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Generation AI

How can rapidly improving artificial intelligence change the economy forever?

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We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights into recent action in the equity and fixed-income markets; what economic data is telling us about the Federal Reserve’s next decision; how generative AI is rapidly changing our world; and opportunities in fixed income. We finished up with a speed round of questions and a personal reflection.

Market Performance: Total Return
Past performance does not guarantee future results. Source: Morningstar as of 1/31/24. *The S&P 500 Equal Weight Index is the equal-weight version of the widely used S&P 500 Index, which is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States. The Russell 2000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States. Bank loans represented by Credit Suisse Leveraged Loan Index, which is designed to mirror the investable universe of the U.S. dollar-denominated leveraged loan market. HY Corporates represented by Bloomberg US Corporate High Yield Index, which measures the USD-denominated, high-yield, fixed-rate corporate bond market. IG Corporates represented by Bloomberg US Corporate Index, which covers performance for United States corporate bonds. The Bloomberg US Aggregate Bond Index (Agg) is composed of investment-grade U.S. government bonds, investment-grade corporate bonds, mortgage pass-through securities, and asset-backed securities, and is commonly used to track the performance of U.S. investment-grade bonds.

Let’s start with the markets. Equities reached an all-time high in February. What’s driving this?

In a nutshell, the economy’s performing better than expectations. Entering the year, blue-chip consensus started with a U.S. Q1 GDP estimate between zero to 1%. Today, the Atlanta Fed’s GDPNow is forecasting 2.5%, and blue-chip consensus has now upped their forecast of GDP to around 2%. And by the way, that’s real GDP. Interest rates are stubbornly higher than we expected, so nominal GDP should be much higher than expected.

Magnificent 7
Past performance does not guarantee future results. Source: FactSet, 1/1/2024 - 2/29/2024. *Weighted average return, 3.98% of the total return of 7.11%. A full list of each fund's holdings can be found at www.aristotlefunds.com/resources/prospectuses-reports and are subject to change at anytime. Any discussion of individual companies in this presentation is not intended as a recommendation to buy, hold or sell securities issued by those companies.

What’s happening with the darling of the stock market in 2023, the Magnificent 7?

The S&P 500 Index is up about 7% through February. And while the Magnificent 7 was up about 3%, the S&P 493 was up almost 4%. There is quite a bit of dispersion when it comes to the performance within the Magnificent 7. Three of the companies—Apple, Alphabet and Tesla—are negative year-to-date.

What about fixed income?

Because inflation remains higher than expected, rates are higher. Investment grade is suffering, but the floating-rate loan asset class continues to be the standout performer. Higher-for-longer has been in play for more than a year beyond expectations.

U.S. Treasuries have drifted higher since the start of the year with most of the moves in 3- and 5-year maturities. How do you view this?

I think it is the market tempering the expectations for a Fed rate cut.

Consumer Spending
Source: BofA Securities and Aristotle Funds, as of 3/6/24.

Let’s turn to the economy. What’s the economic data telling us?

First quarter GDP is forecasted around 2 to 3%. That is a solid number. And again, that’s real GDP, nominal will be much higher. Inflation’s up about 3% year-over-year. Food is up less than that. Energy is down almost 5%. Unemployment is at 3.7%, and it’s expected to stay near that number. Average hourly earnings are up 4.4% year-over-year. With inflation up 3% and hourly wages up 4%, the worker is catching up a little bit over the past year. One of the elements I am watching is consumer spending. In particular, the BofA daily credit card spend data is down over the past year during much of February. Behavioral elements are also changing as sectors such as transit and grocery spending are up while airline, lodging, and restaurants are down. This suggests that consumers are shifting to less expensive consumption.

Fed Futures: Rate-Cut Doubts
Source: Bloomberg, as of 3/5/24.

Will the Fed pause rate hikes again when it meets later this month?

I don’t think there’s a cut on the table in March. When we entered the year, market expectations were for six cuts in 2024. Now, that number stands at three. I think the Fed has navigated the economy into a decent spot where a soft landing is in play, and they have a window to execute. We’ll see if they hold on too tight for too long, which has been my concern for a while.

Let’s shift gears and talk about generative AI, which may turn out to be one of the most disruptive technologies in human history. To begin with, what is generative AI?

