Worry List Is Growing More Worrisome
We’re still strong believers in our Roaring 2020s scenario, hinging on a productivity boom that strengthens economic growth even as it contains inflation. However, we’ve shaved the subjective odds that we ascribe to that scenario from 80% to 70% and now see a 30% chance that rising geopolitical and other risks could derail it. Today, Ed and Elias update our deepened worry list, detailing the concerning prospects, as well as reiterate the reasons that we remain bullish. We still believe that strong earnings growth will lift the S&P 500 to our 8400 price target by year-end. … Also: Check out our chart collection (https://cdn.sanity.io/files/m74go295/production/6084f48b93665a21b57b9c792abf0e20c042c053.pdf).
US Stock Market I: Updating the Worry List
There is no shortage of worries for investors in the current environment. The list includes higher oil prices amid escalating tensions in the Middle East, rising bond yields around the world, sticky inflation, and a Federal Reserve that will likely deliver a 25bps rate hike at the September 16-17 FOMC meeting.
Yet we are sticking with our bullish year-end target for the S&P 500 of 8400 because a key pillar of the bull market, Fabulous Earnings Momentum (FEMO), remains alive and well and so does our base-case Roaring 2020s scenario, which should keep the FEMO rolling. The essence of that scenario: A technology-driven productivity boom, fueled by AI and other innovations, will allow the economy to grow faster as it also contains inflation, boosts real wages, and supports record-high profit margins and earnings growth.
However, the recent confluence of risks has prompted us to lower the subjective probability we assign to the Roaring 2020s scenario from 80% to 70%, while raising the probability of outcomes that could derail this happy scenario to 30% from 20%. We are often optimists, but we always strive to be realists first and foremost. That is why we regularly update our worry list.
Consider the following prospective developments on our worry list:
(1) The prospect of a worsening geopolitical maelstrom. The latest Middle East conflict started on February 28, when the US and Israel attacked Iran. Most observers expected a short war after Iran’s leadership and conventional military capabilities were badly damaged. We changed our mind on the second day of the war. We argued that Iran is likely to remain effectively under the control of the Islamic Revolutionary Guard Corps (IRGC), which can continue the fight through asymmetric warfare and its network of regional proxies.
The US continues to enforce its naval blockade on Iranian shipping in the Strait of Hormuz, severely restricting Iran’s oil exports. Tehran and its allies are responding by widening the battlefield. At the end of last week, Saudi Arabia’s East-West oil pipeline was forced offline after a drone attack originating from Iraq, while the Iran-backed Houthis are strengthening their position around the Bab el-Mandeb Strait.
The IRGC has responded to the US economic war on Iran by attacking oil supplies. Their goal is to drive up the price of oil so that the Republican Party loses the midterm congressional elections. Treasury Secretary Scott Bessent has argued that the Strait of Hormuz could eventually become largely redundant as Gulf producers build more pipelines around it. Maybe so. But Iran and its proxies can attack those pipelines too, along with refineries, export terminals, and the shipping routes they feed into. That is what is happening now.
The escalation already has pushed up oil prices to above $104 for a barrel of Brent crude and above $100 for West Texas Intermediate (WTI) crude, while depleted inventories have left the oil market vulnerable to further disruptions.
Refined products look even tighter, due to the conflicts in Iran and Ukraine. US diesel has surged above $6 per gallon at the pump, and is considerably more expensive than WTI crude.
For now, we think the US economy can handle the latest round of higher energy prices. The bigger near-term risk is that a prolonged energy shock reinforces already-sticky inflation, making the Fed’s job even harder. If sustained long enough, higher energy costs could eventually weigh on economic growth. For stocks, the stagflationary mix of higher inflation and slower growth would be particularly troublesome.
(2) The prospect that current inflation shocks become entrenched. Inflation is being pushed higher by three major shocks: the AI capital-spending boom, higher US tariffs, and higher energy prices. At the same time, the economy remains remarkably resilient, making it easier for businesses to pass higher costs on to consumers. These shocks are arriving after inflation has already remained above the Fed’s 2.0% y/y target for more than five years.
