Higher Rates Put the AI Buildout to the Test

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

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.

Wall Street wrap

Small business optimism slips as inflation and borrowing costs bite

The NFIB Small Business Optimism Index fell to 97.9 from 98.7, putting it just below its 52-year average of 98. Six of the 10 components declined, three increased, and one held steady.

Underlying details showed some signs of caution among small business owners. The share who viewed the current environment as a good time to expand fell to 7 percent from 12 percent, tying April and May for the lowest level since a reading of 6 percent in October 2024.

One development that bears watching, particularly given our concerns about the impact of rising interest rates, was an increase in borrowing costs. A net 8 percent of owners reported paying a higher interest rate on their most recent loan, up four points from August and the highest level since a reading of 9 percent in June 2025. The average rate paid rose to 8.2 percent from 7.5 percent last month.

Those higher borrowing costs are occurring against a backdrop of rising inflation pressures. Labor quality remained the single most important problem for the third month, rising three points to 26 percent. At the same time, a growing 20 percent of businesses said inflation was their single biggest problem, up four points and well above the long-term average of 7 percent.

A net 31 percent of owners reported raising prices during the past three months, unchanged from last month and well above the historical average of 14 percent. Only May and June, at 36 percent and 38 percent, respectively, were higher this year. Before that, the most recent higher readings were 32 percent in February 2025 and 32 percent in May 2023. Meanwhile, a net 31 percent plan to raise prices over the next three months, up from 28 percent and above the historical average of 22 percent.

Sales measures were mixed. The net share reporting higher sales improved one point from August to -8 percent, tying April for the second-lowest reading of 2026, behind August’s -9 percent. Owners expecting higher real sales rose three points to 9 percent.

The earnings change measure declined another one point to -20 percent. Among owners reporting lower profits, 34 percent blamed weaker sales, up six points; 24 percent cited rising material costs, up eight points; and 8 percent cited price changes for their product or service, down two points.

Beige Book shows growth but persistent price pressures

The Federal Reserve’s Beige Book painted a picture of continued economic growth accompanied by stubborn inflation pressures. Two of the 12 Fed districts reported moderate growth in economic activity, three reported modest growth, four reported slight growth, and three reported no significant change.

Manufacturing was one area of relative strength. Robust, broad-based manufacturing growth drove the moderate growth reported by the Dallas district, while another six districts reported modest to moderate growth among manufacturing firms. The remaining five districts noted little or no manufacturing growth.

Reports from other sectors suggested little growth overall. Most districts reported little or no change in consumer spending, and more than half noted that consumer spending was being driven by high-income households.

The labor market offered a similarly balanced picture. Most districts described little or no net change in overall employment levels. Three districts described modest increases, five reported slight increases, and four reported no significant change. Labor supply was generally adequate to meet demand, although shortages persisted for specialized, technical, and skilled trade workers.

Perhaps most noteworthy were signs of continued pricing pressures. Three districts characterized overall price growth as robust, while eight said growth was moderate. Three of those eight noted that input price pressures were intensifying, if not already growing robustly. One district reported modest price growth. Four districts also reported that the pace of price increases had picked up since the prior period.

Contacts in multiple districts cited continued price pressures stemming from other commodities, tariffs and insurance. Consumer-facing firms reported tighter profit margins as price-sensitive customers continued to resist price increases. Firms in several districts also cited persistent uncertainty around energy and tariffs and expect prices to increase further in coming months as existing contracts expire and firms renegotiate hedge contracts for their inputs and delivery contracts with customers.

CPI shows inflation pressures remaining sticky

The CPI rose 0.6 percent, matching expectations, while the year-over-year pace accelerated to 3.7 percent from 3.4 percent and came in above expectations of 3.6 percent. The increase was driven by a 20 percent advance in energy, with energy commodities up 35.3 percent year over year.

Core CPI rose 0.3 percent, the same as last month’s 0.3 percent increase and above expectations of 0.2 percent. On a year-over-year basis, core prices rose 2.6 percent, up from 2.4 percent and above expectations of 2.5 percent.

On a three-month basis, core inflation is running at 3.4 percent. On a six-month basis, core is at 2.9 percent. On a nine-month basis, core is at 2.9 percent. These shorter-term readings suggest the underlying pace of core inflation is pushing higher and appears to be running around 3 percent, similar to core personal consumption expenditures (PCE) inflation.

Goods prices increased for the third consecutive month, rising 0.25 percent, the strongest reading since a 0.3 percent increase in January 2025. Goods prices are now up 0.7 percent year over year.

Services prices rose 0.37 percent and are now up 3.1 percent year over year. Over three months, services inflation is running at 3.76 percent, while both the six- and nine-month measures are at 3.6 percent. Put simply, the data continues to point to sticky inflation pressures.

Industrial production gets a boost from AI

Industrial production rose 0.7 percent after last month’s increase was revised up to 0.1 percent versus an initial reading of 0 percent.

Manufacturing rose 0.3 percent after last month’s reading was revised up to -0.2 percent from -0.3 percent. Manufacturing output is now up 1.1 percent year over year, led by strength in business equipment and defense and space, which are up 6.7 percent year over year.

