The market is not being driven by valuation alone

This cycle is different from the late stages of the dot-com boom in one important respect. The rally has not been driven only by investors capitalizing distant growth expectations with limited earnings support. Earnings have done real work.

Since the end of 2022, expected earnings for the S&P 500 have risen sharply, with the gains concentrated in the three sectors most closely linked to AI: information technology, communication services and consumer discretionary. More than 70%1 of the growth in forward earnings has come from those three sectors, with information technology alone accounting for about half. ¹

That matters. A valuation-driven market can break when the multiple breaks. An earnings driven market usually needs the earnings story to weaken.

This is why I would be careful with simple bubble analogies. The AI theme may be over-owned. Expectations may be high. Some business models may not ultimately justify today’s enthusiasm. But the market is not rising in the absence of earnings support.

The risk is narrower and more specific: if investors begin to doubt the durability of AI-related revenues, margins or capital spending, the support under the index could weaken quickly.

Inflation is the first real test

Inflation is the most immediate risk because it affects almost every part of the equity story. Higher inflation can pressure margins through input costs. It can weaken household purchasing power. It can raise discount rates. And, if it persists, it can force central banks to tighten policy even when growth is slowing.

The historical record is not kind to equities when inflation is high, especially when the inflation shock is supply-driven. Since the 1970s, real U.S. equity returns have tended to be weaker in high-inflation regimes, and they have generally been worse when supply factors were driving inflation rather than demand.

That is important in the current environment because the inflation pressure is not simply a sign of strong demand. It is tied to energy, shipping, fertilizer and supply constraints. Historically, that is the more difficult mix for equities.

There is a sector dimension too. Energy and consumer staples have typically held up better in high-inflation environments. The technology-oriented sectors have tended to struggle, partly because higher rate expectations weigh more heavily on companies whose value is tied to longer-dated earnings growth.

That is the tension in today’s market. The sectors that have led the rally are also the sectors that have historically been most vulnerable when inflation becomes sustained.

The baseline is not the problem. The adverse scenario is.

There is an important distinction between an inflation scare and an inflation regime. In the baseline case, inflation rises but does not become self-reinforcing. Energy prices remain elevated for a period, food and transport costs move higher, but labour markets are softer than they were in 2022 and demand is not running far ahead of capacity. That makes second-round effects less likely.

That is why I do not think a temporary move in inflation is enough to derail the equity market by itself. Markets can look through an energy-driven inflation spike if central banks do the same, earnings remain intact and inflation expectations stay broadly anchored.

The adverse scenario is different.

If energy disruption persists, inflation could move from a temporary shock to a macro constraint. In that scenario, oil prices remain high for longer, natural gas prices rise further, food and goods inflation broaden, and central banks face pressure to raise rates again. In our adverse scenario, global inflation would be materially higher, growth would be weaker, and policy rates could move back toward prior tightening-cycle peaks before growth weakness eventually forces reversals in 2027.

That is the kind of inflation backdrop that could derail equities.

Not because inflation moves from 3% to 4% for a few months. Because the market would have to reprice the interaction between inflation, policy, growth and earnings.

Energy is still the transmission mechanism

The reported progress toward reopening the Strait of Hormuz is positive. It reduces the probability of the most damaging outcome. But it does not return the global energy system to normal.

This point is easy to miss. Opening the waterway is necessary, but not sufficient. Shipping flows need to normalize. Tankers need to reposition. Insurance needs to become available at workable prices. Production and refining facilities need to return toward pre-conflict utilization. Inventories need to be rebuilt.

In one scenario, roughly 80% of energy flows through the Strait of Hormuz resume within two months, with conditions returning to something closer to normal within three to six months.

We would treat that as an optimistic timeline. Even under that more constructive path, energy markets would not normalize quickly. Shipping, insurance, production, refining and inventory rebuilding all point to a longer and uneven adjustment back to pre-conflict flows.

That keeps the market vulnerable.

Oil prices can fall sharply when risk premia compress. But if inventories continue to draw down and physical supply does not recover quickly, lower prices may not be durable. Brent had fallen to around $95 per barrel after reports of a potential deal, but further declines may be limited until energy flows recover and commercial inventories are rebuilt.

