The Market is Being Paid for AI Earnings, but Charged for Inflation Risk

Inflation is moving in the wrong direction

The next phase of the inflation cycle is unlikely to look as benign as the last one.

U.S. inflation is expected to move back above 4%, with core inflation also drifting higher. For now, the pressure is concentrated in energy linked categories such as gasoline and airfares. But core inflation moving back toward 3% is not a comfortable backdrop for the Federal Reserve, especially when the labour market is not weakening in the way many expected.

The latest U.S. payrolls report matters for that reason. Strong job growth in the middle of an energy shock changes the policy discussion (1). It suggests the economy may be able to absorb tighter policy, or at least that the Fed may believe it can. That is why expectations have shifted toward rate hikes later this year, with higher Treasury yields and a stronger U.S. dollar becoming a more realistic path.

The temptation is to call this a short-term blip. That may prove correct if the Strait of Hormuz reopens quickly and energy flows normalize. But “short term” is doing a lot of work in that sentence.

Even with an improvement in energy supply, we would not expect inflation pressure to disappear immediately, and the summer data may still look uncomfortable. The question is how high inflation goes, how long it stays there, and whether households, businesses and markets start to behave as though higher inflation is becoming embedded again.

That is the part central banks cannot ignore.

Central banks are being asked to solve the wrong problem

The current inflation shock is not a classic demand shock.

Central banks know how to deal with excess demand. They raise interest rates, cool spending, loosen the labour market and reduce inflation pressure. The problem today is different. Recent inflation shocks have come mainly from the supply side: COVID, Russia’s invasion of Ukraine, tariffs, and now the closure of the Strait of Hormuz.

Interest rates do not reopen shipping lanes. They do not produce oil. They do not lower tariff barriers. They do not solve geopolitical fragmentation.

What higher rates can do is protect inflation expectations. That is why central banks may still lean hawkish even if they know rate hikes are a blunt instrument. They are not trying to fix the energy shock itself. They are trying to prevent a temporary price shock from becoming a wage and price problem.



For now, the more realistic risk is that central banks become less willing to ease, and more willing to deliver selective hikes, just as growth outside the U.S. remains uneven.

Canada is not in recession, but it is not in a clean expansion either

Canada adds an important nuance.

The earlier GDP data made the economy look as though it had slipped into a technical recession. That likely overstated the weakness, but it did not eliminate the concern. The May labour market data were much stronger than expected, with employment rising by 87,800 and the unemployment rate falling to 6.6% from 6.9% (2). The quality of the gain was better than the headline suggests, with full time employment rising sharply while part time employment fell.

That should reduce fears that Canada is already in, or on the edge of, recession. It also makes the Bank of Canada’s job harder.

Wage growth slowed to 3.0% year over year from 4.5%, which gives the Bank some comfort. But a stronger labour market, combined with rising input prices, keeps the risk of second round inflation effects alive. The Bank is still likely to hold rates steady, but the message is unlikely to sound relaxed.

This is the Canadian problem in one sentence: growth is not strong enough to welcome higher rates, but inflation is not soft enough to dismiss the risk.

There is also a margin story. Earlier evidence suggested that weak demand was limiting companies’ ability to pass through higher energy costs. In other words, higher input prices were being absorbed through margins rather than fully passed on to consumers (3).

That is not a healthy version of disinflation. It is an inflation shock moving through corporate profitability instead of household prices.

For Canadian equities, that distinction matters. Canada may benefit from higher energy exports and stronger resource income, but the benefit is uneven. Higher gasoline, transportation and input costs hit households and companies quickly. The income benefit from higher commodity prices is slower, narrower and dependent on reinvestment, wages and fiscal transmission.

This is why we are cautious about treating Canada’s energy exposure as a clean offset to the inflation shock.

Tariffs are back, but the bigger issue is CUSMA

Tariffs are no longer the dominant market story, but they have not disappeared.

The latest tariff proposal would include a 10% tariff on Canada tied to forced labour import enforcement (4). At face value, the direct economic impact may be limited because CUSMA compliant goods would still be exempt and the measure appears to roll forward a version of the existing universal tariff structure. The effective tariff rate on Canadian exports to the U.S. would likely remain around 6%.

That does not make it irrelevant.

