Making Sense: April Market Update

Making Sense

Market Update | April 2026

Recorded on April 29, 2026

Amy: Hello, everyone. I'm Amy Thomas, and I want to welcome you to the First Citizens Market Update series. Today is Wednesday, April 29, 2026. Today, Phil Neuhart and Blake Taylor will take a deep dive into the markets and the economy.

As always, the information you're about to hear are the views and opinions of only the authors at the time of recording and should be considered for educational purposes only. This should not be considered as tax, legal or investment advice. And without further ado, I'll turn it over to Phil.

Phil: Thank you, Amy. And Blake, thank you so much for joining us with Brent out of the office today. We have a lot to cover, so let’s jump right in.

What are we going to cover today? So first, a special update—the war in the Middle East. We want to update everyone on what we're seeing in the Middle East and its impact on the economy and markets. We're going to do an economic update, everything from growth, the labor market, inflation—what that might mean for the Fed policy as well—and artificial intelligence.

Market update—want to dig into equity markets, fixed income and of course interest rates. But with that, Blake, why don't you jump into our special update on the war in the Middle East?

Blake: Well, energy supplies still remain constrained. So it was about 40 days where there was intense fighting over in the Middle East. And then when that ceasefire came in, obviously massive improvement going on in that overall geopolitical situation.

But for financial markets, what we have always been emphasizing is that this is mostly, again, for markets, an energy supply shock. So what we're showing here is the number of crude oil tankers that are passing through the Strait of Hormuz. That's that narrow channel between Iran and Oman, where about 20% of the world's oil supply floats during a normal period. That collapsed to about zero.

So even though it's been a few weeks since the ceasefire was enacted and there's been a huge amount of improvement in the military and geopolitical situation, those energy supplies still aren't moving. So what we're still tracking and what global financial markets are paying a lot of attention to is are we getting improvement here in a resumption of oil supply through that strait? That's what needs to happen before things really start to normalize.

But after about 2 months, oil prices are still high. We're at about 40% to 50% above where we were at the start of the crisis. And on the drive in this morning, I saw gasoline above $4 for the first time. However, for those first few weeks, what we saw was for about every 10% increase in the oil price, we got about a 1% decline in the S&P 500. Obviously, there's always a lot going on—the S&P 500 does not only depend on the oil price—but that was sort of the loose relationship that we saw for those 40 days.

What we've seen now is that US equities appear to have moved on, and we're now up for the year—up since the crisis began in the S&P 500—while oil prices are still up 40% to 50%. So why is that? Is that because the market doesn't care about oil prices and about commodities? Probably not. Oil prices are way up. Jet fuel, diesel, fertilizer—all of these inputs are significantly higher than they were before. And it's possible that the market has gotten a little bit complacent. However, that is not the whole story. The whole story is something you're going to cover here, Phil.

Phil: Yeah, so it's really about fundamentals. So what are we showing here? We're showing next 12-month earnings expectations from the consensus. You can see two periods that we're indexing to. First, Liberation Day tariffs last year. As a reminder, the S&P 500 sold off 19% last year, much more than it did this year during the war. And why is that? When you think about tariffs and their impact, there was real fear around earnings. We had analysts cutting earnings estimates dramatically. Look at this blue line, it dipping down and eventually recovering.

We've seen the opposite since the start of the Iran war. We've seen earnings revisions move higher. Why is that? Some of the story is AI adoption and the hyperscalers, but also remember, we have large energy companies in this country. And when the price of oil goes up, they're selling their product for more. So there is a fundamental reason why stocks have rebounded. We'll talk about this more later in the presentation, but I don't want to ignore that there is still good news in this marketplace. And when you have an S&P trading near all-time highs, there is a reason, and that's that earnings expectations are at an all-time high as well.

So what about the impacts to the economy and to the consumer? On the left side here, we are showing retail gasoline prices and diesel prices as well. Pretty amazing to see that spike in diesel prices, by the way. And this is something I hear a lot about on the road from our clients, business owners who have trucking fleets, et cetera. This is a real concern in the marketplace. So it does matter.

There is no question that when you fill up your car, it's going to be more expensive. When a gas engine that's delivering something to your house fills up, that is going to be—or diesel engine, rather—that is going to be more expensive as well. This is inflationary in the marketplace. But remember that gasoline and motor-fuel spending as a share of disposable personal income on the right side here has fallen structurally through the decades. Engines are just more efficient. We have hybrids. We have electrical vehicles.