The longer they last, the greater the risk of second-round inflation effects.
August’s CPI report showed that inflation pressures remain broad based. Headline CPI rose 0.4% m/m, while core CPI increased 0.3%.
Goods inflation strengthened, reflecting pressure from energy, tariffs, and AI-related demand, while services inflation remained firm.
On a y/y basis, core and headline inflation remain above the Fed’s 2.0% target.
The PPI sent a similar message. Final-demand prices rose 0.4% m/m, while the core PPI also increased 0.4%, showing that producer price pressures extended beyond energy.
The core PPI for personal consumption rose to 4.6% y/y. It remained above both core PCED and core CPI inflation, suggesting that upside risks to inflation remain elevated.
Combining the components from both reports that feed into the PCE deflator (PCED), the Fed’s preferred inflation measure, points to a robust 0.27% m/m increase, according to the Cleveland Fed Nowcasting model. That would keep core inflation running at 3.7%, well above the Fed’s 2.0% y/y target. Additionally, supercore inflation remains elevated, highlighting persistent underlying price pressures.
The risk is that these inflation shocks start reinforcing one another: Higher input costs are passed through to consumers, strong demand allows firms to maintain pricing power, and workers demand compensatory wage increases as inflation expectations rise. If that process were to take hold, inflation would become increasingly entrenched, keeping bond yields elevated, pressuring stocks’ valuation multiples, and forcing the Fed to raise interest rates more aggressively.
(3) The prospect of a wage-price spiral. Wage pressures tend to build when labor demand persistently exceeds labor supply. That has been the case for four consecutive months, and wage growth is beginning to accelerate in some of the tightest parts of the labor market.
The AI buildout is a good example. It has boosted demand for specialized technical, engineering, and construction workers whose skills remain scarce. Average hourly earnings in construction rose 4.2% y/y in August, while wage growth in information services remained elevated at 5.2%.
Wage gains in utilities also have picked up sharply.
Aggregate wage growth looks less concerning. Average hourly earnings rose just 3.1% y/y in August.
But the Atlanta Fed’s Wage Growth Tracker accelerated for a third consecutive month, to 4.1% y/y, the fastest in a year.
Wage growth for job switchers rose to 5.0% y/y, the fastest since May 2024, potentially signaling that employers increasingly have to pay up to lure workers away from existing jobs.
One explanation for the divergence may be accelerating Baby Boomer retirements.
Average hourly earnings are affected by workforce composition, so the retirement of highly paid older workers can pull the average lower. The Atlanta Fed instead tracks wage changes for continuing workers, so retirees simply disappear from the sample. If wage growth continues to accelerate, a wage-price spiral could result. That could make the inflationary impacts of today’s supply shocks more persistent, the Fed’s rate hikes more aggressive, and profit margins more vulnerable unless productivity keeps pace. So far, unit labor costs remain subdued, reducing the risk of a wage-price spiral.
(4) The prospect that the Fed will keep hiking. Fed officials have provided a fairly clear reaction function for the September 16-17 FOMC meeting. Governors Christopher Waller and Michael Barr, along with New York Fed President John Williams, indicated that persistent inflation in the August CPI and PPI reports would support a hike in the federal funds rate. Both reports came in firm and suggest core PCED likely rose about 0.3% m/m in August, enough to secure majority support for a September hike. Market pricing now reflects that. The CME FedWatch Tool puts the probability of a September rate hike near 87%. At this point, if the Fed doesn’t raise rates, its credibility would suffer and long-term bond yields would be pushed higher. The bigger risk is that September is not one and done. The 2-year Treasury yield is roughly 80bps above the effective federal funds rate, the widest positive spread since the Fed’s 2022 hiking cycle.
That suggests that the financial markets expect more than one rate hike. Indeed, they’re now pricing in 3.7 hikes of 25bps over the next six months!
For stocks, a hiking cycle would tighten financial conditions and could pressure both earnings growth and valuation multiples.
