AI Spending Scrutiny Deepens as Markets Rotate Beyond Tech

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

Disappointing earnings from some of the technology world’s behemoths drove the S&P 500 Index of large-cap stocks lower for the third week in a row, as it fell 0.57 percent on losses in two of its 11 sectors: technology and communication services. That decline came despite a Federal Reserve that stayed on hold in the face of continued signs of sticky inflation and economic data showing that growth remains resilient. The pain was most acute in AI-related stocks. The tech-heavy Nasdaq 100 Index fell 1.98 percent for the week and is now off 9.1 percent from its recent high, nearing correction territory, while the Philadelphia Semiconductor Index (SOX) fell 7.2 percent on Friday, erasing its gains for the week, and is now down 27 percent from its recent high. Put simply, AI continues to permeate both companies and the broader U.S. economy, and its impact continues to evolve. But investors are increasingly questioning whether the massive sums being spent to bring it to life will produce the profits needed to justify them.

Once again, however, the headline index masked a healthier picture beneath the surface. A continued rotation saw 70 percent of the stocks in the S&P 500 outperform the index, pushing the equal-weighted S&P 500 up 0.8 percent, while the S&P 600 Index of small-cap stocks and the S&P 400 Index of mid-cap stocks rose 1.46 percent and 1.28 percent, respectively. The Dow Jones U.S. Select REIT Index, which we have recently highlighted given its low to negative correlation to the AI trade, rose 1.01 percent, helped by falling real yields that have provided a tailwind for interest-rate-sensitive areas.

While questions grew around individual companies, third-quarter gross domestic product (GDP) highlighted the positive impact AI spending is currently having on the overall economy, as growth quickened to a 3.4 percent annualized pace from 2.2 percent in the second quarter. Business fixed investment rose 12.7 percent, the most since Q3 2020, and contributed 1.78 percentage points to GDP, its largest contribution since Q3 2011 outside the pandemic. That strength was led by AI-related categories: Equipment investment jumped 20.9 percent (adding 1.16 points), driven by a 37.4 percent surge in information processing equipment that included a 66.7 percent gain in computers and peripherals, while intellectual property products rose 8.4 percent (adding 0.47 points).

The consumer also continued to power ahead, with spending rising 3.8 percent and serving as the largest contributor to growth at 2.5 percent. But beneath that strength, consumers are increasingly spending out of savings, likely bolstered by the wealth effect of an equity market that has been driven by AI. Personal income and outlays data released during the week showed that real disposable personal income fell 0.2 percent in September (its second negative print this year), was flat for the quarter, and is up a mere 0.95 percent from a year ago as the impact of high inflation presses up against moderating wage growth. This pushed the savings rate down to 3.8 percent, its lowest level since the end of 2022. Put simply, consumers are leaning on rising stock prices and dwindling savings to keep spending as inflation outpaces their paychecks, a combination that leaves spending vulnerable if the AI trade continues to falter.

That leaves the Federal Reserve in a difficult spot. The committee voted 10–2 to keep rates steady, although readings over the past few months have done little to dispel the notion that inflation remains sticky. While the committee has promised under Chair Warsh to be “unambiguous and unanimous” in its commitment to restoring price stability, members decided that additional action to produce that outcome could wait another month so it could “accumulate more information.”

That patience came even as the Fed described economic growth that has strengthened and a balanced labor market with quite positive conditions set against the reality that core inflation remains stuck around 3 percent. This week’s Personal Consumption Expenditures (PCE) report only reinforced that point, as core PCE rose 0.32 percent in September and 3.1 percent from a year ago, with its three- and six-month annualized paces at 2.9 percent and its nine-month pace at 3.3 percent. With Chair Warsh still “unwilling and unable” to describe financial conditions as restrictive, investors are increasingly likely to begin questioning the Fed’s commitment to 2 percent inflation if November brings hot inflation readings like those we saw in October, which could lead to the need for a 0.5 percent hike in December.

Even with a strong economy and still accommodative financial conditions, strains are beginning to appear, with continued questions around the sheer size of AI capital spending and its impact on the overall economy and equity markets. Last week, we pointed to a crucial week of earnings from the market’s heaviest weights, and the risks of concentration we have long warned about were once again on display, as the S&P 500 was hampered by its heavy weightings in technology and the previously “Magnificent 7.”

We have also long warned that AI was becoming more interest-rate sensitive as it shifted from being financed out of free cash flow to being financed through debt and equity issuance. That shift was evident in this week’s earnings, as the AI story pushed into a new chapter marked by growing questions about the sustainability of spending given the massive funding needs, the profit payoff for those investing in AI, and the potential disruption to companies’ core businesses.

