AI faces a tougher near-term test

Will fundamentals stand up to intensified investor scrutiny?

Investor scrutiny of AI is intensifying this earnings season. How results hold up will be key to our broader medium-term conviction in the AI transformation. The Nasdaq posted its worst month since March 2025 as AI scrutiny intensified. We see multiple plausible outcomes for growth, profitability, and returns. We are watching October U.S. jobs data amid signs of a tight labor market in recent months. Any further wage pressure could drive core services inflation.

Four years of booming AI investment have sent earnings expectations soaring. Investors now want evidence that spending can deliver returns, especially as rising capital expenditures squeeze free cash flow, pushing it into negative territory for some firms. We recently downgraded U.S. equities to neutral to lock in profits, but our core conviction in the AI transformation remains intact. That supports our EM equity overweight through exposure to bottlenecks in the AI buildout.

We will learn much more about the AI theme this earnings season, especially how impactful the technology will ultimately be. But the backdrop for mega-cap tech stocks is starkly different from just four months ago.

After narrowing considerably earlier this year, the earnings growth gap has now flipped for the first time since 2022, with the S&P 493 outpacing the “magnificent seven” at roughly 29% versus 18% (see the chart below).

The bar remains high. Consensus expects S&P 500 earnings to grow about 30% – marking a third consecutive quarter of growth above 20% – according to LSEG data. Meanwhile, scrutiny of the AI theme has grown. That shifting backdrop contributed to our decision to downgrade U.S. equities to neutral last month. Our conviction in AI fundamentals, however, remains intact.

Late October earnings highlighted a growing tension between strong demand for AI-linked goods and services and the rising cost of meeting it. Hyperscaler capital spending has surged to about $649 billion over the past year, from about $357 billion in the prior-year period, according to data from Bloomberg, leaving little cash surplus after capex. And while hyperscalers’ operating margins have edged up to 27.1% from 26.9% in the previous four quarters, incremental margins have fallen to 27.9% from 40.4% over that same period. In other words, each additional dollar of revenue is generating less additional profit, raising questions about whether returns can keep pace with soaring investment.

Still, our analysis finds that companies with higher AI adoption outside the S&P 500 technology and communication sectors are on track for 3% higher earnings growth this quarter than lower adopters, based on evidence of AI use in regulatory filings. Cloud revenue growth at Microsoft and Alphabet also points to sustained momentum in AI demand. But whether that demand will be enough to justify the scale of investment is still an open question.

As the AI buildout becomes increasingly debt-financed, leverage and differences in funding capacity are coming into sharper focus. Credit markets are becoming an important signpost of how much additional AI investment can be financed and at what cost. The Treasury rally alongside the tech selloff also fits our view that the ebb and flow of AI investment expectations will drive competition for capital and bond yields around structurally higher levels.

Investment implications

Within equities, we’re selective with our AI exposures. We favor companies and listed infrastructure poised to benefit from the critical bottlenecks in the AI buildout, a key reason for our move back to overweight EM equities in September. We see that opportunity playing out in Asia.

Recent results from chipmakers point to tight supply and strong AI demand. But staying nimble is crucial, as our EM positioning shows: We upgraded at the start of the year, took profits midyear, and returned to overweight in September. Brazil’s post-election selloff bears watching, but it does not change our EM overweight.

Bottom line: AI faces a tougher near-term test as investor scrutiny intensifies. But our conviction in AI fundamentals remains intact, keeping us selective on where we take AI exposure while favoring opportunities tied to scarcity in the buildout.

Jean Boivin is Managing Director, Head of the BlackRock Investment Institute at BlackRock Inc.

Wei Li, Managing Director and Global Chief Investment Strategist at BlackRock Investment Institute, Carrie King, Global Chief Investment Officer, Fundamental Equities – BlackRock, Devan Nathwani, Portfolio Strategist – BlackRock Investment Institute, and Valerie Chan, Investment Strategist – BlackRock Investment Institute, contributed to this article.

Disclaimer

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