The truth is, yes, it does matter, but we do spend less on gas as a share of our income than we did in the past. Think about how much the average person spends on childcare or education or healthcare. It is much more than what we spend on gas prices. Does it matter? Does it hurt the lower-end consumer specifically more than the higher end? It does, but it may not matter as much as it would have a few decades ago.

So let's jump into the economic update as well. To that point of what I just mentioned, if you look at 2026, this year's real GDP growth estimate from professional forecasters has come down from the peaks right before the war, right? But still it's around 2.2%. That's kind of been our trend.

Blake: Yeah. It's just solid pace.

Phil: Yeah, 2% to 2.5%. Why would it come down? Well, 70% of GDP is personal consumption. If people are spending more on gas, they aren't spending more on something else. But it is not moving into recessionary territory, as you can see on the right side.

This is professional forecasters' recession probability. It's around 25% today. Look, is that zero? It is not. Is there risk? Of course there is of a recession in the next 12 months. But it is not anywhere close to the base case. And look how much further below it is compared to recent years.

So fundamentals, again, on the earnings perspective are in place. From an economic perspective, they might have weakened to an extent but still are in place.

So how is the consumer feeling? Well, the consumer is in a pretty bad mood. We are seeing record lows in consumer sentiment. Why is this? Well, we saw a real deterioration after tariffs last year and some inflation with that. And then people really do not like it when gas prices go up. Something we talk about a lot when we meet with clients is there's very little in your life that is more in your face than the price of gas. You see it on your way to work. It is a type of inflation that we're much more aware of.

We are not as cognizant of necessarily the price of healthcare, right? That is not advertised on our way to work. So it does impact sentiment. Now, the correlation between sentiment and spending is not always very strong. In fact, it's not very statistically significant at all because what we're more concerned about is not how people are feeling, it's are they willing to spend.

So that's what we continue to watch. Spending is still okay, not great. I will point out we do have a K-shaped recovery. High-end consumers are carrying spending. Lower end are struggling, and they are the ones that are hit the most by retail sales. So the big aggregate data skews towards those higher-end consumers that are carrying us. But that's also what supports things like corporate earnings. So we do have to pay attention to that.

Blake: There's any kind of long list of reasons why households are experiencing such depressed levels of sentiment, but one of them is probably because the labor market is not actually as strong underneath the hood than it looks on the surface.

The unemployment rate has been stable for the last couple of years—actually remarkably stable—between 4% and 4.4% or so. That's lower than any kind of historical average, and something that has surprised a lot of economic analysts is the fact that the unemployment rate just kind of leveled off and did not continue rising after it came up from its bottom.

But what we're seeing is that workers are saying that it's harder to find jobs out there. The New York Fed asks a simple question every month of "What is the likelihood that if you lost your job today, you could find another one in the next 3 months?" And that percent has fallen pretty sharply, down to about 45%. So workers are telling us that the job market is not as strong out there.

A second survey corroborates this. The Conference Board asks every single month, "Are jobs plentiful, or are jobs harder to find?" And actually we're still in positive territory there, but look how sharply that's come down just over the last few years.

Now I want to draw a stark line within labor demand between hiring and layoffs. And we still think that the overall layoffs rate is quite low. We're seeing a lot of that in the headlines, particularly in the tech space, but when you look at the aggregate data, the overall layoff rate is not very high.

So what we're seeing here is a slower hiring rate. Companies are not wanting to expand their workforces. Maybe they're cutting job openings. They're not backfilling. And that is making its way through the system, but it's not quite as stark as a higher layoff rate. But if you're a new graduate, if you're looking to make a change, if you are laid off, then what these graphs are showing us is it's probably a little bit harder out there than headline numbers suggest.

Phil: And I hear this on the road. If you think 2022, consistently our business owner clients said, "I cannot find enough workers." There were shortages. We are not hearing that anymore. But at the same time, watch things like initial jobless claims, which come out every Thursday morning—still low. Continuing claims are still low.

So we have not seen that mass layoff. I think of it a little bit—it's as if the labor market has hit some sort of equilibrium. We'll talk about that more in a moment. So it's not that we have a robust, booming labor market, but we also don't have one that's deteriorating sharply. Now, we probably don't stay in equilibrium forever. So we are going to move one way or another, but that's kind of where we are today.

