AI Disruption Pauses While the US Economy Remains Resilient

Executive Summary 

Last week, the S&P 500 returned +1.0%.  Markets continued to be whipsawed as traders assess the impact of AI across a number of industries; oil rose and perceived inflation risks kept a lid on bond prices as the U.S. continues a substantial military buildup in the Middle East. Late in the week, the U.S. Supreme Court struck down President Trump’s tariff, adding to trade policy uncertainty. Mid cap (+1.0%) and small cap (+0.7%) stocks slightly underperformed large caps. Communication services (+2.3%) and industrials (+1.7%) were the best performing sectors in the S&P 500; consumer staples (-2.3%) and healthcare (-0.6%) were the laggards. Non US Developed EAFE markets returned +0.9% with gains in the U.K. (+2.6%) and Europe (+1.6%) offset by losses in Japan (-1.8%), while EM markets returned +0.8% led by recovery in Korea (+3.2%). 

Rates rose across the curve as markets assessed the inflation risks due to the rise in oil prices. The 2Year-10Year spread compressed 4bps to +60. Rates also fell in other developed markets. The Italian BTP-German Bund government spread is at 0.60%, indicating complacency amongst higher leverage and lower leveraged sovereigns. The 5-year breakeven inflation expectations rose 2bps to 2.46% (vs. low of 1.88% on Sept 10, 2024); 10-year breakeven inflation expectations were unchanged at 2.29% (vs. recent low of 2.03% on Sept 10, 2024); the 10Y real yield rose 3bps to 1.79%. For 2026, the market expects 2 cuts vs. the Fed’s guidance of 1 cut.  

Regarding year-to-date (YTD) performance, through the close of February 19, the S&P Equal Weight Index was up 6.0% while the market cap weighted S&P500 was up 1.0% with Emerging Markets and EAFE up approximately 11% and 8%, respectively.   Within the S&P 500, 343 stocks, or 68% of the index, have positive YTD gains. On a percentage basis, 41% of S&P 500 stocks were up more than 10% YTD. Yet the Mag 7 names are down 6.5% YTD.  Investors will be paying attention to the Nvidia earnings report February 25, which will be Jensen Huang’s “State of the Union” address and may be more impactful than President Trump’s address on February 24. 

Key Takeaways 

1. The AI Disruption Trade Pauses. Markets stabilized last week after two volatile, AI-driven selloff weeks, with calmer trading across equities, rates, and credit. Volatility eased as the VIX fell below 20, credit spreads tightened, and the most pressured areas of the market, including the growth factor, technology and financial sectors, and high beta stocks, stabilized after multi-week declines.  The software sector has been ground zero, but the volatility has spread to the financial, real estate and logistics industries in the last few days. We think it will continue to spread where long-standing business models are being tested. Software is a good example where, for years, investors could depend upon subscription-based models to generate consistent cash flow streams. As a result, higher valuation multiples were awarded to the sector. Now, it’s possible AI could disrupt that scenario and, as a result, terminal values are being questioned. This will take time to play out, and the key is separating the winning business models from those in the crosshairs of disruption. This is not the AI bubble bursting; this is AI disruption mostly and destruction episodically.  Implication – Last week’s calmer tone is a positive sign, as the market’s tension between fear and greed rebalances and fights to differentiate between AI risks and opportunities. 

2. Manufacturing & Housing Data Surprise to the Upside. A wave of stronger-than-expected economic data hit last week, suggesting overall economic activity remains solid. Industrial production expanded +0.7% in January, while housing starts and building permits both came in above forecast for December, signaling improving residential construction activity. Orders for durable goods, items with expected lives of more than 3 years, were mixed on the surface, but excluding volatile categories like aircraft, core business investment measures strengthened, suggesting companies continue to spend on equipment and technology. Implication – While the data reflects late-2025 conditions, it suggests the economy ended the year on a resilient note. 

3. Treasury Yields Rise After Multi-Week Decline. Treasury yields rose last week after the Fed’s January meeting minutes struck a more hawkish tone, with some officials discussing the possibility of rate hikes if inflation remains above target. The 10-year yield rose to 4.09%, pausing a multi-week decline that had pulled it down almost -0.25%. The move was reinforced by this week’s stronger-than-expected economic data and soft demand at a 20-year Treasury auction, both of which added to the pressure. Implication – Markets continue to price limited odds of a near-term rate cut, with expectations shifting toward mid-2026. While a few policymakers emphasized inflation risks, the market’s base case is that the next move is lower, not higher. 

4. Oil Prices Rise as Geopolitical Risk Escalates. Geopolitical tensions pushed oil higher last week, as renewed tensions between the U.S. and Iran added a fresh risk premium to energy markets. Crude prices surged nearly +4.5% in a single session, with WTI trading above $66 for the first time since early August. The catalyst was a combination of stalled diplomatic progress and concerns around the Strait of Hormuz, a critical route for global oil shipments. Implication – While there’s been no major supply disruption, markets tend to react quickly when risks involve key producing regions and transit chokepoints. If oil prices remain elevated, they could add to inflation pressures, impact the pace of future rate cuts, and weigh on consumer sentiment.  However, we believe the administration doesn’t want to aggravate oil prices in advance of mid-term elections. 

5. The US Supreme Court ruled that the President doesn’t have the authority to unilaterally impose tariffs under the International Emergency Economic Powers Act (IEEPA). The ruling is important because tariffs enacted under the IEEPA accounted for approximately 60% of the recent 17% average effective US tariff rate.  The ruling was largely anticipated. Prediction markets had consistently projected a low probability that IEEPA tariffs would be upheld.  Implication – There are some conclusions that can be drawn, albeit with limited precision. Assuming that they are paid out (subject to all types of adjudication), rebates will increase the fiscal deficit of the United States.  Rebates will also act as some type of fiscal stimulus via corporations but unlikely consumers.  Rebates can only be paid to the people who paid the tariff as a tax payment to the US government, i.e. US importers.  These are disproportionately small and medium-sized businesses.  We believe the rebates are unlikely to be passed on to the US consumer.  Certainly, when selected US tariffs came down last year, they tended not to be matched by US consumer price reductions.