Strong US growth leaves the Fed with difficult choices

The US economy continues to show remarkable resilience, although the latest figures suggest that the strength of the recovery is not being felt evenly.

Third-quarter GDP expanded at an annualised 3.4%, beating expectations as consumer spending, investment and government expenditure supported activity. It was another reminder that higher borrowing costs have yet to produce the broad slowdown many economists had anticipated.

Look beneath the headline, however, and the picture becomes less reassuring. Consumer spending rose 0.5% in nominal terms during September, but virtually all of that increase was absorbed by higher prices. In real terms, spending was effectively unchanged. Headline PCE inflation reached 3.6% annually, with a monthly increase of 0.5%, while core inflation stood at 3.1% annually and 0.3% for the month. Real disposable income declined 0.3%, leaving the household saving rate at just 3.8%.

There is an important distinction here. The economy is growing strongly, helped in part by investment, but households are not necessarily enjoying the benefits. Consumers are spending more without getting much more for their money.

That leaves the Federal Reserve in an uncomfortable position. Growth remains robust enough to justify tighter policy, yet the pressure on household purchasing power raises questions about how much further the economy can be pushed.

The Fed left interest rates unchanged at 3.75% to 4.00%, as widely expected. Nevertheless, the 10–2 vote revealed a more hawkish committee than the headline decision suggested. Governor Lisa Cook and Cleveland Fed President Beth Hammack both favoured an immediate quarter-point increase.

Chair Kevin Warsh acknowledged that improving productivity could allow the economy to expand more quickly without generating excessive inflation. Even so, he offered little reassurance that the tightening cycle was over. Markets are now assigning roughly a 72% probability to a December increase, compared with around 80% immediately after the decision. Investors still expect the Fed to move, although the recent weakness in equities has introduced an additional complication. If falling share prices begin to tighten financial conditions more broadly, the central bank may have less reason to act aggressively.

AI enthusiasm meets the reality of cash flow

For much of the past two years, investors have been prepared to reward companies for their exposure to artificial intelligence and their willingness to invest heavily in its development. But that willingness is beginning to wear thin.

The latest technology earnings offered little reason to doubt the strength of underlying AI demand. What they did raise, however, were fresh questions about how much companies must spend to capture that demand and, more importantly, when shareholders can expect a meaningful return.

Alphabet illustrated the dilemma. Cloud revenue more than doubled to $30.71 billion, an impressive performance by almost any measure. Yet weaker search advertising, a 25% decline in attributable net income and mounting pressure on cash flow overshadowed the achievement. Adjusted earnings of $2.67 per share also fell short of the $3.02 expected by analysts.

Microsoft delivered a more convincing balance between cloud growth and cash generation. Amazon, meanwhile, unsettled investors with disappointing sales guidance and plans for further investment.

The scale of the spending is becoming difficult to ignore. The five largest hyperscalers are expected to invest approximately $800 billion this year, with that figure potentially reaching $1.2 trillion in 2027. These are extraordinary amounts of capital, even for companies with substantial financial resources.

The question is no longer simply whether AI will transform the economy. Increasingly, it is whether the returns from that transformation will arrive quickly enough to justify the investment required today.

The shift in sentiment has been reflected in equity markets.

The NAS100 fell 2.09% over the week, while the SPX500 declined 0.64% and the US30 lost 0.92%. The US2000, by contrast, advanced 1.27%, suggesting that investors were not abandoning equities altogether. Rather, they were becoming more selective about where they were prepared to take risk.

Friday brought particularly heavy selling. The NAS100 dropped 2.27%, while Intel plunged almost 29% after issuing disappointing profit guidance.

October proved especially painful for technology investors. The NAS100 lost almost 7%, its weakest monthly performance since April 2025, and more than $2 trillion was wiped from its market value.

There is a broader message in these declines. For some time, investors have been willing to look several years into the future when valuing AI-related businesses. They are now paying closer attention to what those ambitions cost in the present.

AI may still deliver on its considerable promise. The market is simply becoming less willing to pay any price for that possibility.

Central banks pause, but the pressure to tighten remains

The Federal Reserve was not alone in keeping interest rates unchanged last week. The European Central Bank and Bank of Japan also held their respective policy rates steady. Yet across all three institutions, the message was much the same. Inflation remains a concern, and further tightening is still on the table.

The ECB maintained its deposit rate at 2.50%, with President Christine Lagarde highlighting the renewed inflationary threat from expensive energy.

December remains a genuine possibility for another increase. Three policymakers subsequently told Reuters that a quarter-point move to 2.75% was highly likely unless energy prices fell sharply. They also suggested that the ECB could pause thereafter, allowing higher bond yields to do some of the work of restraining demand.

The difficulty is that the eurozone is far from economically uniform. Third-quarter growth surprised positively overall, but the differences between countries remain striking. Germany expanded 0.2%, ahead of expectations for 0.1%, while Spain and the Netherlands each recorded growth of 0.6%. Italy stagnated and France contracted 0.1%.