Blake: So workers are telling us things are a little bit tougher out there, and the wage data corroborate that as well. So what we're seeing here is after adjusting for inflation, real wage growth is actually pretty close to zero. So workers are not really pulling ahead the way that they used to.

We're showing two series here. The gold line on top is from the Bureau of Labor Statistics. That's the overall aggregate data encompassing all types of workers and all types of employers. And that one has fallen to about positive 0.5% on a year-over-year basis, but still above zero.

But if we come down to the second line, the blue line, that is actual small business wages. Looking at a payroll processor for small businesses and just looking at how those wage trends have changed, that's now fallen below zero. And small business workers on average are actually pulling in about negative 0.6% wage growth on a year-over-year basis. So small business workers are actually falling behind on an inflation-adjusted basis.

So we have labor demand that's soft, and we have wage growth that's pointing soft. So why isn't this really showing up in the headline statistics? And that is because over the last few years, we have started to learn that anemic job growth—job growth close to zero—used to be a signal of recession. That is not the case anymore.

So in the blue line here, what we're showing is that actual monthly job growth has fallen to about zero. On any given month, the number of net-new jobs—new jobs created minus those that are being lost—is basically zero. And if we take healthcare out of that, which has driven most of the gains in the job market, then that number is actually a net negative, which makes sense looking at professional services jobs, finance, technology, where we have seen a much slower rate of job growth or even declines.

But the point here is that if you look at this gold line, new research from the Federal Reserve is suggesting that the break-even job rate—the number of jobs that need to be created each month in order for the unemployment rate to stay stable—has actually fallen to about zero. So in previous times, we needed to see about 100,000 to 150,000 jobs being created in order to keep the unemployment rate flat.

Now, with changes in the population and demographic trends, that number is actually probably zero. So how could that be the case? It's probably three things. First, after 2020 we did see a lot of people leaving the labor market, particularly people who are 55 and 65 plus. So over the last few years, those people have not returned to the labor market.

But second, what was filling that gap was immigration. So for the last few years, immigration was the offset between some people leaving the labor market and not returning, keeping the labor force growth positive. That tailwind has now reversed and has become a headwind as immigration has fallen basically to zero or to below zero.

But third, and maybe most troublingly, is that the population is just not growing the way that it used to. And that's what we're showing on this graph here, is the contribution to overall population growth broken between what we call native-born population growth—just organic birth and death in the population—and then second, net migration—the number of people coming in in excess of those leaving.

And if you look at these blue bars here, the native-born population contribution, that fell off a cliff after 2020. And unfortunately, it has not recovered. So lower rates of family formation, lower fertility rates are keeping native-born population growth close to zero. And actually that is projected to fall to zero and actually be a drag on overall population growth by about 2030.

So where that leaves us is with net migration driving the outlook for population growth if those blue bars don't turn around. And what we've seen is that net migration has actually fallen to zero, as we said, and that's what’s kept that break-even pace of job growth at about zero.

Phil: This is something that I hear a lot about from business owners is "I need workers," and our native-born population growth is muted at best. People are just having fewer children. It's pretty simple math, and when you think about an economy, if you think about potential growth being population growth times productivity growth, well, productivity growth is starting to rebound and there's hope for AI, but you do need population growth.

Think about even a city you live in. If you live in a city that's losing people, it's not going to grow. So this is a structural problem. There's no easy answers here, but something that I think has implications for potential growth, has implications for the fiscal situation in the US—this is a big structural thing.

I don't think it's investable, by the way, because a lot of what we're talking about here has been the case for some time, but it is a real concern and something that we're quite focused on and we'll continue to highlight for you all.

So let's talk about—we talked about the labor market—let's talk about the other side of the Fed's dual mandate, which is price stability or inflation. The most recent Consumer Price Index report came in at 3.3%—the headline did. Why is that? Gas prices moved up. That was expected.

Core inflation's running about 2.6%, so let’s just call inflation 2.5% to 3%. Well the Fed's target, as you could see here, is 2%. So the Fed is caught a little bit between a rock and a hard place where, yes, the labor market's not as strong as it was, but it's kind of in some sort of equilibrium—whether that equilibrium is sustainable is a debate—but inflation remains above target. That is, in our belief, why the Fed is currently on hold.

