Capital Formation and the Next Market Cycle
Clarity in a Changing World.
For informational purposes only. Not investment advice.
Introduction
For much of the past three years, financial markets have focused on employment, inflation and the timing of Federal Reserve decisions.
These variables remain important. They may no longer provide a complete account of the current cycle.
The United States is experiencing a substantial wave of capital investment in artificial intelligence, digital infrastructure, energy systems and advanced technology. The central question is whether this investment will raise productivity sufficiently to support future earnings and expand the economy’s productive capacity.
The next market cycle may therefore depend less on the next interest-rate decision than on whether today’s capital formation becomes tomorrow’s productivity.
I. Looking Beyond the Employment Headlines
Employment remains one of the most closely watched indicators of the US economy. Strong payroll growth is generally interpreted as evidence of resilient demand, while weak employment figures are often treated as an early warning of recession.
The relationship is less straightforward than the headlines suggest.
Employment is a lagging indicator, and monthly payroll reports measure changes in employment rather than the durability of underlying labour demand. Temporary events can affect individual releases without changing the broader direction of the labour market.
The 2026 FIFA World Cup provides a useful example. Before the tournament, several forecasts anticipated temporary hiring across hospitality, transport, security and event management. Such employment could have made the labour market appear stronger for a limited period, particularly in host cities.
The national figures were less robust.
US non-farm payrolls increased by 57,000 in June, while employment gains for April and May were revised down by a combined 74,000. Leisure and hospitality employment, which had been expected to benefit from the tournament, declined by 61,000 after seasonal adjustment. The labour-force participation rate fell to 61.5%, and the employment-population ratio declined to 59.0%.
(Source: US Bureau of Labor Statistics, Employment Situation, July 2026.)
These data do not allow the precise employment effect of the World Cup to be isolated. Seasonal adjustment, sampling uncertainty and differences between national and local labour markets make that calculation difficult. They do show, however, that any temporary event-related hiring was insufficient to produce a strong national employment report.
Major sporting events can increase employment flows for a limited period, but they rarely alter the structural direction of labour demand. Many event-related positions disappear once the tournament ends, while permanent hiring continues to depend on corporate investment, consumer demand and broader economic conditions.
The composition of employment also deserves attention. Hiring has slowed across parts of the private sector, while long-term unemployment has remained elevated. At the same time, companies have continued to invest in automation and artificial intelligence while reducing headcount in selected functions.
This does not mean that every technology-sector job reduction is caused by AI. Restructuring, cost control, mergers and changes in demand also matter. It does suggest that some companies are reallocating resources from labour-intensive activities towards software, computing capacity and other forms of capital investment.
Microsoft provides one example of this pattern. In its fiscal third quarter, the company reported continued investment in computing capacity, AI talent and data, while total headcount declined year on year. Operating income nevertheless increased by 20%.
(Source: Microsoft, FY2026 third-quarter performance report.)
Historically, weaker hiring was often associated with deteriorating corporate performance. That relationship may now be less reliable for companies able to increase output through automation and capital deepening.
Once temporary distortions associated with the FIFA World Cup are taken into account, the available evidence suggests that the labour market is gradually cooling.
The evidence does not yet point to the broad deterioration normally associated with a severe recession. It does, however, weaken the argument that labour demand remains sufficiently strong to require another round of monetary tightening.
II. Capital Formation Is Returning
Employment describes where the economy has been. Investment offers a better indication of where it may be heading.
Large improvements in productivity have historically required sustained capital formation. Railways, electrification, computing and the internet all demanded substantial investment before their full economic benefits became visible.
The current wave of AI-related investment appears to be following a similar pattern.
Official company guidance illustrates the scale involved. Microsoft expects to invest roughly US$190 billion in capital expenditure during calendar year 2026. Alphabet has raised its 2026 capital-expenditure guidance to US$180–190 billion. Amazon expects approximately US$200 billion of capital expenditure during the year, covering AI, chips, robotics and low-earth-orbit satellite infrastructure.
(Sources: Microsoft FY2026 third-quarter earnings call; Alphabet 2026 first-quarter earnings call; Amazon 2025 fourth-quarter results and 2026 guidance.)
These figures are not directly comparable in every respect. Companies classify leases, equipment and infrastructure spending differently, and not all expenditure is attributable solely to AI. Even so, they provide strong evidence that a major capital-investment cycle is under way.
In the short term, this spending can add to inflationary pressure. Data centres require electricity, construction, land, specialised equipment and skilled labour. Demand for semiconductors, networking hardware and power infrastructure can exceed available supply.
The longer-term effect may be different.
The purpose of productive capital investment is to expand supply capacity. Economists describe part of this process as capital deepening: increasing the quantity or quality of capital available to each worker. If successful, businesses can produce more output with the same labour input, raising productivity and reducing unit costs.
This distinction is central to the current cycle.
Investment does not automatically reduce inflation. Projects can be inefficient, returns can disappoint, and supply constraints can persist longer than expected. But if the current expenditure produces useful computing capacity, better software and more efficient business processes, it could eventually increase potential output.
Today’s capital investment may therefore have two effects operating over different periods:
in the near term, it raises demand for scarce resources;
over time, it may expand productive capacity and reduce the cost of producing each unit of output.
The relevant question is not simply whether AI spending is large. It is whether the capital being created will generate an adequate economic return.
If it does, productivity rather than monetary easing may become the more important source of future earnings growth.
III. Why Monetary Policy May Matter Less Than Investors Think
The Federal Reserve remains important. Interest rates influence borrowing costs, discount rates, housing activity and financial conditions.
But markets may place too much weight on predicting the next policy meeting and too little on the forces shaping the economy over several years.
