Market Outlook: Navigating Tariff Shocks and the Dawn of an AI-Driven Economy

Beneath the surface of alarming inflation headlines, the market is misinterpreting a temporary, tariff-induced price shock for a structural trend. The Federal Reserve, however, is poised to look past this distortion, setting the stage for a rate-cutting cycle driven by the powerful disinflationary forces of an artificial intelligence-fueled productivity boom.

Key Insights

Inflation's False Signal: Why the Fed Will Cut Despite Hot Data

"If you control for the base effects year over year, headline came in at 2.33%, not the 2.7% headline number... the numbers that they're probably paying attention to are the 233 and the 278."

While recent headline CPI of 2.7% and Core CPI of 3.1% have spooked investors, a deeper analysis reveals these figures are heavily distorted by base effects from the prior year. When controlling for these effects, the true underlying inflation is significantly lower: headline at 2.33% and core at 2.78%. The Federal Reserve is acutely aware of this statistical noise; Chairman Powell previously guided that inflation would appear to rise as these base effects worked their way through the data. Consequently, the Fed is likely to discount the official prints and focus on the adjusted, more benign trend, keeping a September rate cut firmly on the table.

The more concerning data point is the Producer Price Index (PPI), which is flashing warning signs with multiple components hitting 12-month highs. Final demand rose 0.9%, and final demand less food, energy, and trade jumped 0.6%. This surge is not a signal of a re-accelerating economy but rather a clear "footprint" of recently imposed tariffs. While this will keep near-term inflation data elevated and may cause market volatility, the Fed is expected to view it as a one-time price level adjustment rather than a persistent inflationary force, reinforcing the case for easing monetary policy to support the broader economy.

The Tariff Trojan Horse: A Corporate Tax in Disguise

"This is of the amount of the tariff that they cannot pass along that they're just absorbing, which is, say it with me now, a tax on corporations."

The prevailing narrative on tariffs misses their true economic nature: they are functioning as a stealth tax on U.S. corporations, smuggled into the supply chain through the cost of goods sold. The impact is not theoretical. Deere & Co. (DE) reported that tariffs cost them $200 million in Q3 alone and are projected to hit $600 million for the full fiscal year. This direct hit to profitability compresses margins and forces companies to absorb costs they cannot pass on to consumers, effectively negating a portion of previous corporate tax cuts.

The burden of these tariffs is being split roughly three ways: one-third absorbed by U.S. businesses, one-third passed to U.S. consumers, and one-third borne by foreign exporters. However, the net effect on the U.S. economy appears to be negative. The strategy has triggered retaliatory actions and boycotts, such as a $1 billion annual loss in U.S. alcohol sales to Canada and a 24% drop in Canadian cross-border shopping. More damaging is the permanent reorientation of global trade routes. Canada, for example, is now investing in East-West infrastructure to bypass the U.S., representing a perpetual loss of future trade that far outweighs any revenue gained from the tariffs.

The AI Productivity Boom: The Dominant Disinflationary Force Ahead

"One thing I know for sure is AI is here and it's real and it does work better than an average employee... The now version that we're using is going to be the worst version that we'll be using on a going forward basis because it'll only get better."

The upcoming Jackson Hole symposium, themed "Labor Markets in Transition," is set to be dominated by the economic impact of artificial intelligence. AI is no longer a futuristic concept; it is a present-day reality delivering tangible productivity gains. This technological wave represents a powerful, long-term disinflationary force that will fundamentally reshape the economy. The forecast for 2030 suggests that the average organization will be 10% to 15% smaller for the same level of output, leading to significant efficiency gains.

This transition will create a bifurcated labor market. A "talent war" for top-tier experts will intensify, potentially doubling salaries for indispensable, high-performing employees. Conversely, the number of entry-level positions is expected to be cut significantly as AI automates routine tasks. The disruption extends to the education sector, where standardized test-prep companies are facing obsolescence, and a large portion of higher education institutions may face existential crises. For central bankers, this productivity wave, combined with the immense pressure of servicing national debt at high interest rates, creates a compelling argument for a lower long-term policy rate.

The Fed's Plumbing Problem: A Countdown to the End of QT

The financial system's plumbing is signaling an imminent policy shift. The Fed's Reverse Repo (RRP) facility, a key indicator of excess liquidity, has dwindled to just $37.75 billion and is on track to hit zero within weeks. The RRP has acted as a buffer, absorbing liquidity drains from the system. Once it is empty, any further tightening or liquidity needs will begin to directly reduce bank reserves.

This is a critical development because the Fed operates under an "ample reserves" regime, but the exact level of "ample" is unknown. The last time reserves became scarce in 2019, they were around $1.8 trillion, causing significant stress in funding markets. The new floor is estimated to be around $2.5 trillion. As reserves begin to fall from their current levels toward this threshold, the Fed will be forced to halt its balance sheet runoff (Quantitative Tightening, or QT) and potentially intervene to provide liquidity. This mechanical constraint suggests that the end of QT is much closer than many market participants realize, representing another form of impending monetary easing.

Actionable Rotations for a Rate-Cutting Cycle

With a Fed pivot on the horizon, specific market segments are beginning to price in a new regime. Small-cap stocks, which are highly sensitive to interest rates and domestic economic conditions, are showing signs of life. The iShares Russell 2000 ETF (IWM) posted a strong 3% gain for the week, significantly outpacing large-cap tech. A confirmed rate-cutting cycle could propel small caps to break out of their multi-year underperformance and challenge their all-time highs.

Mortgage REITs (mREITs) like Annaly (NLY) and AGNC Investment Corp. (AGNC) stand out as direct beneficiaries of lower short-term rates. Their business model profits from the spread between long-term asset yields and short-term funding costs. As the Fed cuts, their liability costs on repurchase agreements will fall immediately, directly boosting net income. This sector offers significant latent upside potential, especially if the yield curve steepens as the Fed eases. For a more direct play on Fed policy, long-dated Fed Funds futures, such as the October 2026 contract, appear attractive. They are currently pricing in about four-and-a-half cuts, a level that could prove conservative given the combined pressures of AI-driven disinflation, political influence, and the unsustainability of high debt-servicing costs.

Market Implications

The market is at a critical inflection point, fixated on backward-looking, distorted inflation data while underappreciating the profound impact of tariffs and the AI revolution. The immediate takeaway is that the Federal Reserve has sufficient justification to begin an easing cycle, viewing recent PPI strength as a transitory shock. This creates a favorable environment for rate-sensitive assets that have been suppressed by the most aggressive hiking cycle in decades.

Investment strategies should focus on this impending rotation. A move into small-cap equities (IWM, IJR) and mortgage REITs (NLY, AGNC) offers direct exposure to the benefits of lower interest rates. The industrial sector, exemplified by Deere (DE), faces persistent headwinds from tariffs acting as a margin-compressing tax. The most significant long-term opportunity may lie in positioning for a much lower terminal Fed Funds rate than is currently priced in, as the powerful disinflationary wave from AI productivity gains forces a structural repricing of the cost of money.