The Fed's other problem is that we have seen a real move higher in inflation expectations. Here, we're showing the inflation swap rate—1-year, 2-year and 5-year. Of course, you've seen a big move up in the 1-year and the 2-year due to the price of commodities, particularly crude oil. The 5 year is lower, but look, inflation expectations, they're not necessarily predictive of what the inflation rate's going to do exactly, but they do get into the sauce, as we like to say, and it is something that the Fed has to watch.

So the inflation side of the Fed's dual mandate remains a real challenge, and outside of real deterioration of course in the labor market, we think this keeps the Fed's bias on hold.

Blake: And a big driver for this is going to be the oil price, and what financial markets have communicated via their pricing since the start of this conflict is that this appears to be a finite, limited and temporary disruption to energy prices and to financial markets.

So what we're showing here is the oil price futures curve. There is no one oil price, like there is one price for a stock or for a Treasury on any given day. Instead, there are numerous global oil markets priced at various tenors into the future. What we saw is that on April 7 at the peak of oil prices, the price for spot—a delivery of a barrel of oil at the shortest term possible—rose close to an all-time high at about $145.

However, even on that day, delivery of a barrel of oil 1, 2, 3, 6, 7 months out was always only moderately higher than it was before the conflict. So the oil market has been communicating to us even on the worst day that this was going to be a limited conflict.

What we've seen is that between April 7 and the latest data available through yesterday, which is that dark blue line, things have moved up just a little bit.

Phil: Further out.

Blake: Further out, the price is now creeping up maybe by a few dollars. But I would emphasize that even though, you know, we might be $20, $30 higher, this is not the kind of massive energy-price shock that one might have expected, especially from what we saw in 2007, 2008 and back in the 1970s during other oil price shocks.

Phil: Yeah, if you think of markets as probability-weighted pricing mechanisms, $100, $110 oil—whether you're looking at Brent or WTI—is not pricing the worst-case outcome. It's pricing some mixed probability-weighted outcomes. Remember, 2008, the price of crude oil was $150, okay? That was almost 20 years ago. So if the question is "Could oil go higher if the bear case plays out?" Absolutely. It should be well higher than $150. What is pricing is that, yes, supplies are disrupted, but they aren't going remain disrupted forever.

Blake: Right. In addition to these oil prices, we can also look similarly out into the future, looking at derivatives pricing, of what is the market expecting for the inflation rate, and that similarly has been pretty muted further out in the out months but has started to creep higher.

And that's one major reason why the Federal Reserve is on hold—seeming, according to market pricing—basically indefinitely for the next 12 to 18 months. Before the conflicts broke out, the market was looking for two to three interest rate cuts in 2026 headed into 2027. That expectation has disappeared.

The market is now priced for a flat federal funds rate as far out as we can see the federal funds futures pricing. There's a lot to digest here. We have a new Fed chair on the way in. Policy and expectations are partly on hold because of that. We don't know what the new leadership is going to do. But just based on the fundamentals that we walked through—a little bit of a softer labor market, that might suggest the Fed wants to accommodate with lower rates. But with what you just said, and what we talked about with the outlook for energy and for consumer prices, that leaves the Fed, as you said, between a rock and a hard place.

Phil: So we've talked a lot about the war in the Middle East. Let's talk about other things that are really on our minds and clients' minds as well. The biggest is, of course, artificial intelligence. Just in the interest of full disclosure, I'm lucky enough to talk to a lot of our clients. I have noticed in say the last 6 months, really since last fall, adoption has picked up. Does the adoption justify the CapEx—the capital expenditures we're showing here? That is yet to be seen.

So where are we? What's the state of play? Well, first of all, after the close today, we have four hyperscalers reports, so these numbers are going to be adjusted. But the short answer is expectations keep rising. Look at 2026. The expectations for CapEx spending on generative AI, as of January of this year, the expectation from hyperscalers was around $650 billion. Now, that is around $770 billion. And again, if there's bias, that bias is probably higher. If you look at cumulative capital expenditure spending from 2026 to 2032, you end up at $7.5 trillion.

Blake: That's trillion with a T?

Phil: Trillion with a T estimated dollars spent. So what does that mean? Well, one, it means that this had better be a game-changing technology. I increasingly am seeing real impact from an economic perspective and productivity perspective in our clients on the ground. I think it is.