For the ECB, this creates an awkward balancing act. Higher rates may be necessary to contain inflation across the currency union, but they will inevitably place greater pressure on economies already struggling to generate meaningful growth.

Japan faces a different challenge, although the direction of policy is becoming clearer. The Bank of Japan kept its policy rate at 1.25%, with an 8–1 vote. Board member Hajime Takata favoured an immediate increase to 1.50%.

The central bank also raised its inflation outlook and indicated that another increase could arrive as early as December. Plans to accelerate sales of its exchange-traded-fund holdings from January added to the sense that monetary conditions are gradually becoming less accommodative.

Perhaps the most significant change is how investors now view Japanese monetary policy. Interest rate increases are no longer treated as unusual events. They have become credible possibilities at successive meetings, marking a considerable departure from the monetary environment that defined Japan for decades.

Falling bond yields offer only limited reassurance

US Treasury yields declined last week, providing some relief to financial markets after a difficult period for equities. The benchmark ten-year yield ended the week near 4.94%, approximately six basis points lower. That is comfortably below October's peak of 5.36%.

Ordinarily, falling bond yields might be welcomed as evidence that inflation pressures are easing and the interest rate outlook is becoming more favourable. That is not quite what happened here.

Inflation remains stubbornly high, and markets continue to expect another Fed increase in December. Instead, the Treasury rally appears to have been driven largely by demand for safer assets as technology shares came under pressure. Investors also appear to be considering whether a sustained equity correction could eventually reduce the need for further monetary tightening.

The distinction matters. Lower yields resulting from improving inflation would support both company valuations and the outlook for consumer spending. Lower yields driven by concerns over corporate profitability and financial conditions offer considerably less reassurance.

Foreign exchange markets were comparatively subdued. The euro traded near $1.117 today, while the dollar remained around ¥157.75 against the yen. Strong US growth has provided less support for the greenback than might otherwise have been expected, partly because Treasury yields have retreated and both the ECB and BOJ have kept the possibility of December tightening alive.

For now, the dollar is caught between the relative strength of the US economy and the increasingly hawkish outlook beyond its borders.

Oil prices ease, but the underlying threat remains

Energy markets continue to reflect the uneasy geopolitical backdrop. UKOil surged 14.6% during October as attacks on Gulf shipping and fears of further regional escalation pushed prices sharply higher.

Monday brought some relief. UKOil fell to approximately $110.05 a barrel, while USOil declined to around $100.65. Continued discussions involving Iranian and Qatari officials raised hopes that regional tensions might ease.

The decline is welcome, but it would be premature to interpret it as a decisive improvement. Attacks on tankers have continued, and crude prices remain elevated enough to place significant pressure on transport costs, business margins and household purchasing power.

That matters particularly at a time when central banks are already struggling to bring inflation under control. A sustained energy shock would make their task considerably more difficult, especially in Europe and other economies heavily exposed to imported fuel.

Gold, meanwhile, recovered to approximately $3,906 today after declining 6.83% during October. Its weakness has been somewhat surprising given the combination of geopolitical uncertainty and falling equity prices. Elevated real yields appear to have weighed on demand, while reports of forced selling to meet margin requirements may also help explain the decline.

The week ahead

Investors face another busy week, with several developments likely to shape expectations for interest rates and the direction of equity markets. Friday's US employment report will be particularly important.

Economists expect approximately 65,000 new jobs, with the unemployment rate holding at 4.2%. A weaker-than-expected reading could challenge expectations for another Fed increase in December. A stronger report would reinforce the argument that the US economy remains resilient enough to withstand further tightening.

The Bank of England is also expected to raise interest rates this week, while the US Treasury's quarterly refunding announcement will provide a fresh test of investor appetite for substantial government borrowing.

In Europe, incoming inflation figures could strengthen or weaken the case for another ECB increase before year-end.

Corporate earnings will remain just as important as economic data. Apple's results offer an interesting contrast with those of the major hyperscalers. The company's comparatively restrained approach to data-centre investment has helped it stand apart during the recent technology sell-off.

If Apple can demonstrate healthy demand and solid cash generation without committing to the same enormous capital expenditure programmes, it may reinforce a preference that has become increasingly apparent in the market. Investors are still prepared to reward growth. They are simply becoming much more interested in how much of that growth ultimately translates into cash.

Final thought

The global economy continues to show resilience, and there is little doubt that artificial intelligence holds enormous potential. But investors are beginning to draw a sharper distinction between a compelling story and a profitable investment. Growth and ambition still matter. Increasingly, however, it is the ability to turn both into sustainable returns that will determine which companies emerge stronger from the next stage of the cycle.

Sources & References

• reuters.com
• reuters.com
• investing.com
• investing.com
• ec.europa.eu
• ecb.europa.eu
• federalreserve.gov
• bea.gov
• bea.gov