Alphabet followed Meta’s stumble from the prior week, not only disappointing on earnings as investors pondered AI’s threat to its core search and advertising business but also posting negative free cash flow, its second straight quarter of doing so, sending its shares down more than 12.3 percent on the week. Amazon likewise disappointed in its core business while increasing its AI-related spending on property and equipment to $77 billion for the quarter and saying that capital expenditures would rise “meaningfully” in 2027 from its roughly $220 billion pace in 2026. That spending produced negative free cash flow for the second straight quarter, pushing free cash flow over the past 12 months to -$42.4 billion. In a sign of the times, Amazon tapped an $80 billion loan facility on Friday to help fund its AI expenditures. Intel, meanwhile, plunged by 28.6 percent on Friday after posting disappointing results in its core business.

Even the good news came with a reminder of the capital required. While Microsoft beat earnings expectations and reported positive free cash flow, it announced plans to raise $25 billion in the U.S. bond market to help pay for an infrastructure buildout that includes $170 billion in 2026 capital expenditures, its first such sale since raising $17 billion in 2017. Investors welcomed the deal given Microsoft’s AAA credit rating from S&P, the highest credit quality available. However, in another sign of the cost and impact of AI, Microsoft also announced voluntary buyouts for 60,000 of its employees as it looks to trim its headcount to prepare for the future.

Microsoft’s bond deal was just one piece of a growing web of AI financing that continues to raise questions about the sustainability of the incredible amounts of capital needed to bring AI to life as well as concerns about circular financing. On the back of last week’s news, Meta raised $37.5 billion, comprising $25 billion in common stock and $12.5 billion in mandatory convertible preferred shares, as part of a broader $97.5 billion financing program, with NVIDIA and AMD among the anchor investors. Separately, a $63 billion special-purpose vehicle backed by Bank of America, Blackstone, Citi, and Morgan Stanley will purchase Broadcom’s XPU AI accelerators and lease them to Anthropic, while SpaceX arranged a $40 billion equipment finance lease from Apollo.

All of this came to a head on Friday, as investors sold first and asked questions later. NVIDIA, the world’s largest company, fell 4.2 percent, extending its decline since October 6 to 14.46 percent. Interestingly, the cost to insure NVIDIA’s debt against default through five-year credit-default swaps has spiked to 147 basis points from 81 on October 6 and just 40 as recently as early June. We believe this likely reflects the ties and debt guarantees NVIDIA has with many technology companies, including CoreWeave, a reminder that the risks within the AI ecosystem are increasingly interconnected.

We have continually reminded investors of the risks of concentration, or having all of your eggs in the AI basket. While we believe AI will have a positive impact on the U.S. economy, we believe the benefits will ultimately shift from the companies building the infrastructure to those that use it to increase the productivity and profitability of their employees and businesses. That is the same path the dot-com era followed. The large question that remains is whether the cost of bringing AI to life will be justified by future profits for the companies involved, especially as the technology adapts and improves and as it disrupts the business models of the incumbents.

While we are always apt to quip that we have never met a certain time period, this one feels weighted more heavily to the uncertainty side than most—from geopolitics and elections to sticky inflation and the Fed’s reaction to it, along with questions about future economic growth, all topped off by the unknown of what AI ultimately becomes and the path it takes to get there. This is why we continue to believe the benefits of diversification are as important today as they have been in recent decades.

We continue to advocate building portfolios that are not dependent solely on AI, including REITs, the equal-weighted S&P 500, and small- and mid-cap stocks—segments that trade at relative discounts and, for now, are benefiting from a rotation away from the AI trade—alongside bonds that offer attractive income.

That said, if the pain in AI continues and widens, these areas will likely pull back as well, as they would not escape a broader market drawdown. But we believe the relative discounts they offer today mean that intermediate- to longer-term investors will be rewarded for staying with them, even through bouts of near-term volatility.

That is where bonds come in. Despite fears to the contrary, bonds continue to do exactly what we believed they would as concerns about growth and AI weighed on equity markets, with the 10-year Treasury yield falling from its 5.3 percent peak on October 5, right before AI worries began to grow, to 4.93 percent to end the week. In the near term, we believe they would likely help cushion the blow of a broader pullback, making it easier for investors to hold on to the segments we believe offer the better long-term opportunity.