I actually typed that question into ChatGPT, which is powered by generative AI, and here’s the answer I received: “Generative AI refers to systems that create new content—like images, text or music—using patterns and information learned from existing data. It’s about machines generating creative outputs on their own.” Here’s another way to think about it. Search engines of the past have been organizers of data. Generative AI is an interpreter of data, creating new data.

AI's Rapid Adoption
Sources: Global X ETFs with information from BBC News, Netflix History, and CBS News.

Can you give me a sense of how rapidly generative AI is being adopted?

It’s mind blowing to me. It took Netflix a decade to get 100 million users. It took Google Translate a few years. TikTok blew up in this country, and it still took nine months before it saw 100 million users. ChatGPT did it in two months. I’m very much in the camp that this is a disruptive, transformative technology, and 100 million users in two months gives you a sense of the velocity of what’s happening.

Generative AI Impact
Note: Impact is average. ¹ Excluding software engineering. Source: Comparative Industry Service (CIS); IHS Markit, Oxford Economics; McKinsey Corporate and Business Functions database; McKinsey Manufacturing and Supply Chain 360; McKinsey Sales Navigator; Ignite, a McKinsey database; and McKinsey analysis as of 6/30/23.

How is it impacting sectors?

It’s still very early, but let’s take one example. The Swedish company Klarna, which offers buy-now-pay-later products, launched a generative AI
customer-service assistant in January. Below is from a press release in February. I think these are meaningful data points to understand potential impacts of AI.

• It is doing the equivalent work of 700 full-time agents

• It is on par with human agents in regard to customer satisfaction score

• It is more accurate in errand resolution, leading to a 25% drop in repeat inquiries

• Customers now resolve their errands in less than 2 minutes compared to 11 minutes previously

• It’s available in 23 markets, 24/7 and communicates in more than 35 languages

• It’s estimated to drive a $40 million USD in profit improvement to Klarna in 2024

Generative AI Semiconductor Revenue
Past performance does not guarantee future results. Source: FactSet 3/1/2021 - 2/29/2024.

What company has profited the most from generative AI so far?

NVIDIA. The chips—GPUs or graphics processing units—used in generative AI are different than the CPU chips we grew up with. GPUs are something NVIDIA has been doing in the gaming consoles for decades. The GPUs’ ability to translate complex data makes them more ideal for generative AI. So far in 2024, NVIDIA's shares have surged by 80% and, over the past 12 months, increased 269%, making it the world’s third most-valuable company with a market cap of over $2 trillion. NVIDIA is not a generative AI company; it’s picks and shovels for AI.

Now some of the most well-known developers of generative AI have given ominous warnings about the technology. What sort of kind of dangers do you see?

Any powerful tool in the hands of humans is going to have risks. For example, AI’s ability to create fake images or videos—which can’t be distinguished from real ones—is very troubling. Recently, scammers used generative AI on a video call to impersonate a finance professional’s CEO and staff members, who convinced him to wire out $25 million.

On a scale of one to 10, how worried are you about generative AI?

I think it’s going to do much more good than harm. I’ll rate the danger a three. As far as the capabilities to do harm, that’s much higher. So, the benefits far outweigh the risks, so that number is low, but the capabilities to do harm are extreme. It could be an eight or nine in the wrong hands.

Let’s talk bonds. Where do you see opportunities in fixed income today?

Once again, I will lean into the floating-rate loan trade. The curve on the short end is less inverted today, but with the data-dependent Fed continuing to pause, inflation being a little bit stickier and the economy hanging in there, the loan trade is still attractive to me. I would say duration, however, is a little more attractive as rates have gone up since the beginning of the year. Yield levels are still quite strong.

Attractive Yields
Past performance does not guarantee future results. Source: Bloomberg and Credit Suisse, as of 1/31/24. Yield quoted is yield-to-worst—a measure of the lowest possible yield that can be received on a bond with an early retirement provision—except for Bank Loans, which represents 4-year effective yield. (The effective yield is the return on a bond that has its interest payments or coupons reinvested at the same rate by the bondholder). US Treasury represented by the Bloomberg US Treasury Index. Investment-Grade Corporates Bonds represented by Bloomberg US Corporate Index. Short term investment grade corporate bonds are the 1-3 year component of the Bloomberg US Credit Index. Bank loans are represented by the Credit Suisse Leveraged Loan Index and index components. High yield is represented by the Bloomberg US Corporate High Yield Index.

Now for the lightning round. First topic: Bitcoin.

