The More Things Resolve, the More They Remain Unclear
Geopolitical Resolutions are Scarce
As we entered 2026, the prospect of a fifth year of the ongoing Russian invasion of Ukraine and a possible resolution was on our watch list. But since the end of February, when the USA and Israel launched attacks on Iran, geopolitics has played an even more prominent role in investment outcomes and the situation in Ukraine took a back seat. With war comes chaos and opportunity. The Iranian conflict has presented much chaos and limited opportunity, we would mostly say in the energy space.
But we have also learned a few things in these last few months that could have important investment lessons. We have learned the Strait of Hormuz is itself a particularly effective weapon. In fact, both the US and the Iranian Revolutionary Guard Corps have used the strait to weaponize their varying abilities to shut down the transit of ships carrying critical natural resources to help power the world’s economies, especially the Asia Pacific region.
Currently there is another 60-day ceasefire and a 14-point memorandum of understanding to work on in structuring a long-term peace agreement. We have been down this road a couple of times before, but this MOU seems to provide investors a bit more confidence that a final deal can be reached. The two-month period should expire on or around August 19.
AI Growth and IPO Effects
For the third year in a row, we are seeing growth in AI related stocks outstrip the annual estimates of capital expenditures, that is the money going into the buildout of AI datacenters and compute capacity. This is pushing up the indices of the related sectors, which include hyperscalers and specialized microchip companies, but it is also driving returns overall in semiconductors and the major indices. Two charts illustrate the trend. These are from a recent report published by Goldman Sachs.
In the first, you can see how year-over-year earnings growth in semiconductors and semiconductor equipment has grown as free cash flows in the same period from the hyperscalers has gone deeply negative. Then you see in the second chart the improvement and expectations for higher profit margins for the chipmakers and related companies.
There have been a good number of curious deals where AI companies have both financed and agreed to purchase chip production in circular arrangements, including some with long-term leases that allow startups to get financing on very favorable terms. These deals are interesting given the negative state of free cash flow reported by these mega cap tech names.
And it points to a second trend that has started this year, and that we believe will continue. For a couple of decades now, the total number of shares outstanding on the major exchanges has been declining, mostly because of fewer and/or smaller initial public offerings (IPOs) but also because public companies in aggregate have been buying back more shares than they issue. Meanwhile, more investors and more investment flows have been coming into the market. The law of supply and demand cannot be ignored. More demand and less supply pushes prices up.
With several mega IPOs likely happening this year, and one of the biggest just happened, we believe we could be looking at a long-term trend reversal. Share buybacks are slowing. IPO volume is increasing. After all, doesn’t it make sense to sell shares if you believe your company could be at the high end of the valuation range? Overall, more shares are likely to be available than we have seen in many years.
Our view is that the buildout of AI will continue, although the pace could moderate. At some point, investors will need to see returns on the massive sums pouring into these infrastructure projects. The tech sector has mostly benefited from being an “asset light” industry. The focus on AI has now changed that concept and many of these companies will now be making big adjustments as they are forced to focus on capex and depreciation of property, plant and equipment.
Rates and a new Fed Chair
On May 22, Kevin Warsh was sworn in as the new chair of the Federal Reserve Open Markets Committee. He has ample experience and is a known quantity to Wall Street. He was also viewed as the best candidate by the White House given a perceived dovish view on rates.
He chaired his first fed meeting last week and though there were few surprises, there are some interesting things we believe bear watching. The new fed head seems to want to take the central bank in a different direction than his predecessor. That is not easy to do and maintain the credibility that is so important for any central bank. Despite increasing inflationary pressure in the latest data, the fed voted to hold rates steady. And the announcement was little changed in substance. However, it was much shorter than what we have become accustomed to, and Warsh has made it clear he believes the fed should have less influence on markets, meaning forward guidance should be muted. That’s easy to say when markets are calm. What we have seen since the Bernanke years is that forward guidance has really become a tool in itself to keep inflation expectations in check.
Warsh also announced the creation of a task force to analyze different aspects of fed operations including communications, balance sheet management, inflation framework, data sources and uses, and productivity and its economic impact. We have yet to discover who will lead the efforts related to this announcement and the work is expected to take several months with results coming toward year end.
Of considerable interest for us is the attention to balance sheet management. Warsh in months leading up to his confirmation was critical of the bank’s handling of asset purchases. Quantitative easing, and tightening, has become a major tool in managing monetary conditions. It has also been controversial in some circles, particularly among those who are primarily focused on government debt levels.
In 2024, the fed began to allow maturing securities to roll off and the balance sheet began to decrease, also known as tightening. In response to overnight bank lending difficulties in the repo market, the fed paused tightening and then in late 2025, restarted QE or quantitative easing. Since then, it has added about $40 billion on average each month. The chart from the St. Louis Fed below is through May of 2026.
If the task force comes up with some sort of rigid guidelines about balance sheet management and they get adopted, we believe an important flexible tool for the fed could be disrupted.
Other changes could also have significant effects on central bank policy and, accordingly, economic activity. The new fed chair refused to answer a number of questions about the direction of rates and also gave no indication about the future of the projection of economic analysis, or dot plot, taking the step of removing his own projection.
Because there will be a lag in getting the results of the work of the task force and the fact that inflation is likely to continue to keep pressure on the fed, we would be surprised to see any change in fed policy for the rest of the year. But surprises make a market. We will be watching.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.