- Fed delivered first rate hike since 2023 amid simmering concerns on how the US-Iran conflict and AI capex boom could impact domestic inflation
- Rising yields are negative for equities as higher cost of capital translates to topline weakness and higher financing costs
- In the current cycle, negative impact from rising yields is offset by robust corporate earnings as sustained AI capex leads to broader adoption and structural margin expansion
- Equities historically struggled around the start of a rate hiking cycle; but subsequent 12-month returns averaged c.10%
- Look beyond the near-term gyrations and seek opportunities in US technology, energy, and financials
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Defiance: Fed inflation fighters strike back. The FOMC committee has unanimously raised the Fed Funds rate by 25 bps as persistent inflation keeps price stability firmly in focus. Despite Trump’s demands for lower policy rates, Fed Chair Kevin Warsh delivered the first rate hike since 2023, with at least one more hike planned this year. This hawkish shift reflects simmering concerns on how the US-Iran conflict and AI capex boom could impact domestic inflation in the US. On the flipside, it also reflects strong confidence in the US economy and its ability to absorb tighter financial conditions.
Tug-of-war: Rising yields vs earnings strength. Based on conventional wisdom, rising yields are negative for equities as higher cost of capital translates to topline weakness and higher financing costs. From a dividend discount model standpoint, the terminal value typically accounts for the bulk of a company’s intrinsic value, which explains why longer-term bond yields have a greater impact on equity valuation than short-term yields. Currently, both short- and long-term yields are on the rise. But thanks to the AI capex cycle, the negative impact of rising yields is offset by robust corporate earnings.
In the 2Q26 US earnings season, c.88% reported positive earnings surprises, and this is partly attributed to productivity gains from accelerating enterprise AI adoption. This is reaffirmed by the US Census Bureau’s Business Trends and Outlook Survey, which shows broad-based AI adoption, particularly among large firms. We expect sustained AI capex to drive broader adoption, unlocking productivity gains and driving structural margin expansion.
Impact from Fed monetary tightening: A non-event. Based on our tracking of past policy tightening episodes since the 90s, equities have historically struggled around the start of a rate hiking cycle, generating an average 3-month return of c.-2% across the past six cycles. However, subsequent 12-month returns averaged c.10% with gains observed in every cycle (with the exception of 2022). Barring any acute spike in inflation, we believe this tightening cycle will be no different. Investors are advised to look beyond near-term gyrations and seek opportunities in:
- Technology: Technology, particularly AI infrastructure plays, remains well positioned to capture the accelerating AI capex cycle. Beyond hyperscalers’ investments, accelerating AI adoption across enterprises should provide the next leg of structural growth.
- Financials: Banks are positioned for positive earnings momentum, supported by improving net interest margins in a higher-interest-rate environment and stronger capital markets activity (both beneficiaries of the sustained AI capex boom).
- Energy: With Brent crude breaching USD100/bbl amid escalating US-Iran tensions, the US energy sector, particularly integrated oil majors, is well positioned to capture the upside from higher oil prices which translate to margin expansion and stronger revenue growth.
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