But the other question that is very fair to ask: Is there waste? Well the answer is almost certainly yes. Think about the fiber-optic buildout of the 1990s. Think about the internet. A lot of the companies that built that out were not the winners in the long term. It ended up being companies that used that technology. So two things can be true. This can be a game changer, and there can also be a decent amount of waste.

Usually, when you see a massive technological advancement—think about the automobile, think about how many automobile companies there were in this country 60, 70 years ago—we've seen consolidation. You are going to see excess CapEx and some waste entering the economy, but this is very important to economic growth right now and something that we're going to continue to watch and continue to analyze very carefully.

So how do we put this CapEx spending in context? Something we've seen a lot is some sort of back-of-the-envelope calculations on the AI buildout, artificial intelligence buildout, relative to past major spending. So we decided to do some of the work ourselves. When I say we, I really mean you, Blake, did some great work looking back at major infrastructure buildouts that we've seen in the past. Why don't you spend just a moment describing what we're showing here in terms of CapEx as a share of GDP and what you found?

Blake: Well what we’re showing here is that the AI build out is probably the most expensive project in the last 150 years, going back to the railroad booms in the 1870s through 1890s. So what we did here is we looked back to, in some cases primary-source data, and found out how much was spent in aggregate during the peak years of these investment booms.

So railroads went through famous boom-and-bust periods in the late 19th century. We looked at one of the most intensive periods of buildout, and what we found is 4.9% of GDP at the time was being spent on that railroad buildout. So GDP today is about $30 trillion. So to put that into today's dollars, call it 5%, that's over a $1 trillion, $1.5 trillion spent laying railroad track—

Phil: Annually.

Blake: Annually, for those few years going across the country. Electrification peaked in the late 1910s and into the 1920s, where we saw the rates of adoption for households rising from like 10%, 20% to over half in that period. That was only 0.8% of GDP spent per year.

The Marshall Plan—one of the most transformative international investment projects in history—was 1.1% after World War 2. Interstate highways, pouring concrete all across the country to connect all the major cities and cities to suburbs, was 1.9%. The Apollo mission—we choose to go to the moon in this decade and do the other things because they're hard—0.4%.

The telecom boom that you mentioned, laying fiber that could've gone around the world several times, was 0.9%. And today's AI build out—those dollar figures that you mentioned put into percentage of GDP—is 2.9%. So it eclipses all of these going back to the railroads.

One point that I would make here is that not all of these projects were private-sector investments that needed to pay off. The interstate highway system was a government project that was paid for with taxpayer dollars that didn't need to turn a profit. So what's interesting here is that this enormous amount of CapEx expenditure is among the largest in history, and it's expected to turn a profit.

Phil: That's right, and there's a huge question there. I don't think we're going to have an answer to that question for years, but that remains the major question.

Why don't we dig into markets, Blake, and a little bit more in terms of the fundamentals supporting the market, particularly earnings and margins?

Blake: Yeah, corporate fundamentals for the S&P 500 look exceptionally strong. Two of our favorite things to look at here are earnings growth expectations for this year, which is rolling in at the latest print at 18.6%, and operating margin, which has climbed almost in a straight line over the last several months to 19.9%. Those are very high expectations. That's what's propelling a lot of optimism in the equity market, but we would point out that those high expectations need to be met.

And as you said, after the close tonight, we're going to get a lot of information on if these major technology companies that comprise a lot of this index are meeting those expectations.

Phil: Yeah, we're in the middle of an earnings season. So far we have seen outperformance, which is kind of the playbook. Usually companies outperform the average expectation, but we've seen over 80% of companies beat. That is above average. Again, a lot of the biggest companies have reported so TBD, but we are having a good earnings season when you look at that first quarter expectation of 15% growth.

Blake: And an encouraging trend that we saw at the beginning of the year was broadening in US and in global equity markets. So looking at the right panel of this slide here, what we saw was some of the biggest outperformers before the Iran conflict were actually international equities and a broader look at US stocks, including small caps and the equal-weighted S&P 500.

However, since early April what we've seen is a reversal in that trend, and we're back to the largest mega-cap technology companies propelling the index higher and comprising a large amount of the gain—with the Magnificent Seven stocks up 22% compared to the equal-weighted index up just 7% since that rebound began.

