Balancing AI optimism with economic realities

Author: Janet Mui, Head of Market Analysis

The second quarter highlighted two powerful forces shaping markets: the continued acceleration of AI investment, and a macroeconomic backdrop still constrained by inflation, interest rates and fiscal realities.

Recent developments in the Middle East and political change in the UK are important through that same lens. Energy prices feed directly into inflation and monetary policy. Meanwhile, leadership transitions in Westminster are a reminder that governments ultimately operate within hard economic limits.

Our outlook remains broadly constructive. Economic growth continues to hold up, corporate earnings remain resilient and the AI investment cycle has further to run. But investors should not lose sight of the constraints imposed by inflation, interest rates and government finances: they may not dominate every headline, but they continue to shape the investment environment.

AI: Strong momentum, high expectations

AI remains the dominant force in markets today and the scale of investment continues to be extraordinary. The world’s largest technology companies are spending hundreds of billions of dollars on data centres, chips and AI infrastructure, with little sign of slowing. Increasingly, these investments are being viewed not as optional growth projects, but as necessary spending to remain competitive.

There’s growing evidence that AI adoption is translating into commercial outcomes. AI-related revenues continue to accelerate, demand for computing power remains exceptionally strong and investors remain willing to back such significant capital expenditure as a result.

For now, this remains a powerful tailwind for both corporate earnings and economic growth. However, the discussion is shifting from opportunity to expectations, and that matters.

The expectation that AI will deliver better productivity, economic growth and corporate profits may well prove correct, but it leaves less room for disappointment. Valuations across parts of the AI ecosystem are elevated while some economic indicators are becoming less supportive. U.S. job growth has slowed, real household income growth has turned negative, and corporate profits as a percentage of GDP remain near historic highs. This limits the scope for further expansion without squeezing workers’ share of income, something that would be politically difficult to achieve.

Investors are also beginning to ask harder questions:

• Can the industry generate sufficient returns to justify the enormous levels of capital spending?
• How much additional capital will companies need to raise over the coming years?
• Which existing business models stand to benefit as AI capabilities improve – and which face disruption?

These questions do not undermine our constructive long-term view. We believe AI represents one of the most important technological shifts of our generation, and the investment cycle has further to run. But the next phase is unlikely to be as straightforward as the last. Strong returns remain achievable; investors should expect periods of volatility as markets weigh enormous opportunities against increasingly high expectations.

The answer is not to reduce AI exposure but to avoid over-concentration in a single theme. Diversification remains important, particularly when enthusiasm around one area of the market becomes this dominant.

Middle East tensions ease but the inflation battle continues

Earlier conflict between the U.S. and Iran has moved in a more constructive direction.

Oil prices have fallen significantly from their peaks, traffic through the Strait of Hormuz is recovering, albeit lightly, and Gulf producers stand ready to increase supply if needed. Together, these developments have reduced the risk of the prolonged energy shock that many investors feared a few months ago.

Markets will likely remain sensitive to regional developments, and full normalisation of energy markets may take time. But the worst-case scenarios that dominated discussion earlier in the year now appear less likely.

For investors, the more important question is what this means for inflation and monetary policy. Lower oil prices are welcome, but they don’t fundamentally change the broader picture. Under new Federal Reserve (the Fed) Chair Kevin Warsh, it’s adopted a notably hawkish tone, revising up its inflation forecasts and signalling that interest rates are likely to remain elevated.

In his first press conference, Warsh emphasised the priority of preventing inflation from becoming embedded through wages, expectations and corporate pricing behaviour. Markets have consequently shifted from pricing in rate cuts to rate rises. Ultimately, rates are likely to remain higher for longer.

Against this backdrop, we’ve reduced our modest overweight position in gold to neutral. The long-term case for gold remains intact, supported by central bank purchases, reserve diversification and its role as a portfolio diversifier. However, a more hawkish Fed and higher real yields suggest a less favourable environment.

UK political change meets fiscal reality

Andy Burnham is widely viewed as the frontrunner to become the country’s next prime minister, with betting markets assigning a high probability to his success – though the leadership process still has some way to run.

For investors, the key question is whether a change in leadership would shift economic policy meaningfully. Burnham is generally viewed as more interventionist than Sir Keir Starmer, raising the prospect of greater public investment, industrial strategy and regional development initiatives. For investors, the more tangible question is what an interventionist approach might mean in practice. A re-examination of the tax framework could be on the table – equalising capital gains and income tax rates, for example, is a measure that has attracted attention and would have a direct bearing on investment returns. The jury is out, and we’ll be watching closely. The Autumn Budget will be a telling moment.

Whatever the instincts and ambitions of the next prime minister, any government inherits the same fiscal constraints.

The experience of 2022 remains a powerful reminder that financial markets can quickly challenge policies perceived as fiscally unsustainable. The UK’s fiscal framework, the Office for Budget Responsibility and the independence of the Bank of England (BoE) continue to act as important anchors of market confidence. In practice, the bond market often exerts more discipline on governments than political rhetoric alone would suggest.

On that front, UK government bond yields are already the highest across the G7, reflecting the premium investors demand for persistent inflation, fiscal challenges and political uncertainty.

On monetary policy, the BoE held interest rates at its latest meeting. Inflation remains above target and policymakers are alert to the risk of higher costs feeding through into wages and broader pricing behaviour. However, the labour market is softening, vacancies are falling and private-sector wage growth has slowed materially, reducing the likelihood of a more persistent inflation cycle.

The message from policymakers is one of patience, not urgency. Whatever happens at Westminster, the path for UK markets will continue to be shaped primarily by economic fundamentals, not local politics.

Looking ahead

The macro outlook remains broadly constructive, with AI a strong structural support. At the same time, inflation is proving persistent, interest rates are likely to stay elevated and governments have limited room for policy manoeuvre. These constraints may not prevent markets from moving higher, but they do argue for a more selective approach.

In an environment where technological innovation and macroeconomic realities coexist, maintaining that balance remains as important as ever.

About the author

Janet Mui

Head of Market Analysis

Janet Mui, CFA is Head of Market Analysis at RBC Brewin Dolphin and a voting member of the Asset Allocation Committee. She is part of the investment solutions team which generates central investment guidance and manages a range of risk-rated portfolios.

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