Photo credit: Aleksandra Jankovic

A week filled with hotter inflation readings brought growing concerns about the sustainability of the pace of AI spending. Despite rising inflation, bond yields ended the week lower. While the S&P 500 Index of large-cap stocks fell 1.95 percent for the week, the decline was largely driven by its heavy weighting to technology stocks, which faltered by 6.37 percent. Indeed, seven of the 11 sectors within the index actually advanced, led by staples and energy, each rising over 5 percent. That helped the equal-weighted S&P 500, which weights every stock equally, push higher by 0.48 percent.

Much as we highlighted last week, other segments of U.S. equity markets fared better, led by a 1.06 percent advance in U.S. real estate investment trusts (REITs). We have recently highlighted REITs given their low correlation to the AI trade, which had previously driven markets higher but came into question this week and pushed the technology sector lower. In a sign of this, the Philadelphia Semiconductor Index fell 11.41 percent this week, while a Goldman Sachs basket of AI stocks we highlighted last week declined by a similar 11.61 percent.

Economic data for the week showcased the sticky inflation that we have continually warned about in the recent past. Core consumer price index (CPI) checked in at a higher-than-expected 0.3 percent, which drove the year-over-year pace up to 2.6 percent. Inflation pressures continued to leak into the services sector, where supercore services excluding shelter rose 0.42 percent month over month after the prior month’s 0.52 percent increase.

Similarly, producer prices surprised sharply to the upside, showing that inflation pressures remain in the production pipeline. Prices for final demand rose an elevated 1.3 percent during September versus expectations for a 0.6 percent increase, which drove the year-over-year pace to 6.3 percent, the highest since December 2022. Core Producer Price Index (PPI) excluding food and energy showed that price pressures extend beyond energy, rising 0.7 percent and pushing the year-over-year pace to 5 percent, a level last seen in January 2023.

Lastly, import and export prices also spiked. Import prices rose 1.1 percent, pushing the year-over-year pace to 8.1 percent, while prices excluding petroleum increased 0.8 percent and are now up 6 percent over the past year. Export prices jumped 2.2 percent, lifting their year-over-year pace to 11.6 percent, the largest increase outside the COVID-impacted period in data going back to the mid-1980s.

Not only did the hard economic data paint a picture of continued price pressures, but survey data showed similar results. The Federal Reserve’s Beige Book, which is released two weeks before each Fed meeting, showed that strong economic growth remained in place but with an unwanted dose of rising price pressures. Three districts characterized overall price growth as robust, while eight noted that growth was moderate, and three of the eight noted that input price pressures were intensifying, if not already growing robustly. The last time at least this many districts saw “robust” price growth was 2022.

The National Federation of Independent Business (NFIB) Small Business Optimism Index, which pulled back to 97.9, below its 52-year average of 98, also revealed that price pressures remain elevated. A net 31 percent of respondents reported hiking prices in the past three months, the same as last month but well above the historical average of 14 percent. More interestingly, a growing net 20 percent of small business owners reported that inflation is their single biggest problem, up four points from last month and well above the 7 percent long-term average. Apart from a slightly higher reading of 21 in June of this year and the COVID-related spike from December 2021 to December 2024, one must go back to June and July 2008 and, before that, the period from the survey’s inception in 1973 through January 1982 to find similar readings.

Interestingly, despite the concerning inflation news, bonds actually posted gains for the week, with the Bloomberg U.S. Aggregate Bond Index rising 0.88 percent. Both the two- and 10-year Treasury yields fell, with the latter declining from 5.24 percent to begin the week to 5.08 percent at week’s end.

To understand why bonds rallied in the face of hotter inflation, it helps to first understand what had driven yields higher. From the 10-year Treasury’s low of 3.94 percent in late February through its October 5th high of 5.30 percent, the 1.36 percent rise in yield came almost entirely through higher real yields, which rose 1.26 percent, while inflation expectations remained surprisingly stable (+10 basis points). Put simply, investors were likely pricing in a stronger real growth outlook and demanding greater compensation for the risks of holding an ever-growing stockpile of longer-term bonds, not materially higher expected inflation.

This week, that process continued its recent reversal. Despite a string of hotter inflation readings, the nominal 10-year Treasury yield fell from 5.30 percent on October 5th to 5.08 percent on Friday. The entirety of that move was explained by a 22-basis-point decline in real yields. Investors are now shifting their focus from today’s inflation to the impact that higher interest rates may have on tomorrow’s economic growth and, as such, are moving back toward the safety that Treasurys may provide in such an event.

That shift is beginning to validate an argument we have long made, one that has frequently been met with pushback: The current AI buildout is no longer interest-rate insensitive. It is increasingly being financed through increased debt and equity issuance rather than the free cash flow of a narrow group of companies. That reality has begun to show up in the prices of bonds issued by many AI infrastructure builders over the past few weeks.

The clearest warning this week came from CoreWeave, a major provider of the GPU-based cloud infrastructure used to train and run AI models. The yield on its debt due in 2031 surged above 15 percent, while the cost to insure against a default through credit-default swaps climbed to 1,140.17 from 450 in June and 835 as recently as October 5th. For investors, those moves signal that lenders are demanding substantially greater compensation for the risk of financing the AI buildout.

That matters because AI-related investment has provided meaningful support to recent U.S. economic growth, while the market gains tied to the AI boom have bolstered household wealth and consumer spending. Yet bringing AI to life requires enormous and increasingly interest-rate-sensitive amounts of capital, some of which feels circular: One company’s debt issuance becomes another company’s revenue. If elevated financing costs slow that issuance, the resulting loss of revenue could weaken investment directly and, through softer equity markets and a diminished wealth effect, weigh on consumer spending as well.

In other words, the same AI investment boom that helped justify higher real yields on the way up may now be contributing to lower real yields as investors question its staying power and potential impact on U.S. economic growth. This week was therefore a useful reminder of why we continue to view Treasurys as a hedge against the possibility of weaker growth and economic risk. Inflation is not yet vanquished, but the bond market’s message was that a meaningful slowdown in the AI trade could have consequences, and that risk was enough to drive a reversal in real yields.

Is CoreWeave a canary in the coal mine, or, as Nvidia CEO Jensen Huang argued this week, is its financial strength actually improving and its cost of capital declining? Is this simply another AI scare, like the many we have seen over the past few years, that ultimately proves to be a mere bump in the road on the path to more spending and higher stock prices? Is the bond market right to view inflation as a lesser risk, especially given that Fed Chair Kevin Warsh was perceived during his Thursday evening interview in Thailand as shrugging off another rate hike at the Fed’s upcoming October meeting?

These are among the many unanswered questions and risks that remain, which is why we continue to believe diversification is even more important today than it has been in recent decades. We continue to advocate building portfolios with multiple themes that are not overly reliant on the AI buildout trade while acknowledging that it has permeated large swaths of the U.S. economy and markets. As a result, it will continue to drive the near-term narrative and likely contribute to heightened volatility.

However, much as we have witnessed time and again, we believe investors with intermediate- to longer-term horizons will reap the rewards of staying invested and remaining true to their financial plans as the potential benefits of AI accrue to the broader economy and markets in the coming years.

About the Author:

Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.