The ongoing AI boom continues to provide meaningful support to this portion of the industrial economy. Select high-tech industries rose 1.5 percent and are up 17.5 percent year over year. Within that category, semiconductors rose 2 percent and are up 19.9 percent year over year.

Producer prices add to inflation concerns

The PPI provided another sign that inflation pressures remain elevated. Producer prices rose 1.3 percent versus expectations for a 0.6 percent increase and the prior month’s 0.4 percent gain. That pushed the year-over-year pace to 6.3 percent, the fastest pace in four years.

Core PPI, excluding food and energy, rose 0.7 percent, pushing its year-over-year pace to 5.0 percent.

Record-high prices for diesel and jet fuel helped push transportation costs higher. Transportation and warehousing prices rose 3.4 percent on fuel surcharges, while wholesalers began rebuilding margins after months of absorbing higher input and freight costs, with those prices rising 1.4 percent. This represents another potential channel through which higher costs could be passed to consumers.

Importantly, the portions of PPI that feed into the PCE price index came in above expectations, raising upside risks for PCE, with estimates for core PCE rising by 0.3 percent or 0.4 percent.

Retail sales remain strong, but details are mixed

Retail sales, which are not adjusted for inflation, rose 0.8 percent after last month’s strong 1.2 percent advance was revised higher to 1.3 percent. Sales are now up 6.8 percent year over year.

Excluding autos and gasoline, sales rose a more modest 0.2 percent following last month’s 1.1 percent advance. The control group used in calculating gross domestic product, which excludes food services, auto dealers, building material stores, and gasoline stations, rose a disappointing 0.1 percent. However, that came on the heels of a strong 1.2 percent increase in August.

Eight of the 13 categories posted increases after all 13 rose in August. Gasoline stations recorded a 6.4 percent increase and contributed 0.58 percent to the overall 0.77 percent gain. The next-largest contribution came from eating and drinking establishments (the only service-sector category among the 13), which rose 1.1 percent and contributed 0.14 percent. Furniture sales increased 1.3 percent but, given their smaller weighting, contributed just 0.02 percent.

Overall, the week’s reports reinforce the tension we continue to highlight: Economic activity remains resilient in several areas, but inflation pressures aren’t going away quietly. At the same time, rising borrowing costs are beginning to show up more clearly for small businesses, creating another potential headwind as investors assess how long the current pace of economic growth can persist.

The week ahead

Monday: The National Association of Home Builders/Wells Fargo Housing Market Index is scheduled for release at 10:00 a.m. ET. The report will provide a timely look at homebuilder sentiment and conditions in the residential housing market. We will be watching for signs of how affordability challenges and borrowing costs are influencing builders’ outlooks as the fourth quarter gets underway.

Tuesday: Housing Starts and Building Permits for September are scheduled for release at 8:30 a.m. ET, followed by Pending Home Sales at 10:00 a.m. ET. We will be watching these reports for additional insight into housing supply, construction activity, and demand. Together, the data should provide a broader look at how the housing market is navigating current financing and affordability conditions.

Wednesday: The economic calendar is relatively light, with no major market-moving U.S. economic reports scheduled for release. The Energy Information Administration’s weekly petroleum report is due at 10:30 a.m. ET.

With few significant economic releases on the calendar, investors may turn their attention toward corporate earnings and developments ahead of Thursday’s labor market data report. Meta Platforms reports after Wednesday’s market close, making it one of the first Magnificent Seven companies to report this season and a key release to watch for updates on AI spending and its implications for future growth.

Thursday: Initial Jobless Claims are scheduled for release at 8:30 a.m. ET, followed by the Leading Economic Index at 10:00 a.m. ET. We will be paying particular attention to jobless claims for the latest indication of labor market conditions. The Leading Economic Index should offer additional perspective on the near-term direction of economic activity.

Friday: Preliminary October Purchasing Managers’ Index readings for manufacturing and services are scheduled for release at 9:45 a.m. ET, followed by the final October University of Michigan Consumer Sentiment Index at 10:00 a.m. ET. We will be watching the purchasing managers’ indexes for signs of how business activity is evolving early in the fourth quarter, while the consumer sentiment report should provide additional insight into households’ views of the economy and inflation. Together, Friday’s reports should offer a timely read on both business and consumer conditions.

Frequently Asked Questions

How do higher interest rates affect the AI buildout?

Building artificial intelligence (AI) infrastructure requires substantial investment, increasingly funded through borrowing and stock issuance rather than existing cash flow alone. Higher borrowing costs can make projects more expensive and slow spending. As this week’s commentary explains, a slowdown could affect not only AI companies and their suppliers but also broader economic growth and consumer spending supported by stock market gains.

Why does diversification matter when AI stocks come under pressure?

A portfolio concentrated in one theme can be especially sensitive to changes in that theme’s outlook. This week, technology shares declined while seven of the S&P 500’s 11 sectors advanced, illustrating how different parts of the market can move in different directions. Diversification spreads exposure across investments with different drivers of performance, reducing reliance on the AI buildout without eliminating investment risk.

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