The larger issue is that the tariff structure keeps shifting while the CUSMA review approaches. The U.S. has already signalled an interest in higher North American auto content requirements, including a higher U.S. content share. Even if that does not materially change the Canadian auto sector immediately, it points to where the negotiation may go next.

The near term inflation impact may be modest. The business uncertainty is not.

For Canada, this is another reason the investment backdrop remains complicated. Firms are being asked to make capital spending decisions in an environment where energy prices, tariffs and trade rules are all moving at the same time.

That is not a backdrop that encourages confidence.

Europe’s challenge is more acute

Europe looks more vulnerable than North America.

The euro-zone economy is being hit by the energy shock at a time when business surveys already point to a stall in activity. Inflation is expected to rise further, with headline inflation forecast to peak around 3.5% and core inflation around 2.5% (5). The ECB is expected to raise rates in June and likely again in the third quarter, although those hikes may eventually be reversed if energy prices fall and second round effects remain contained.



That is a narrow path.

The labour market is still tight, but less tight than it was during the 2022 energy shock. Wage growth has slowed, vacancy rates have come down, and firms still expect wage growth to moderate. That helps reduce the risk of a wage price spiral. It does not remove the problem. Europe is facing weaker growth, higher energy costs and less policy flexibility at the same time.

The regional details also matter. Activity has been particularly weak in Germany and France, while Italy and Spain have been more resilient. That unevenness makes a coherent policy response harder.

The equity market has recognized part of this. Euro-zone equities have recovered from the initial shock, but U.S. equities have moved ahead more forcefully. The reason is not that Europe has no good companies. It is that the U.S. index has a much larger technology weight, and that sector exposure has become the dominant driver of relative equity performance.

This reinforces our caution toward broad developed international exposure.

The U.S. still has the growth advantage, but AI is carrying more weight

The U.S. economy remains in better shape than most other developed markets. A major reason is the investment boom around artificial intelligence.

AI related investment has become a meaningful contributor to U.S. growth. Without that impulse, U.S. growth would look materially less impressive. That matters because it changes the way investors should think about U.S. resilience.

The U.S. is not simply stronger because the consumer is stronger, or because policy has been more supportive. It is stronger because one very large capital spending cycle has been doing a lot of work.



That does not make the cycle unsustainable. It makes it important.

There is also a meaningful difference between the AI boom and the technology boom of the 1990s. The information and communications technology revolution eventually helped generate disinflationary pressure through productivity gains. AI may do that too, but the evidence today is less clear. In the near term, the AI buildout is creating demand for power, chips, software, data centres and capital. That can be inflationary before it becomes productivity enhancing.

This is one of the more important tensions in markets today. Investors are treating AI as a growth story. Central banks may increasingly have to treat parts of it as a demand and inflation story.

Earnings have justified more of the rally than valuations alone suggest

It is easy to say U.S. equities are expensive. It is harder to say the rally has been purely speculative.

Forward earnings in the large technology companies have more than doubled since the AI cycle began in late 2022. Earnings for the broader index have also risen significantly, even though much of that increase has been driven by the size and profitability of the largest technology related companies.

That earnings growth has done important work. It has prevented valuations from looking even more stretched. The forward price to earnings ratio for the S&P 500 has fallen from levels seen late last year, even as the index has remained elevated, because earnings expectations have continued to rise.

This is why the comparison with the late 1990s is useful but incomplete.

In the dotcom period, valuations reached more extreme levels before the bubble burst. Today, valuations are high, but earnings growth has also been unusually strong. If earnings continue to grow at anything close to the recent pace, the market can continue to move higher.

But that is also the weakness in the argument.

The market does not need earnings to be good. It needs earnings to keep being exceptional.

Good news can become bad news when discount rates rise

A stronger economy is usually good for equities.

Not always.

When inflation is rising and central banks are becoming more hawkish, strong economic data can push yields higher and weigh on equity valuations. That is the “good news is bad news” dynamic markets have been wrestling with.

This matters more today because the AI boom has driven equity gains beyond what U.S. economic growth alone would justify. In that context, Fed hikes would add another late 1990s parallel: a powerful technology narrative, a market willing to pay high multiples for future earnings, and a central bank moving in the other direction.

That does not mean a repeat of 2000 is inevitable. It means the hurdle for earnings is rising.

A market that depends on long duration growth expectations is sensitive to real yields. If Treasury yields rise further, especially at the front end and in real terms, equity investors will demand more proof that the earnings story is durable.