Phil: You know, it's amazing—that recent rebound is pretty incredible. What still is pretty impressive to me, though, is if you look at year to date, just widen the aperture a little bit, the Magnificent Seven is still being outperformed by the S&P, by small caps, et cetera.

So year to date, we have had broadening. Clients would see that in their portfolio. But there is no question that the recent, big move higher has been much more narrow. I think that's okay because it's a little bit of catch up, honestly, but it is good to see small caps outperform, et cetera.

The debate is if AI is really going to be a margin driver, a productivity driver, it has to benefit companies outside of the companies building AI, right? So to me, this makes some sense that we've seen some broadening year to date. Does it continue for the full year? Who knows. That's not the point. The point is that if AI really does drive productivity and margins higher, we should see benefit outside of just those seven largest companies.

Blake: Valuations took a breather this year because while stock prices declined 7% or 8% over the course of the Iran conflict, as you said at the beginning of this presentation, earnings expectations were being revised higher. So pretty much all of that decline was from the price, not from the earnings expectation. We have seen a rebound in the multiple over the last few weeks, but at 20, 21 times forward earnings, valuations are not quite as sky high as they were last year, and that raises the question of, given these strong earnings expectations, what do we make of that potentially more attractive multiple?

Phil: Yeah, look, we came into this year—our annual outlook was tied to something like cautiously constructive—and part of it was just that valuation was very high. Think when we were working on our outlook, the multiple, or price-to-forward earnings for the S&P 500, was around 23 times.

We declined quite a bit to around 19 times, but the truth is if you liked the stock market late last year, you should like it more today. It's actually cheaper. Is it cheap compared to historical context? No. But seeing earnings growth outpace price growth—that's a good thing. That is a good thing for markets. And we do have a multiple that is more reasonable today than it was late last year.

What about fundamentals globally? Well, what we're really seeing is corporate fundamentals are strong and improving. I want to focus on the gold line for a little bit. We spend a lot of time talking about the US. Here we're showing the All Country World Index, excluding the US—so think of it as everything, developed world, emerging markets, minus the US.

If you think about the prior decade in which international underperformed the US, kind of draw a trend line in that yellow line sideways. We really didn't see growth. Earnings were just kind of sideways in a channel outside the US, whereas look at the blue line—the US was trending higher. That has changed recently, and I don’t think it’s an accident that in 2025 international outperformed the US, and for much of this year international outperformed the US.

We have seen underperformance, of course, with the Strait of Hormuz impacting international markets more, but you are seeing fundamentals globally improve. I think this is something that we, as diversified investors, have to think about. There is markets outside of just the US, and some of those are doing quite well.

So what about our price target? We are keeping it at 7,300. As a reminder, we have not adjusted our price target during the war in the Middle East. At one point, our price target showed double-digit upside, but now we are seeing a pretty rapid rise in the S&P 500.

Our price target at 12 months is up a few percent from here. Reminder, we update this generally on a quarterly basis, but we came into the year thinking that you could not expect a lot of multiple expansion, that we needed earnings growth, and we had mid- to high-single-digit upside in the S&P coming into the year. And here we are up about 4% year to date, and that's how you get to these numbers.

So we remain cautiously constructive. If you are very bearish, of course you can see our bear case there, and the bull case is up about 11%. That, of course, is a scenario where we see quick resolution in the Middle East and continued margin expansion in the US.

So what about fixed income? What's interesting is we talked about the fact that the stock market has more than recovered its level before the war. We have not seen that in fixed income. Fixed-income yields are higher than they were on February 27. For example, the 10-year Treasury—4.3% versus 3.9% the day before the conflict began.

Look at the aggregate bond index, 4.6%. It started the year at 4.3%. What does this mean for investors? It means that we've been talking about fixed income being a viable asset class, a balance in portfolios. There is more expected return—i.e. yield—in the aggregate bond index today than there was at the start of the year.

It is not that we've seen skyrocketing in yields, something scary from a fiscal perspective. What we've really just seen is potential income improve. We're not showing it here, but just quickly on corporate bond spreads, investment grade and high yield, we did see them widen initially during the war, but we have seen a retracement. So spreads remain pretty tight. Fixed income, we think, balance of portfolios still makes quite a bit of sense for long-term investors.