To me, the SEC approving Bitcoin ETFs in January was a game changer for cryptocurrency.

The chances of a recession this year.

For me, it feels like it’s less than 50% and probably now down to 30% to 40%. My prediction is probably a little higher than most because, to me, the Fed will keep conditions tighter for longer.

California’s unemployment rate, the second highest in the nation at 5.1%.

It largely reflects tech tightening its belt, creating some distortion in those unemployment numbers. But make no mistake, the tech innovation coming out of California is still unmatched by the rest of the country.

Oprah and WeightWatchers.

I think she did what she needed to do—resign from the WeightWatchers’ board and donate the stock to a nonprofit. It apparently wasn’t discipline that got her to lose pounds, it was a weight-loss drug.

Wendy's dynamic pricing.

I think it’s a big miss by their marketing department. Many people are taking Wendy’s dynamic-pricing announcement as, “You’re going to jack the prices on me.” And it went over like a lead balloon. Sit-down restaurants and bars do the same thing, but they call it happy hour. That’s a positive connotation. Surge pricing is a very negative connotation. Wendy’s promotion was poorly rolled out, missed the mark and they’ve been on the defensive since.

Let’s close with a personal reflection.

We just went through Super Tuesday, and it appears the country has decided on two presidential candidates to choose from to lead the free world. When I speak to people about the upcoming general election, most folks say their decision’s going to be based on who they think will do the least amount of harm. To me, it feels like the vast majority of the people has become beholden to what I’ll call the tyranny of the extremes. I think this has happened, in part, because the voice of the majority doesn’t seem to be media worthy since it tends to be non-controversial and common-sense based. The extremes and their views have had media leverage for years. What I hope is that non-extremist leader finds a voice that helps us change course. I think the United States could use someone today that unifies the majority—citizens who don’t want to be at odds with each other and appreciate constructive, respectful debate and compromise. I hope there’s a person out there who shows him or herself in the very near future and our country embraces it.

The Atlanta Fed GDPNow is a running estimate of real GDP growth based on available economic data for the current measured quarter.

Bank loans (or floating-rate loans) are financial instruments that pay a variable or floating interest rate. A floating rate fund invests in bonds and debt instruments whose interest payments fluctuate with an underlying interest-rate level.

Blue Chip Economic Indicators is a monthly survey and associated publication by Wolters Kluwer collecting macroeconomic forecasts related to the economy of the United States.

Bonds are debt instruments and represent loans made to the issuer. Governments and corporations commonly use bonds in order to borrow money.

Duration can measure how long it takes, in years, for an investor to be repaid a bond’s price by the bond’s total cash flows. Duration can also measure the sensitivity of a bond’s or fixed income portfolio’s price to changes in interest rates.

The federal funds rate is the interest rate that banks charge each other to borrow or lend excess reserves overnight. The nominal Gross Domestic Product (GDP) growth rate compares the year-over-year (or quarterly) change in a country’s economic output to measure how fast an economy is growing. Real GDP is GDP adjusted for inflation.

Investment grade refers to the quality of a company’s credit. To be considered an investment grade issue, the company must be rated at ‘BBB’ or higher by Standard and Poor’s or Moody’s.

The Magnificent 7 stocks are a group of high-performing and influential companies in the U.S. stock market: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla.

The S&P 500 Index is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.

A soft landing refers to a moderate economic slowdown following a period of growth.

The U.S. Treasury yield curve refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds.

A U.S. Treasury note is a government debt security with a fixed interest rate and maturity between two and 10 years. Yield is the income returned on an investment, such as the interest received from holding a security.

Any performance data quoted represent past performance, which does not guarantee future results. Index performance is not indicative of any fund’s performance. Indexes are unmanaged and it is not possible to invest directly in an index. For current standardized performance of the funds, please visit www.AristotleFunds.com.

The views expressed are as of the publication date and are presented for informational purposes only. These views should not be considered as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment or market. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant.

Investors should consider a fund’s investment goal, risk, charges and expenses carefully before investing. The prospectus contains this and other information about the fund and can be obtained at www.AristotleFunds.com. It should be read carefully before investing.

Investing involves risk. Principal loss is possible.

Aristotle Funds and Foreside Financial Services, LLC are not affiliated with Pacific Life Fund Advisors LLC.

Foreside Financial Services, LLC, distributor.

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