The "core contradiction" of the U.S. economy: strong AI vs. weak employment

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The current U.S. economy is sending starkly different signals, with strong consumption and AI investment forming a sharp contrast to a weakening labor market.

Morgan Stanley's chief economist Seth Carpenter pointed out in his latest report that the ultimate outcome of these "contradictory signals" will determine the fate of asset prices, and the market is at a critical crossroads.

On the one hand, consumer spending data shows the economy remains robust, with third-quarter consumer spending growth approaching 3%; on the other hand, signs of weakness in the labor market are continuing to mount.

Goldman's latest research further confirms this contradiction. The firm noted that the two main themes of the U.S. stock market have remained fundamentally unchanged: the continued development of artificial intelligence is driving strong performance in the AI stocks basket (GSTMTAIP), while continued concerns about the labor market are reflected in the poor performance of the labor-sensitive basket (GSXULABR).

"Something always has to give," said Carpenter.

Consumer Spending and AI Investment Show Resilience

According to Morgan Stanley data, economic growth ultimately depends on spending, and the latest spending data shows the economy is robust if not strong. Although the second quarter GDP data is relatively old, it shows a rebound in household service spending, and based on existing data, third-quarter consumer spending growth is close to 3%.

Carpenter pointed out that high-income and high-wealth households account for a disproportionate share of total consumer spending, and wealth has recently increased significantly.

In addition to consumer spending, AI-related capital expenditures are also significant. Such investments are relatively insensitive to short-term cyclical fluctuations because they are a multi-year investment theme.

The Labor Market Shows Signs of Weakness

However, evidence pointing to an economic slowdown is equally convincing. According to Morgan Stanley analysis, job creation has visibly slowed this year. Immigration restrictions have slowed workforce growth, but the unemployment rate has increased with no wage pressure, indicating that labor demand is weakening at least as seriously.

As a result, labor income growth has slowed, and on an inflation-adjusted basis, it was essentially flat or negative last quarter. Carpenter stated that much of consumer spending is concentrated on automobiles, with EV tax credits driving pre-purchase, along with advance buying due to tariffs. This increased spending is likely to see a pullback in the coming months.

Regarding the impact of tariffs, the 2018-19 experience shows that tariffs had a huge negative effect on U.S. domestic manufacturing, lasting more than a year, but this drag began with a lag of about two quarters.

Morgan Stanley analyst Michael Gapen pointed out in recent research that there is evidence that the tariffs so far are essentially equivalent to a tax on production.

The Fed's Policy Path Faces Major Divergence

For the Federal Reserve, the policy path is completely different under the two scenarios. The unemployment rate is close to its full employment estimate, and inflation has exceeded the target for more than four years. Economic resilience or accelerating growth calls for restrictive policy, so little further rate cutting is needed.

By contrast, if the economy slows sharply, unemployment rises, and growth is near stagnation, more rate cuts than current market pricing would be needed.

Carpenter summarized: "There must be a trade-off—if the economy is strong, the market's expectation for rate cuts is excessive; if the economy is weak, corporate earnings may not be as optimistic as expected. Sometimes, the best forecast is simply the average of all possible scenarios."

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