That proof is more likely to come from revenues, margins and guidance than from narrative alone.

The market’s problem is not current earnings. It is the expectation of uninterrupted earnings growth

The most important risk to this rally is not that AI suddenly disappears. It will not.

The risk is that the revenue path becomes less linear than investors expect. A semiconductor company misses guidance. A hyperscaler signals a slower pace of demand. Margins compress. AI lab spending disappoints. The market begins to question whether the final end use demand is large enough to justify the scale of capital being deployed.

That is when the narrative can shift quickly.

The equity market is not simply pricing AI adoption. It is pricing rapid AI adoption, sustained capital spending, strong pricing power, rising earnings, and limited evidence of overcapacity. That combination leaves little room for disappointment.

It is also worth remembering that bubbles do not always need a single obvious catalyst. The dotcom unwind began through the valuation channel before the earnings damage became clear. Markets can fall because expectations stop rising. The earnings disappointment can come later.



This setup deserves respect. It does not deserve complacency.

Canada Life Investment Management portfolio implications

We are not treating this as a reason to step away from risk. We are treating it as a reason to be more deliberate about which risks we own.

U.S. equities still have the strongest earnings support among major developed markets. The AI cycle remains powerful, and there is not yet clear evidence that demand is fading. But the market is relying on a narrow earnings engine, and that engine has to keep delivering.

In our view, this places greater value on companies and managers that demonstrate earnings discipline, balance sheet strength, durable cash flow generation and the ability to withstand a higher nominal rate environment. It also reinforces the importance of not treating all AI exposure as equal.

The question is not who can tell the most compelling AI story. The question is who can turn that story into repeatable earnings without relying on permanent multiple expansion.

Outside the U.S., the hurdle remains higher. Canada has improved at the margin, but weak productivity, trade uncertainty and uneven inflation pass through still create a difficult backdrop. Europe faces an even harder balance between weak growth and rising prices. In our view, broad international developed exposure carries more macro risk than the recent rebound suggests.

We are viewing fixed income through the same lens. Duration can still help if growth weakens, but the inflation backdrop is less comfortable. Central banks may not be able to cut as quickly as markets would like if inflation expectations become less anchored. Quality, liquidity and flexibility remain important considerations.



We continue to see alternatives as an important part of portfolio construction. Inflation risk, geopolitical risk, rate volatility and equity concentration are all present at the same time. This is not an environment being driven by one clean macro variable.

Final thought

The rally can continue.

That is the uncomfortable part for investors focused only on valuation. Earnings have been strong enough to justify more of the move than many expected, and AI related investment continues to support the U.S. economy.

But the market now needs more things to go right at the same time.

Inflation is moving higher. Central banks are becoming less comfortable. U.S. labour market strength makes Fed hikes more plausible. Canada is not as weak as feared, but the Bank of Canada cannot ignore second round inflation risk. Europe is dealing with the harder combination of weak growth and rising prices. Tariffs and CUSMA uncertainty are adding another layer of friction.

The equity market is increasingly reliant on the assumption that AI related earnings can continue to grow at an exceptional pace.

That may prove right.

But when investors become emotionally attached to a narrative, evidence stops being evidence. The AI story may still have room to run, but from here, enthusiasm alone is not enough. Earnings have to keep confirming the story.

Sincerely,

Corrado Tiralongo (he/him)

Vice President, Asset Allocation & Chief Investment Officer

Canada Life Investment Management Ltd.

(1) U.S. Bureau of Labor Statistics, Employment Situation, May 2026 – nonfarm payrolls increased by 172,000, while the unemployment was unchanged at 4.3%

(2) Statistics Canada, Labour Force Survey, May 2026

(3) Statistics Canada, Consumer Price Index, April 2026, released May 19, 2026. The CPI increased 2.8% year over year in April, up from 2.4% in March, while gasoline prices rose 28.6% year over year.

(4) Office of the United States Trade Representative

(5) Eurostat data

The views expressed in this commentary are those of Canada Life Investment Management Ltd. as at the date of publication and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice. Prospective investors should review the offering documents relating to any investment carefully before making an investment decision and should ask their financial security advisor for advice based on their specific circumstances. 

This material may contain forward-looking information that reflects our or third-party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of June 7, 2026. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise. 

Investment Planning Counsel and the Investment Planning Counsel logo are trademarks of Investment Planning Counsel Inc.