Last week, I outlined the case for fiscal dominance (see
Will the Next Fed Chair Matter Much to Policy?). U.S. debt to GDP is rising and not stabilizing. In all likelihood, the Fed will follow the path of the BoJ of cutting short rates, restarting quantitative easing and yield curve control to suppress long rates, which would put upward pressure on inflation and downward pressure on the USD. For investors, the best hedge for inflation-adjusted returns will be equities — global equities.
One U.S. based reader asked for greater guidance to regional equity allocation. I replied that, that, when considering long-term investment policy, a passive allocation to global equities would be appropriate as it’s difficult to forecast the long-term outlook for different regional economies in the future.
I would now add that, as an active strategy, investors adopt a barbell allocation in the equity portion of their portfolio to U.S. large-cap growth and non-U.S. value stocks. The top panel of the accompanying chart shows that the U.S. and non-U.S. value and growth cycle tracked each other closely until early 2023 when they bifurcated. Growth outperformed in the U.S., while value began a steady multi-year uptrend.
My active strategy is based on the principle that “the trend is your friend”.
The bottom panel shows the relative performance of the two barbell portions of the allocation. U.S. growth is leading the MSCI All-Country World Index (ACWI) benchmark, mainly because U.S. equities have been on a tear against global equities since the GFC. Outside the U.S., EAFE value stocks have been flat against ACWI since mid-2020.
The bifurcate of growth and value relationship is additional evidence of American Exceptionalism in equity performance, which is mainly based on the promise of gains from artificial intelligence. For investors, the key question is how long AI will dominate American equity returns.
American Exceptionalism Visualized
The accompanying chart demonstrates the fundamentals of American Exceptionalism in the U.S. market. S&P 500 forward EPS estimates have been rising steadily since mid 2022, and the gains are mainly attributable to the Magnificent Seven and AI in particular. By contrast, small and mid-cap stocks have been undergoing an earnings recession. The mid-cap S&P 400 EPS estimates only rose modestly, and the small-cap S&P 600 estimates are flat to down.
AI-related capital expenditure has been unreal and it’s unprecedented from a historical viewpoint. Callie Cox pointed out that AI-related GDP growth dwarfed consumer growth in Q2.
The Longevity of AI Dominance
Here are some key questions for investors. How long can this trend of AI economic dominance last? Can AI save the economy if the consumer were to falter?
The U.S. economic growth outlook is teetering. New Deal democrat, who monitors the economy using a series of coincident, short-leading, and long-leading indicators, is on “recession watch”, which is an indication of elevated risk and not an explicit recession forecast. The last straw for him was the weakness in ISM manufacturing and services.
Mark Zandi of Moody’s Analytics also warned that the economy is on the precipice of recession: “Consumer spending has flatlined, construction and manufacturing are contracting, and employment is set to fall. And with inflation on the rise, it is tough for the Fed to come to the rescue.” He went on to cite the weak employment picture, tariff headwinds, and the immigration crackdown as his reasoning.
Callie Cox also provided some sense of scale of the relative sizes of the AI and regular economy. Big tech headcount growth has been roughly flat during the 2022-2024 period, while capital expenditures were strong.
If the U.S. economy falls into recession, Cox concluded that AI-related growth won’t save the economy:
You can’t just brush off the human economy’s issues right now. Consumers are too influential to ignore, and recessions have been powerful forces of nature. And even though AI is a compelling story that can’t be wiped away with one crisis, it’s hard to think it’ll single-handedly save us from the sway of 300 million wallets.
To be sure, in a slow growth or no growth environment, investors tend to bid up growth stocks for their scarcity value. The key question is how a U.S. recession affects the rest of the world, as the effects of Trump’s trade policy has been to ring-fence the U.S. economy from her trading partners (see
The Trade War is Dead! Long Live the Trade War!).
Putting all together, I am not disputing the value of the AI revolution. The key question is the magnitude of the impact of AI on productivity and growth. Bob Elliott of Unlimited Funds estimated the GDP growth impact of AI for the next few years, and the effects are relatively modest. In reality, estimates of productivity growth from new technologies like AI are little more than guesses. The error term around estimates are very high relative to the level of the estimate itself.
Another question is how the benefits are shared. The U.S. economy has gone through a series of productivity booms. But markets are forward-looking and can correct investment excesses. The last major productivity boom which was driven by the internet, saw productivity gains well after the top of the Tech Bubble in 2000. Much of the gains accrued to the users of the internet, even as the share prices of internet darlings of the late 1990’s faded.
In all likelihood, the gains from the AI revolution will follow a similar pattern. Many of the benefits will be distributed to participants other than NVIDIA and the hyperscalers. This calls into the question of the longevity of the U.S. growth leadership.
The timing and the nature of the inflection point is anyone’s guess. For now, the trend remains your friend. That’s why I am calling for an active barbell allocation strategy between U.S. large cap growth and non-U.S. value. If U.S. growth stocks were to stumble, I would expect non-U.S. value stocks to benefit and outperform ACWI as investors rotate from growth to value.From a tactical perspective, AI-related enthusiasm may already be topping out. The performance of the Magnificent Seven is roughly flat relative to the S&P 500 in 2025. Leadership, what leadership?
In conclusion, I believe global equity investors should adopt a barbell strategy of overweighting U.S. large cap growth and non-U.S. value stocks in their global equity portfolios. Both are undergoing multi-year uptrends in relative performance. The key question is the length and sustainability of U.S. AI leadership. While I have raised some doubts about the investment thesis behind AI, the trend is your friend, at least for now.