Sometimes the best lessons are the simplest ones, and right now, the market is offering a good old-fashioned lesson on the benefits of diversification. Stay invested, stay diversified, and stick to your financial plan.

Wall Street wrap

Third-quarter growth highlights the impact of AI investment

The first reading of third-quarter GDP showed that the economy grew at a 3.4 percent annualized pace after 2.2 percent in the second quarter. Nominal GDP rose 5.6 percent, with the GDP deflator up 2.3 percent. Consumer spending remained strong, rising 3.8 percent (equal to the second quarter’s 3.8 percent) and contributing 2.52 percentage points to growth. Business investment was an even bigger standout, rising 12.7 percent, the most since 2020, and contributing 1.78 percentage points to GDP, its largest contribution since 2011 outside the pandemic. AI-related investment helped drive the increase, with equipment spending up 20.9 percent and contributing 1.16 percentage points, led by a 37.4 percent increase in information processing equipment and a 66.7 percent rise in computers and peripherals. Intellectual property products rose 8.4 percent and contributed another 0.47 percentage points.

Elsewhere, residential investment fell 3.3 percent and subtracted 0.12 percentage points, inventories contributed 1.61 percentage points, and government contributed 0.9 percentage points. Final spending by private domestic purchasers rose 4.9 percent. Meanwhile, net exports subtracted 3.3 percentage points from growth amid a surge in imports, including data center equipment, and likely efforts to bring in goods ahead of potentially more tariffs.

Inflation remains stuck around 3 percent

PCE inflation rose 0.5 percent and was up 3.6 percent from a year ago, compared with 3.5 percent previously and in line with expectations. Core PCE rose 0.32 percent, while last month’s 0.2 percent increase was revised up to 0.3 percent (0.262), bringing the year-over-year pace to 3.1 percent. The three- and six-month annualized paces of core PCE are both 2.9 percent, while the nine-month pace stands at 3.3 percent. Put simply, inflation remains stuck around 3 percent. The underlying data reinforced that message. Goods prices rose 0.8 percent for the second month in a row after increasing 0.35 percent and are now up 3.95 percent from a year ago. Services prices increased 0.35 percent after rising 0.31 percent and are up 3.5 percent year over year. So-called supercore inflation, which excludes shelter, rose 0.37 percent after 0.38 percent the prior month and is now up 3.63 percent from a year ago.

Consumers keep spending even as income comes under pressure

Personal income rose 0.2 percent in September after increasing 0.3 percent the prior month, but inflation continued to eat into those gains. Real disposable personal income fell 0.3 percent after being flat previously, marking its first negative reading since April, and is up just 1 percent from a year ago, its lowest year-over-year pace since 0.2 percent in April. Personal spending rose 0.5 percent after 0.3 percent a month ago, but real personal spending was unchanged, as inflation also rose 0.5 percent. Meanwhile, the savings rate stood at 3.8 percent, its lowest level since the end of 2022. Put simply, consumers remain willing to spend, but income growth is struggling to keep up with inflation, leaving households increasingly reliant on savings to support that spending.

Consumer confidence rebounds as views of the job market improve

The Conference Board Consumer Confidence Index rose for the first time in four months, climbing to 91.7 after last month’s 81.9 reading was revised to 84.2. The Present Situation Index rose sharply to 120.4 compared with the prior month’s reading, revised from 109.3 to 111.8. The Expectations Index increased to 72.6 from 65.7, which had initially been reported at 63.6. While the improvement is encouraging, confidence is still at its highest level only since June. Inflation expectations eased to 5.8 from 6, while the labor differential improved to 5.3 from 2.9. The share saying jobs were plentiful rose to 26.7 from 24.3, its highest since April, while those saying jobs were hard to get remained at 21.4. Income expectations improved to 6.7 from 3.2. Views of business conditions also strengthened, with those describing present conditions as good rising to 21.4 from 18.8 and expectations for conditions six months from now increasing to 17.7 from 16.5, although that reading remains low.

Durable-goods data points to continued strength in business investment

Durable-goods orders rose 1.8 percent overall versus expectations of 1.9 percent. Excluding transportation, orders increased 0.5 percent versus expectations of 0.6 percent, while last month’s reading was revised up to 0.3 percent from 0.2 percent. Orders for nondefense capital goods excluding aircraft, a proxy for business fixed investment, rose 0.5 percent versus expectations of 0.6 percent following a strong 1.6 percent increase in August. On a year-over-year basis, orders are up 13.7 percent, while the three-month annualized average is up 15.1 percent. While that represents some deceleration, the pace remains strong. Shipments rose 1.2 percent versus expectations of 0.8 percent, and last month’s 0.5 percent gain was revised to 0.6 percent. Shipments are up 11.2 percent, with the strong pace suggesting that new orders are increasingly moving out the door. Third-quarter shipments rose at a 16.5 percent annualized pace and will provide a boost to GDP.