Inflation remains above the Federal Reserve’s long-term objective, while employment conditions have softened. The policy problem is therefore no longer one-dimensional. Officials must distinguish between inflation caused by excessive demand and price pressure associated with supply constraints or productive investment.
Higher rates can restrain consumption and credit growth. They are less effective at increasing power generation, semiconductor supply or data-centre capacity. Excessive tightening could also delay investment that might later raise productivity.
Chair Kevin Warsh has continued to emphasise price stability and institutional credibility. That rhetoric is consistent with the Federal Reserve’s mandate and should not be interpreted as a promise of imminent easing.
At the same time, recent speeches and policy initiatives suggest that the Federal Reserve is placing greater emphasis on how productivity, AI, data quality and changing labour-market relationships should be incorporated into monetary analysis. The institution has established task forces covering monetary-policy communication, the balance sheet, economic data, productivity and employment, and the inflation framework.
(Sources: Federal Reserve, June 2026 FOMC press conference; Federal Reserve announcement on monetary-policy task forces, July 2026.)
These initiatives do not establish that the Federal Reserve intends to cut rates before or during any political event. Nor do they prove that higher productivity has already arrived. They indicate that policymakers are reviewing whether established indicators remain sufficient in an economy undergoing technological and structural change.
Under current conditions, another rate increase appears more consistent with a tail risk than with the central scenario. That assessment would need to change if core inflation accelerated materially, inflation expectations became unanchored or an external supply shock produced persistent price pressure.
The more probable policy challenge is not whether to raise rates immediately, but how long to maintain restrictive conditions while distinguishing temporary inflation from structural changes in productive capacity.
For long-term investors, that distinction matters more than the wording of a single press conference.
IV. Why US Equities Remain Resilient
US equities have remained resilient despite moderating employment growth, restrictive monetary policy and elevated valuations.
This does not necessarily mean that markets have become detached from economic fundamentals. It may reflect the particular composition of the indices and the forward-looking nature of equity valuation.
The S&P 500 is not a comprehensive representation of the US economy. It covers large listed companies and is weighted by market capitalisation. Its performance can therefore be dominated by businesses whose earnings depend more on global technology investment than on near-term changes in domestic employment.
This distinction has become especially important because market concentration is historically elevated. By mid-2025, the ten largest S&P 500 companies represented almost 40% of the index, a level not seen since the mid-1960s.
(Source: S&P Dow Jones Indices, “In the Shadows of Giants”, May 2026.)
Concentration can support index performance when the largest companies continue to deliver earnings growth. It also increases vulnerability: disappointment among a small number of heavily weighted constituents can have an unusually large effect on the broader index.
The current resilience of US equities therefore rests on several linked assumptions.
First, investors expect substantial spending on computing infrastructure to produce future revenue and productivity gains. Second, the largest technology companies are considered capable of financing that investment from strong cash flows and capital-market access. Third, the United States retains structural advantages in research, venture capital, public-market liquidity and the commercialisation of new technology.
Those advantages continue to attract capital, but they do not eliminate valuation risk.
Current prices increasingly reflect the expectation that AI-related investment will generate durable earnings growth. If the returns on that investment are delayed, competed away or absorbed by depreciation and energy costs, valuation multiples could come under pressure even if the underlying technology remains important.
The market is therefore making a forward-looking judgement rather than ignoring current economic weakness.
It is assuming that capital formation will become productivity, and that productivity will become earnings.
That assumption is plausible. It is not guaranteed.
V. What Matters for Investors?
The analysis above suggests that investors may benefit from asking a different set of questions.
Short-term employment reports, inflation releases and Federal Reserve decisions still affect markets. They do not, by themselves, identify where long-term value is being created.
A more useful approach is to examine where sustained capital formation is occurring and whether the recipients of that capital possess durable competitive advantages.
Several areas stand out:
AI and digital infrastructure. Semiconductor capacity, networking, cloud platforms and data centres remain central to the investment cycle.
Power and grid infrastructure. Data-centre expansion raises demand for generation, transmission, storage and cooling.
Advanced manufacturing and automation. Software, robotics and modern production systems may allow businesses to increase output without proportional increases in labour.
Defence and space infrastructure. Autonomous systems, secure communications, satellites and data networks are attracting both public and private investment.
These themes are illustrative rather than exhaustive. Capital formation is also occurring in healthcare, industrial infrastructure and other sectors.
The important distinction is not between fashionable and unfashionable industries. It is between spending that merely increases current demand and investment capable of producing durable assets, higher productivity and defensible earnings.
VI. What Could Change This Outlook?
Several developments could alter this outlook.
The first is persistent inflation. If price pressure remains elevated, the Federal Reserve may need to keep policy restrictive for longer than investors expect. Higher discount rates would weigh most heavily on assets whose valuations depend on distant earnings.
The second is weak investment productivity. Large capital expenditure does not guarantee adequate returns. Excess capacity, rapid technological obsolescence or weak customer demand could reduce the economic value of current projects.
The third is market concentration. When a small group of companies dominates index performance, earnings disappointments can produce wider valuation adjustments.
A fourth risk is financing. Even cash-rich companies face rising depreciation, power and construction costs. Less established businesses may depend on capital markets remaining receptive.
Finally, geopolitical conflict, energy shocks and supply-chain disruption could raise inflation while simultaneously weakening growth.
These possibilities do not invalidate the capital-formation thesis. They define the conditions under which it would need to be reassessed.
Conclusion
Markets rarely turn because of one economic release.
The more important question is whether today’s capital formation ultimately becomes tomorrow’s productivity growth.
If it does, productivity rather than interest rates may define the next market cycle.
If it does not, current valuations will have priced a future that fails to arrive.