstate a naval blockade targeting Iranian shipping while continuing to protect transit for non-Iranian commercial vessels. Iran maintains that it has authority over shipping through the Strait and has threatened restrictions.
Diplomatic channels have not completely closed, but they are under severe strain. No new formal negotiating schedule has been announced, and both governments have issued increasingly confrontational public statements.
Inflation & Jobs
Inflation and employment data continue to paint a mixed picture of the economy. In May, inflation moved higher as measured by the Fed’s preferred inflation gauge, the Personal Consumption Expenditures (PCE) index, which reached its highest level since late 2023. This was primarily driven by rising energy costs tied to the Iran conflict. However, June data showed some improvement, with the Consumer Price Index (CPI) declining 0.4% during the month and annual inflation easing to 3.5%. While the improvement is encouraging, inflation remains above historical norms, and renewed geopolitical tensions could create additional pressure on energy prices and consumer costs.
The labor market is showing signs of gradually losing momentum, creating a more complicated economic backdrop. May data showed early signs of cooling, with hiring activity remaining subdued despite job openings holding relatively steady. That trend continued into June, when payroll growth slowed well below expectations and prior months were revised lower. The concern is that labor markets may be shifting from simply “cooling” toward a more meaningful slowdown, even though overall employment levels remain relatively healthy.
“June data showed some improvement, with the Consumer Price Index (CPI) declining 0.4% during the month and annual inflation easing to 3.5%.”
Consumers have remained a source of resilience despite higher prices and a softer employment backdrop. Personal income and spending continued to grow, indicating households are still supporting economic activity, but the combination of elevated inflation, slowing job growth, and rising costs for everyday essentials remains a challenge.
Federal Reserve
The Fed’s messaging shifted noticeably recently, with policymakers signaling a more cautious approach to interest rates. While the Fed kept rates unchanged in its last meeting, officials removed language that had suggested future rate cuts were likely and emphasized their commitment to bringing inflation back toward its 2% target. Updated projections showed most officials expect rates to remain elevated, with several seeing the potential for additional increases if inflation does not continue to improve.
Inflation remains the primary challenge shaping the outlook for interest rates, especially given the recent inflation data. Underlying inflation remains elevated and simply has not yet shown a consistent path back toward normal levels. This has increased concerns that inflation could prove more persistent, particularly if strong demand, higher government spending, or new sources of economic pressure keep prices elevated.
“The path toward lower interest rates may be slower and more uncertain than investors previously expected.”
Markets reacted negatively to the Fed’s more cautious tone, as investors adjusted expectations for the timing of potential rate cuts. Going forward, investors will be focused on whether inflation continues to moderate and whether slowing employment growth begins to weigh on economic activity. Economic data and inflation trends will play a larger role in determining the direction of interest rates. The key takeaway is that the path toward lower interest rates may be slower and more uncertain than previously expected.
Stocks
The stock market continues to benefit from strong corporate earnings, providing a solid foundation for recent gains. US large cap equities are generally on pace for another quarter of earnings growth well above historical averages. Importantly, market gains have been supported by improving profits rather than just expanding valuations, as earnings growth has helped keep forward valuation levels below where they started the year. This suggests the market’s strength has been driven by real business performance, not solely investor optimism.
The earnings recovery has broadened across many areas of the market, with most sectors expected to report year-over-year profit growth. However, market concentration is a primary risk, as the largest companies now represent an unusually large share of major indexes. Much of this concentration is tied to AI and a small group of technology leaders, creating greater dependence on a limited number of companies to drive overall market returns.
The key takeaway for investors is that strong companies can continue to perform well, but history shows that market leadership eventually changes. The current environment reinforces the importance of diversification, valuation discipline, focusing on long-term fundamentals, and whether AI-related optimism continues to be supported by actual business results.
Bonds
The biggest challenge for bond investors remains uncertainty around the future direction of interest rates. A slowing labor market would typically support lower yields, but inflation remains above desired levels, and energy-related risks continue to complicate the outlook. This has introduced added volatility to the overall bond market as investors weigh the potential impacts of these competing forces. While June inflation data showed meaningful improvement, with CPI declining and core inflation slowing, renewed tensions in the Middle East highlighted how quickly energy shocks can reignite inflation concerns and push yields higher.
Longer-term interest rates remain elevated as investors continue to demand additional compensation for inflation and fiscal risks. Large government deficits and increased Treasury borrowing needs have become a more important consideration for bond markets, as higher debt levels could keep upward pressure on longer-term yields even if short-term rates eventually decline. This reinforces the importance of managing duration exposure, as longer-maturity bonds remain more vulnerable to changes in inflation expectations and government borrowing concerns.
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Bureau of Labor Statistics. Unemployment Rate, Total Nonfarm Employment, Labor Force Participation, Consumer Price Index, Producers Price Index. www.bls.gov. United States, Department of Commerce, Bureau of Economic Analysis. Personal Consumption Expenditures, Gross Domestic Product, Consumer Spending, Personal Income, and Outlays. www.bea.gov. Federal Reserve. Fed Funds Rate, Fed Funds Target Range, Minutes of the Federal Open Market Committee, Board of the Federal Reserve System Calendar. www.federalreserve.gov. Trump, Donald. @realDonaldTrump. Truth Social.