AI investment helps push the trade deficit higher

The trade deficit rose to $134.9 billion, its largest since March 2025, as imports increased 2.4 percent; exports rose 2.6 percent. Capital-goods imports, which include much of the equipment associated with AI investment, jumped 7.5 percent to a new record. The capital-goods deficit stands at $84.09 billion compared with $29.791 billion a year ago, an increase of 77 percent. Consumer-goods imports rose 3.1 percent in September but remain 12 percent lower than a year ago, at $37 billion versus $42 billion. Overall imports increased from $268.435 billion last year to $344.148 billion this year, up 28.2 percent, while exports increased from $185.7 billion to $209.24 billion, a rise of 12.7 percent. U.S. tariffs as a percentage of imports stand at 7.3 percent.

The week ahead

Monday: The week begins with several reports on the manufacturing and construction sectors. S&P Global’s final October manufacturing Purchasing Managers’ Index (PMI) reading is scheduled for release at 9:45 a.m. ET, followed by the Institute for Supply Management (ISM) Manufacturing Index and September Construction Spending at 10:00 a.m. ET. We will be watching the manufacturing data for signs of whether business activity remains resilient and, importantly, whether price pressures are continuing to run hot.

Tuesday: September’s Job Openings and Labor Turnover Survey (JOLTS) is scheduled for release at 10:00 a.m. ET, along with September Factory Orders. We will be watching JOLTS for signs of whether labor demand remains balanced or is beginning to soften, including changes in job openings, hirings, and quits. The report should provide another important piece of the labor market picture ahead of Friday’s employment report.

Wednesday: October ADP employment data is scheduled for release at 8:15 a.m. ET, followed by September international trade data at 8:30 a.m. ET. Final October services PMI is due at 9:45 a.m. ET, with the ISM Services Index following at 10:00 a.m. ET. The Energy Information Administration’s weekly petroleum report is scheduled for 10:30 a.m. ET. We will be paying particular attention to the services data for signs of whether activity remains strong and whether businesses continue to face elevated price pressures.

Thursday: Third-quarter productivity and unit labor costs and weekly Initial Jobless Claims are scheduled for release at 8:30 a.m. ET. We will be watching jobless claims for a timely read on layoffs and broader labor market conditions ahead of Friday’s employment report. Productivity and labor costs should also provide additional perspective on how wage pressures are translating into businesses’ costs and the inflation outlook.

Friday: The October employment report is scheduled for release at 8:30 a.m. ET and will likely be the key economic report of the week. The report includes nonfarm payrolls, the unemployment rate, average hourly earnings, and average weekly hours. We will be watching particularly closely for signs of whether hiring is holding up and whether wage growth remains consistent with continued inflation pressures. With the Federal Reserve keeping rates unchanged last week, the report should provide an important piece of the economic picture as policymakers weigh a labor market that has remained relatively balanced against inflation that continues to run above the Fed’s 2 percent goal.

Frequently Asked Questions

Why are bond yields falling when the economy is growing strongly?

Bond investors weigh future growth as well as current economic strength. Although third-quarter growth was resilient, concerns about AI spending and technology earnings raised questions about the outlook. The 10-year Treasury yield fell from 5.3 percent on October 5 to 4.93 percent at the end of the week. Bonds may help cushion a broader equity pullback, although that protection is not guaranteed.

Why are investors questioning AI spending?

Investors are questioning whether the profits from AI will justify the growing cost of its infrastructure. Alphabet and Amazon reported negative free cash flow for a second consecutive quarter, while major technology companies turned to loans, bonds, and equity financing to support investment. Greater reliance on outside financing makes the buildout more sensitive to interest rates and credit conditions. AI may still benefit the economy, but its eventual winners and the timing of returns remain uncertain.

Why did some stocks rise while the S&P 500 fell?

The S&P 500 gives larger companies greater weight, so losses in heavily weighted technology stocks can outweigh gains elsewhere. During the week, 70 percent of its stocks outperformed the index, and the equal-weighted S&P 500 rose 0.8 percent. Small- and mid-cap stocks and real estate investment trusts also advanced. That rotation highlights the value of looking beyond headline indexes, but these segments would still be vulnerable to a broader market decline.

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