(5) The prospect that higher interest rates worsen the fiscal outlook. Total US federal marketable debt held by the public surpassed $31 trillion in August, roughly double where it stood a decade ago.
Treasury net interest outlays have climbed above $1 trillion on a 12-month basis.
If interest rates keep rising, higher debt-service costs will worsen the budget deficit outlook and require more Treasury issuance. That could provoke the Bond Vigilantes, pushing yields even higher in a self-reinforcing cycle. For stocks, higher bond yields increase competition for capital and weigh on valuations.
(6) The prospect that the AI capital-spending boom slows. The largest US hyperscalers could spend roughly $700 billion to $745 billion on capital expenditures in 2026. That spending is its own stimulus program and increasingly shows up in the real economy, supporting manufacturing, construction, power infrastructure, and industrial activity, while helping to broaden the strong earnings and revenue growth trends beyond the technology sector.
Stronger earnings growth has propelled stocks to repeated record highs, generating a positive wealth effect that supports consumer spending.
If the AI boom were to lose significant momentum, weaker earnings expectations could trigger a broad stock-market pullback and negative wealth effect in the economy. The economy would also suffer as the AI hyperscalers scaled back their capital spending. A meaningful slowdown in AI would be a macroeconomic event, not just a stock-market event.
What could cause the AI boom to go bust? Higher interest rates would raise the hurdle rate for new projects. Growing political and local opposition to data centers over electricity costs, grid constraints, water usage, and land use is another risk. There is also an emerging backlash against AI more broadly.
(7) The prospect that the midterm elections intensify partisanship. The November elections could leave Washington more divided, making debates over taxes, spending, and the deficit even harder to resolve. The next debt-ceiling fight could be especially important. The current $41.1 trillion debt limit could be reached in 2027, forcing the Treasury to rely on extraordinary measures while Congress negotiates another increase. A divided Congress could turn that process into a prolonged standoff, increasing Treasury-market volatility and raising the fiscal risk premium.
The 2026 midterm campaign could also encourage additional spending promises or tax cuts that worsen the deficit outlook. President Donald Trump’s proposal to send a $5,000 check to every adult American if Republicans retain control of Congress underscores how election-year politics could further increase fiscal stimulus expectations. More gridlock would not necessarily be bad for stocks, but greater fiscal uncertainty and concerns about larger deficits could put additional upward pressure on bond yields.
(8) The prospect that mega IPOs weigh on the stock market. The US IPO market is already having a record year, with roughly $137 billion raised through August. Now an even larger wave may be coming. Anthropic is preparing what could become the largest IPO in history, potentially raising as much as $100 billion at a valuation near $2 trillion, while OpenAI and other large private technology companies also are moving toward public listings.
Investors do not have unlimited capital. If several mega offerings arrive within a short period, institutions may have to sell existing holdings to make room.
US Stock Market II: Why We Remain Bullish
That is quite a worry list. Yet we still expect the economy to remain resilient because it is benefiting from three powerful sources of stimulus:
(1) The AI capital-spending boom. Hundreds of billions of dollars are flowing into semiconductors, data centers, manufacturing, construction, and power infrastructure, and we see little evidence that this boom is about to end.
(2) Uncle Sam’s spending. The Congressional Budget Office projects a fiscal 2026 deficit of $1.9 trillion, or 5.8% of GDP, despite a strong economy.
Together with AI investment, that means an enormous amount of capital continues to flow through the US economy, supporting activity and earnings.
(3) The Baby Boomers’ spending. They are sitting on a record pile of wealth and increasingly have both the means and willingness to spend it in retirement, providing an important cushion for consumer spending.
Put it all together, and we expect FEMO to persist. We expect S&P 500 forward earnings and the industry analysts’ 2027 consensus earnings estimate to converge around $425 per share by year-end.
That’s up from our previous estimate of $415. Apply a forward P/E of 19.8 (down from our previous 20.2), and you get our 8400 year-end target.