ROI-US economy is overstimulated — and bond markets fear it: Mike Dolan

The US economy is experiencing a surge, driven by fiscal largesse, loose financial conditions, and booming business investment, but risks overheating due to near-zero real interest rates.

Despite erratic politics and global conflict, the ​U.S. economy is building a powerful head of steam — and risks overheating. Step back from the daily noise and ​the picture is clear: fiscal largesse, loose financial conditions, booming business investment and near-zero ‌real interest ​rates are all stoking the economic engine. If inflation returns to its target in that environment with no tightening of either fiscal or monetary policy, that would be extraordinary. But it also explains why stock markets are refusing to retreat in the face of wild single-stock swings, recent hedge fund stress, and gnawing doubts about whether this is the high-water mark of the AI wave. Investors pursuing "buy ‌the dip" strategies, or merely rotating portfolios across sectors, seem unwilling to raise cash. Stock markets remain close to record highs after a 50% gain in major U.S. equity indexes over the past two years, and another 10% in the first half of this year. That's buoying asset wealth for the richer cohorts of the populationwhoaccount for the bulk of the consumption that drives the economy, encouraging greater spending out of disposable income and allowing companies to pad out margins in a circular flow. Only rising bond yields appear to be a red flag.

Two big ‌numbers stood out over the past week: estimated annual profit growth accelerated to nearly 50% for S&P 500 firms through the latest quarter; and, despite an underwhelming inflation-adjusted headline number, nominal U.S. GDP clocked an annualised growth rate of almost 8% in the ‌second quarter. Although the outsized 6.3% rise in the GDP deflator — which accounts for overall inflation in the report — was largely energy-related, demand components were strong. This nominal GDP growth rate has only been topped twice over the past three years and is almost twice the 25-year average. Consumer spending surged 3.2%, while business investment in equipment raced ahead at a 15% pace.

Fuelled by an AI frenzy that's drawing more than $1 trillion in capex from the "hyperscalers" building infrastructure this year alone, annual U.S. profit growth is tracking at a whopping 47%, more than halfway through the reporting season, LSEG data shows. That's twice the rate expected just a month ago and three times the ⁠January estimate. The ​surprise stems as much from blowout quarters at major banks and Big ⁠Oil companies as from stellar technology earnings. With revenue growth running at a more modest 14%, the extent of the margin expansion is clear.

"Margins have been the driving force as they reach new highs," according to a Barclays readout of the earnings season so far, which pointed to clear strength in the technology and energy ⁠sectors, as well as in materials and consumer staples. TRILLION AFTER TRILLION

Several factors are colliding. Stephen Jen and Fatih Yilmaz at Eurizon SLJ reckon that the sort of "demand destruction" that expensive energy and high inflation would normally cause isn't happening to temper prices this time. Consumers appear far less price-sensitive than ​in the past. They blame the scale of fiscal spending still in the system, which shows no sign of being reversed, and posit a "fiscal stimulus-price spiral" rather than the traditional "wage-price spiral" of past cycles.

Underlining their thesis, the note says ⁠that while AI-related capex is topping $1 trillion, the federal government is running budget deficits of more than $2 trillion a year. Those deficits were further increased by last year's fiscal bill of tax cuts and additional spending, with similar deficits forecast through the next decade. "Huge and persistent transfers through the government have sustained aggregate demand in the U.S., preventing ⁠the ​demand curve from staying flat and giving corporations and producers greater pricing power. These variables are all linked; the causality goes from fiscal stimulus to greater pricing power, to inflation, we think," they concluded.

Of course, there is another loop too. High and rising equities and real estate prices allow the top 25% of earners to spend even more. Their asset wealth allows them to keep buying regardless of 3% to 4% inflation or gas-price volatility. Their collective spending power lets companies keep expanding margins, while the resulting earnings and stock-price ⁠windfall further boost equity wealth among richer households. The obvious question is: where does it end? To the extent that relatively unchecked corporate pricing power is inflationary, the Federal Reserve could do quite a lot — and is far from powerless in the face of ⁠supply or capex shocks. Two quick interest-rate hikes over the remainder of ⁠the year could cool equity values, spending and margin expansion and increase the chances of tamping down inflation for asset-poor households, who suffer most from it.

If the Fed doesn't want to do it, the bond market just might. (The opinions expressed here are those of Mike Dolan, a columnist for Reuters.) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ROI ‌on LinkedIn, and X. And listen to the ‌Morning Bid daily podcast on Apple, Spotify, or the Reuters app. Subscribe to hear Reuters journalists discuss the biggest news in markets and ​finance seven days a week. (By Mike Dolan; Editing by Marguerita Choy)