Blake: The US fiscal situation is not good.

Phil: No.

Blake: The US has been running very large, if not explosive, federal deficits for many years now. That was not as much of a problem when interest rates were low. Fiscal analysts and economists tend to believe that a government can run quite a large budget deficit, so long as interest rates are low and the rate of growth in the economy is exceeding that interest rate that you're borrowing on.

What's changed is that interest rates are no longer high, and these defecits continue to rise—

Phil: No longer low, they’re high now.

Blake: Excuse me, yeah, right, and these deficits are continuing to climb higher. And where we can see that as a problem is in this chart here, where we're looking at the amount of interest that the United States is spending as a fraction of its total budget. So as a fraction of outlays, federal interest expense as a share of everything that we're spending on—defense and Medicare and government programs—has risen close to 15% and is projected to rise even higher.

Even more troubling, when we look at it as a fraction of total government revenues, that's poised to climb closer to 20%. So we're starting to see federal net interest crowd out other government spending and make up a more dominant share of all of federal finances. And this is where the federal deficit really starts to bite. And that's why we think this is probably going to become more of a conversation over the next several months.

And why does that matter most? It's because that borrowing rate that the government is getting to borrow to pay for these massive deficits, again, used to be quite low. The 10-year Treasury yield has been pretty stable for the last few to several quarters, averaging above 4%.

So we will be paying close attention to the relationship between these federal fiscal dynamics, economic growth, inflation expectations, to keep an eye on this benchmark Treasury rate. The upshot is with that fiscal picture that we just showed, uncertainty with inflation—maybe inflation starting to look like it's more likely to trend a little bit higher than lower—then we might simply be in a situation where the 10-year Treasury remains modestly, moderately higher for longer.

Phil: I think it's notable here as we're showing that the Fed has had two cutting cycles since 2024—1.75% worth of cuts—and the 10-year Treasury, as you can see here, is higher than it was when the Fed started cutting. So something we always want to remind clients is the Fed controls the overnight rate. They do not control longer-term rates. Think about your mortgage rate, for example. That's much more correlated with the 10-year Treasury and the 30-year Treasury. Greenspan called this the great conundrum. The Fed controls the overnight rate, not longer-term rates, so borrowing rates remain fairly elevated. That can be good for investors, but certainly for those borrowing it can be a headwind.

So with that, Amy, let's jump into questions and answers.

Amy: Hey, before we jump into questions, I just want to remind you that we have several publications available throughout the month. If you would like to sign up to receive notifications, you can use the QR code on the screen or visit FirstCitizens.com/Market-Outlook to get signed up.

Well, thank you both for taking a deep dive into markets and the economy. We received several questions around the topic of AI. That's top of mind for so many people. Phil, I'm really curious what you're hearing from business owners and how people are tying that into their businesses on a daily basis.

Phil: Yeah, AI remains a major topic on the road. From a business owner perspective, what we're seeing is increased adoption. I've noticed, particularly even since last fall, a real rise in clients using AI in their processes. Is it redefining businesses? In certain cases, maybe—particularly life sciences, for example. But it really is a productivity gainer is what I'm seeing. A lot of times it's AI within a tool you already have, and it's just getting more productivity out of your employees.

What I've not heard from the labor market perspective is mass layoffs due to AI. I know there's been some high-profile examples within technology, but that's not what we're hearing from our clients. What we're really hearing is maybe lower hiring, right? For example, a finance office that maybe would need to go from two to five employees, maybe they're going from two to three or just keeping two. We are seeing that, and that is consistent with this equilibrium Blake and I discussed in terms of the labor market.

So I think adoption—I think we're at the steep part of the curve. An example I like to use is I think we're a little bit more internet personal computer 1995 where Windows 95 had come out, and we really saw adoption ramp pretty quickly going into the back half of the 1990s. I think we're at that point. I think adoption is very high, much higher than some of the more dated surveys are showing, and we're seeing that in more current data. Usage is going up, and I think that this is a very big deal for businesses and their productivity growth.

Blake: And something we've learned from all past major technological cycles is that big new technologies can affect the labor market in three ways. One, just outright layoffs. But two, it can make workers a lot more productive, as Phil was saying, so the quantity or the quality of their output might go way up. And third, there are just new roles out there that we don't know about.

