What The Market Is Not Discounting

• Right now, markets are challenging the way many investors think about risk and reward. There’s a growing sense that inelasticity and market structure are playing a bigger role than many realise. Research by Koijen, Gabaix, and Haddad shows that every dollar going into passive index funds can now create between seven and eight dollars of market value, and for giants like Apple and NVIDIA, that figure can be as high as $75 to $100. This is a big change from what the old Efficient Market Hypothesis used to tell us, which was that new money would barely move prices. These days, passive investing has set off a feedback loop, with money getting pushed into the largest stocks and prices going up simply because the index says so. As these indices get more concentrated, that loop just gets stronger, lifting valuations no matter what’s happening underneath. Rules like Secure Act 1 and 2 have only added fuel to the fire, drawing more and more retirement contributions and employer money into these funds, even as the economy is starting to weaken.

Economic Fragility & Tariffs

• Beneath the surface, the economy isn’t as strong as it looks. Commodity markets are a good place to start: prices for things like iron ore, copper, and nickel are pretty much flat when you measure them against gold. That’s telling us there’s a gap between the financial markets and the real economy, and that gap is getting bigger. Tariffs are making it worse too, they’re basically a sales tax on imported goods. Japan saw something similar back in 2014 when a sales tax hike sent prices shooting up because of supply issues. Now, we’re seeing the same pattern in the US, especially in electronics. Some things are getting more expensive fast, while others are seeing demand fall. Even housing, which people usually think of as inelastic because everyone needs a place to live, is starting to slow down. More young adults are living at home, and adult children are moving back in to help their parents. That’s putting a lid on housing demand. The Cleveland New Tenant Rent Index has been dropping sharply, and housing prices are down in the key S&P Shiller indices for the first time in years. Housing is a big part of the inflation basket, so this slowdown could ease some of the price pressures from tariffs.

Inflation, AI & Real Yields

• Inflation expectations themselves are increasingly distorted by the methods used to measure them. Surveys like the Michigan Consumer Expectations Index now reflect not just economic concerns but also deep tribal polarisation. Democrats expect inflation to rise by 12 percent, while Republicans expect less than 2 percent, creating a headline divergence that doesn’t match market-based metrics. The shift from telephone-based surveys to online platforms has removed the human filter, allowing extreme views to proliferate unchecked. Moreover, the infiltration of surveys by large language models scraping popular media narratives has amplified the perception of unmoored inflation expectations. However, market-based measures such as the 5y5y forward inflation swap are falling, indicating that longer-term inflation risk may be declining rather than rising. In the housing sector, Owner’s Equivalent Rent, a major component of the CPI, is showing signs of normalising after years of lagged responses. Truflation, once a reliable early indicator of housing pressures, now suggests that shelter inflation is retreating towards more sustainable levels. This divergence between survey-based expectations and market-based realities complicates the assessment of real yields and undermines confidence in risk premia calculations.

• The rise of AI investment mirrors the early internet era’s dot-com build-out. The period saw a zealous rush to lay fibre optic cables and build switching equipment based on expectations of permanent high prices for internet services. Yet technological breakthroughs like wave multiplexing and amplifiers soon rendered much of that infrastructure redundant, leaving vast amounts of excess capacity that remain underused today. A similar dynamic now threatens to unfold in AI, where investors have poured capital into anything associated with AI, such as semiconductor stocks, without fully grasping the underlying economics. The transition from the training phase of AI to the exploitation phase, where AI applications achieve human-level performance on routine tasks, will drive costs down dramatically. The analogy to washing machines replacing washerwomen captures this deflationary impact: once AI is embedded in services, prices for those services will collapse, much as physical machines once transformed domestic labour. While the integration of AI will require significant investment in energy infrastructure, particularly in nuclear energy, the overall share of energy in GDP remains modest compared to the services sector. This means that, despite near-term capital expenditure pressures, the broader economic impact of AI is likely to be deflationary, with significant implications for corporate margins.

Equity Risk Premia

• Turning to the equity markets, the confluence of these trends poses a difficult challenge. Passive inflows continue to prop up indices as long as households have jobs and default into retirement contributions via Qualified Default Investment Alternatives. Yet the feedback loop remains vulnerable to disruption. As companies bring in performance reviews to let go of weaker employees, just like Facebook’s recent move to a General Electric-style model of continuous layoffs, the risk of a pronounced rise in unemployment grows. This, in turn, threatens to dampen consumption and ultimately weaken the very flows that sustain equity markets. Meanwhile, concerns around the sustainability of the equity risk premium (ERP) are intensifying. Historically, the ERP averaged around 5 percent in excess returns on bonds, but over the last decade, US investors have enjoyed ERPs exceeding 10 percent. With corporate earnings under pressure and fundamental indicators such as cyclically adjusted PE ratios at all-time highs, questions are mounting over whether the US can sustain these excess returns. Some forecasts even suggest that the ERP could contract to zero or turn negative. Soft data show a slowdown in high-end consumer spending, notably in sectors like hotels and airlines, while CAPEX and new orders are being cut. Rising prices paid by firms, 60 percent of which are small and medium-sized enterprises, are exacerbating the pressure on corporate margins, feeding a feedback loop of declining profits, rising unemployment, and softening consumption.

• Looking more closely at credit markets further reveals the opportunities and challenges ahead. In high-yield investing, strategies that hedge credit exposure, such as those built on the Merton model of capital structure. offer a potential path to navigate the volatility. The Merton model conceptualises equity as a call option on a firm’s assets, with debt holders effectively owning the firm until the assets exceed the debt’s face value. By constructing an index that goes long on high-quality companies unlikely to tap capital markets and short on serial refinancers and loss-making firms, investors can isolate the risk associated with capital market dependence. Overlaying this with high-yield exposure enables a strategy that effectively hedges credit spreads. During periods of credit spread widening, this approach captures outperformance of around 300 basis points relative to standard benchmarks, while giving back a smaller portion, around 100 basis points, during periods of spread tightening. Over time, this compounding of relative gains can produce significant outperformance. The flexibility to reallocate capital at attractive prices, while shielding portfolios from the worst effects of credit spread volatility, becomes a key advantage in the current environment where economic uncertainty and credit market fragility are pronounced.

• At Cordoba Capital, we see the current market as one that demands thinking upside down, asking the opposite, and always questioning the usual story. The self-reinforcing nature of passive investing has created an illusion of strength that hides just how fragile the underlying fundamentals really are. Real yields of 2.8 percent on 30-year Treasuries now offer an alternative to risk-laden equities, especially as the structural challenges facing US markets intensify. The feedback loop of corporate margin contraction, rising unemployment, and softening consumption threatens to unwind the very flows that have underpinned the bull market of the past decade. Navigating this environment requires more than passive allocation; it calls for a granular understanding of risk premia, a keen eye for regional opportunities, and a readiness to embrace alpha-driven strategies that can exploit market inefficiencies. In this landscape, active management is not just a choice but a necessity and looking beyond the US towards regions like Europe and Asia, and more specifically Malaysia, where equity risk premia are higher, may offer investors a more attractive risk-reward profile in the years ahead.