This is the same transmission path we have discussed in prior commentaries. The issue is not only the level of oil. It is whether higher energy prices tighten financial conditions, pressure margins, weaken consumption and eventually impair growth.

That is where the equity market becomes more fragile.  

AI can coexist with higher energy prices. It may not coexist with an energy shock.

The market has been comfortable allowing two forces to coexist: AI optimism and geopolitical inflation.

I am not convinced they can coexist indefinitely if the energy shock persists.

AI is energy intensive. Data centres require power. Semiconductor production is energy intensive. The buildout requires materials, financing and infrastructure. A sustained rise in energy costs does not just affect households at the gas pump. It raises the cost of building and operating the very infrastructure behind the AI theme.

That does not mean the AI cycle ends because oil is higher. It means the margin of safety narrows.

The AI earnings story can be challenged in two ways. Revenues can disappoint, if AI adoption fails to deliver expected productivity gains or if a weaker economy causes firms to reduce planned spending. Costs can overshoot, if semiconductor prices remain high, supply constraints persist or elevated energy prices raise the operating cost of data centres.

The market has tolerated higher inflation and higher yields because AI earnings have kept rising. If the energy shock begins to threaten those earnings, the conversation changes.

Equity issuance is a warning light, not a timing tool

A wave of major AI-related IPOs would not automatically break the market. Large IPOs have not consistently marked equity market peaks.

But equity issuance deserves attention because it can reveal where we are in the psychology of a cycle. Gross equity issuance has often risen during late-stage market booms. Net equity issuance turned positive before the dot-com bubble burst and during the pandemic-era technology bubble.

The potential IPOs of SpaceX, OpenAI and Anthropic matter in that context. Not because any one deal is a market signal on its own, but because a cluster of very large AI-related offerings could test the market’s ability to absorb new supply while investor enthusiasm is already concentrated in the same theme.

That is the oddity of the current setup.

The AI story is still supported by earnings, but the market may soon be asked to fund more of it. If those deals are absorbed easily, it would reinforce the idea that the cycle has further to run. If they struggle, or if they coincide with weakening earnings momentum, they could become a marker that investor appetite is no longer unlimited.

This is why issuance is not a forecast. It is a stress test.

What we are watching

The risk to equities is not one data point. It is alignment across several signals.

The market becomes more vulnerable if oil prices remain elevated even after positive headlines, if inflation expectations move higher beyond the short term, if bond yields rise because investors expect renewed tightening, if credit spreads widen, if AI earnings revisions begin to stall, or if large equity offerings absorb capital that would otherwise support existing market leadership.

The order matters.

Energy affects inflation.

Inflation affects policy expectations.

Policy expectations affect yields and financial conditions.

Financial conditions affect growth and earnings.

Earnings affect the market.

This is the sequence that matters more than any single headline.

Canada Life Investment Management Portfolio positioning

Our positioning continues to reflect a balance between participating in the equity market’s earnings strength and recognizing that the risk environment has become less forgiving.

We have maintained exposure to U.S. equities, where earnings momentum remains stronger and the AI-related earnings story is still intact. At the same time, we do not view this as a market where simply adding more equity risk is the right expression of conviction. The leadership is narrow. The macro risk is real. And the transmission path from energy to inflation to rates to earnings is not theoretical.

Within portfolios, we continue to emphasize diversification across asset classes, regions, styles and strategies. That includes maintaining exposure to areas that can benefit from continued earnings growth, while also incorporating mandates and strategies designed to provide more balance if inflation, rates or volatility move against the equity market.

This is not a market to abandon because risks have risen. It is also not a market to treat as if AI has made the macro cycle irrelevant.

AI remains the market’s engine. Energy and inflation are the stress test. The rally can continue if earnings hold and inflation remains contained. It becomes much harder if the market has to absorb higher rates, slower growth, weaker margins and a more expensive AI buildout at the same time.

That is what could derail the stock market. Not one shock. A sequence. 

Corrado Tiralongo (he/him)
Vice President, Asset Allocation & Chief Investment Officer
Canada Life Investment Management Ltd.