The whole IT service industry was not a thing in the 1950s and 1960s, but after the revolution of IT, a whole new sector was born. So there's a lot that's just going to take a lot of time to play out, and we're in the early innings here.

Amy: Yeah, and Blake, speaking of the labor market, obviously that's half of the Fed's dual mandate. We're at a transition phase for the Fed. What are your expectations going forward?

Blake: Yeah, we'll probably have a new Fed Chair in maybe just 2 or 3 weeks now. We have an outstanding public servant headed out the door in Chair Powell and a really highly credentialed, good-experienced new Chair coming in with former Fed Governor Kevin Warsh. But I would say it's important to remember that the Fed is a committee of 19 people, 12 of whom vote at every interest rate-setting meeting. And the chair is the leader, but is really only one individual.

So it's going to take quite a bit of time to see what incoming Chair Warsh's priorities are. But one area where he will have a lot of control and sway himself is how the Fed communicates. And we've seen former Governor Warsh quite critical of the Fed's use of potentially excessive communication, trying to guide the market 6, 9 months ahead when uncertainty is still high, giving lots and lots of speeches and press conferences after meetings. So it'll be interesting to see how he changes things there. But in terms of actual policy and interest rates, that's still going to be a group decision.

Amy: Yeah, and Phil, one thing I've heard you say many times is if we weren't talking about the war in Iran or AI, we would be talking about the private credit sector. Can you talk a little bit about why that's such a big deal and some broader implications?

Phil: Yeah, it's certainly a hot topic, and there's a few things. One, we've seen an explosion of use of private credit, and all private credit funds are funds that lend. Instead of a bank lending, a fund lends. That is a fairly small sector when you think back to the Great Financial Crisis, for example. It is really big now, multi-trillion. And we've never seen private credit at this size in a down credit cycle.

So one, that just remains kind of an unknown, something we've talked a lot about through the years. But what is different now is that we have this issue of what we call a liquidity mismatch, right? So something that became very popular in the last couple of years is this concept of the democratization of private investments. And certain entities formed products that are semi-liquid, is how they're sold. And you take a private-credit solution and you try to make it more liquid, more appropriate for retail investors.

The issue is it’s not truly liquid. And what we have seen is retail investors would say, "Hey, I'd like to liquidate. I'd like my money back." And these entities say, "Well, actually, this is not truly liquid, and we're going to gate you," which all that means is we're going to give back X percentage per quarter instead of giving back your whole money.

For true private investors, it's normal that you give the money to private equity or private credit and it's there for a long time. We do not use these semi-liquid funds. We have private-credit funds, but they're called wind-down funds, which is the money goes in and it comes out when it's ready to come out, basically when the investment is over. So what we really have is liquidity mismatch. That is what's making the big headlines.

We do not yet have the deterioration or a large default cycle. Is there risk? Yes. There's concern with private credit, some of it is exposure to software, certain parts of the economy that could be impacted by AI. But those are a little bit more unknown is the truth. What's driving the big headlines is liquidity mismatch. We've tried to avoid that in terms of our solutions, but something that I think is going to remain a real topic for the next 24 months. I don't think private credit's going away as a real talking point.

Amy: Well, there's certainly a lot of moving parts in the markets and the economy. Thank you both for answering questions. And to all of you, thank you for trusting us to bring you this information. It's something that we never take for granted, and we look forward to seeing you again next month.

Authors

Brent Ciliano CFA | SVP, Chief Investment Officer

Capital Management Group | First Citizens Bank

8540 Colonnade Center Drive | Raleigh, NC 27615

Brent.Ciliano@FirstCitizens.com | 919-716-2650

Phillip Neuhart | SVP, Head of Market & Economic Research

Capital Management Group | First Citizens Bank

8540 Colonnade Center Drive | Raleigh, NC 27615

Phillip.Neuhart@FirstCitizens.com | 919-716-2403

Blake Taylor | VP, Market & Economic Research Analyst

Capital Management Group | First Citizens Bank

8540 Colonnade Center Drive | Raleigh, NC 27615

Blake.Taylor@FirstCitizens.com | 919-716-7964

Jack Pettit | AVP Research Analyst

Capital Management Group | First Citizens Bank

8540 Colonnade Center Drive | Raleigh, NC 27615

John.Pettit@FirstCitizens.com | 919-986-3667

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