Six Questions That Keep Markets Guessing

Markets have been stagnant since mid-August, despite the majority of U.S. companies reporting outstanding earnings growth. Investors are increasingly focused on several key questions:

1. Is the new Federal Reserve Chair, Kevin Warsh, committed to achieving the 2% inflation target, and does that imply higher interest rates over the coming months?
2. What will be the implications of the upcoming midterm elections?
3. Does the U.S. government have too much debt, and will borrowing costs, as reflected in Treasury yields, continue to rise?
4. Will the ongoing conflict between the U.S. and Iran lead to persistently higher input and energy costs?
5. Is the building of artificial intelligence (AI) destined to fail eventually?
6. Will the Canadian economy suffer as tension with the United States escalates?

Rate hikes or cuts: By traditional metrics such as inflation, corporate profit margins, unemployment and credit spreads, the U.S. economy continues to run somewhat hotter than expected. In that context, a modest rate hike by the Federal Reserve would be reasonable. Markets are currently pricing in better than a 50% probability of a 25-basis-point rate hike in September. A single 25-basis-point increase is unlikely to meaningfully affect corporate investment or consumer spending, and even an additional hike of the same magnitude would probably have only a limited impact. This means certainty of a hike could be a better outcome than a lingering uncertainty, at least for the equity markets.

Midterm elections: The midterm elections remain a wildcard. Given already elevated government debt levels and rising interest expenses, it seems unlikely that U.S. President Trump could significantly expand fiscal spending or tax cuts. However, his administration may continue to take a more confrontational stance toward political opponents and trading partners, including close allies such as Canada.

Sovereign debt and rising yields: With respect to the broader issue of sovereign debt, investors have largely chosen to overlook the problem for years. Debt levels are clearly elevated and would take considerable time to reduce, even with a strong political commitment to fiscal discipline. Governments retain the ability to tax and issue currency, which reduces the market's willingness to impose meaningful discipline on excessive borrowing. That said, investor attitudes may be changing gradually, as reflected in the steady rise in bond yields since 2024, following the end of the most recent rate-hiking cycle.

Geopolitics: The worst-case scenario would be for geopolitical conflicts to persist and become a "new normal." As long as businesses continue to invest and households remain willing to absorb somewhat higher prices, the economic impact should remain manageable and the investment implications may be limited.

Artificial intelligence (AI): For those who have used AI, whether through large language models such as ChatGPT or increasingly sophisticated AI agents, the productivity gains are already proving to be substantial. As a result, AI is likely to become a permanent part of the toolkit for businesses and individuals alike.

Every major technological innovation requires investors to make a judgment about the future, often before there is sufficient history to validate its long-term impact. At its core, investing in AI is a bet on human ingenuity and our ability to create new applications, efficiencies and business models. While the path forward may not be linear, we are optimistic that AI will be a powerful driver of economic growth and productivity in the years ahead.

There will undoubtedly be challenges as companies work to refine business models, improve adoption and generate sustainable profitability. Investors should therefore approach AI with a long-term perspective and expect periods of volatility and occasional setbacks. However, those risks are balanced by the potential for higher long-term returns.

Ultimately, these concerns will take time to work through the system and may periodically flare up. However, provided corporate earnings continue to support the economic outlook, investor anxieties should gradually ease.

Canada: Closer to home, Canada recently reported strong gross domestic product (GDP) growth, supported in part by higher commodity prices and increased exports. If commodity prices remain firm, it is possible that Canada's resource sectors could undergo a positive re-rating by global investors. U.S. President Trump is often viewed unfavorably in Canada due to tariffs and trade-related tensions. However, his administration's more aggressive stance toward Iran has also unintentionally contributed to higher energy and commodity prices, which have been beneficial for parts of Canada's resource sector. As a result, while some policies have created challenges for the Canadian economy, others have provided support for Canadian commodity producers and exporters.