As market expectations for the Federal Reserve to restart its interest rate hiking cycle intensify, and investors begin to reassess the commercial prospects of artificial intelligence (AI), a growing number of Wall Street institutions are issuing warnings about the future trajectory of risk assets.
Citadel Securities and PGIM, an asset manager overseeing $1.4 trillion, have both recently indicated that the US market is entering a more complex phase. High interest rates, persistent inflation, and pressure on AI valuations could converge, potentially increasing the challenges for US stocks significantly in the coming months.
Current Market Exhibits Traits of Both "Dot-com Bubble" and "1970s Inflation Crisis"
Nohshad Shah, Head of EMEA Fixed Income Sales at Citadel Securities, stated in a recent report that the current market environment shares some characteristics with both the 2000 dot-com bubble period and the energy-inflation crisis era of the 1970s. He pointed out a common feature of these two historical periods: persistently high interest rates.
During the dot-com bubble, the Federal Reserve's sustained monetary tightening, combined with rising oil prices and slowing economic growth, ultimately led to the tech stock bubble bursting. In the 1970s, soaring energy prices and high inflation severely constrained the Fed's ability to stimulate the economy, eventually triggering a multi-year bear market in stocks.
Shah noted, "The key historical lesson for investors is that markets are often most vulnerable when a long-term growth story remains compelling, but the macroeconomic environment begins to turn unfavorable." In his view, AI today is playing a role similar to the internet revolution of the past, while high inflation, elevated oil prices, and potential rate hike risks bear some resemblance to the macro pressures of those historical episodes.
Fed Could Hike as Early as September?
Citadel Securities believes current US economic data is prompting markets to recalibrate their monetary policy expectations. On one hand, the US labor market remains robust. On the other, while inflation has retreated from its peak, it remains notably above the Fed's long-term 2% target. Simultaneously, despite signs of easing in Middle East conflicts, oil prices remain at relatively high levels.
Shah argues these factors suggest the Federal Reserve could potentially restart its rate hikes as soon as September. "Stubborn inflation, a persistently strong jobs market, and elevated oil prices collectively increase the likelihood of the Fed raising rates again," he said.
Indeed, market expectations for the Fed's policy path have shifted significantly since the US and Israel initiated military action against Iran in late February. Before the conflict, markets widely anticipated the Fed would implement more than two rate cuts this year. Now, market pricing has pivoted towards a rate hike within the year.
AI Business Models Face Growing Scrutiny
Beyond interest rate risks, Citadel Securities believes the AI industry itself is facing new challenges. Shah cited research by his colleague Frank Flight, noting that investors are increasingly focusing on whether AI business models can justify the high valuations the market currently assigns.
Recent reports that OpenAI is studying price reductions for some of its AI services reflect, in Citadel's view, rising sensitivity among corporate clients to AI costs. If price competition intensifies in the future, the profitability of the AI sector could fall below current market expectations.
Shah stated, "Investors are reassessing whether AI applications are sufficiently broad and whether the most advanced AI models can sustain their current profitability levels over the long term." He believes that if AI revenue growth disappoints while high oil prices and high interest rates continue to tighten financial conditions, valuations of some current AI-related assets could come under pressure.
"Historical experience suggests that when investors become overly concentrated in betting on a single growth theme, a rate-hiking cycle often acts as a key catalyst for cooling the bull market," he added.
PGIM: Fed Could Implement Three Consecutive Hikes This Year
Compared to Citadel Securities, PGIM's view is more aggressive. This asset management arm of Prudential Financial recently released a mid-year outlook report suggesting the Federal Reserve could implement three consecutive rate hikes this year.
Notably, as recently as April, PGIM was still expecting the Fed to cut rates. Its stance has now shifted markedly. PGIM argues that the US economy has performed far better than market expectations. Despite the high-interest-rate environment, the economy has not fallen into recession but has instead shown considerable resilience. At the same time, the pace of inflation's decline has been significantly slower than anticipated.
The team led by Robert Tipp, PGIM's Global Head of Bonds and Chief Investment Strategist, stated, "An exceptionally strong economy and stubborn inflation require investors to rethink the future monetary policy path."
The report notes that the Federal Reserve has consistently failed over the past five years to stabilize inflation near its 2% target. Therefore, the new Fed Chair Wash may need to raise rates to re-establish market confidence in the central bank's commitment to fighting inflation.
PGIM expects the Fed to implement a total of three rate hikes during the remainder of this year. However, the firm also believes these hikes would be more "preventive" in nature. As the economy gradually cools over the next few years, the Fed is expected to implement three consecutive rate cuts in 2027, followed by another cut in 2028.
Market Has Not Fully Embraced "Consecutive Hikes" Expectation
While markets have recently shifted from rate-cut to rate-hike expectations, PGIM's view remains in the minority. Current interest rate swap markets indicate investors are pricing in roughly a 70% probability of one 25-basis-point hike this year and have fully priced in an expected hike for the first quarter of 2027. In contrast, PGIM's forecast of "three hikes" is significantly more hawkish.
Nevertheless, several institutions acknowledge that the key variables for future market direction have changed. If over the past two years investors primarily focused on the growth opportunities presented by AI, then in the coming quarters, the market may need to confront two questions simultaneously: Can AI commercialization deliver on its high-growth expectations? And will the Federal Reserve re-enter a rate-hiking cycle?
For US stocks, whose valuations are already near historical highs, the answers to these questions will likely determine the market's direction in the next phase. As Citadel Securities summarized, "When the macroeconomic environment begins to conflict with the market's hottest growth narrative, that is often precisely when investors need to be most vigilant."
Comments