The AI Arms Race

We recently sat down with Dominic Nolan, CEO of Aristotle Pacific Capital, to get his insights into the heated AI arms race, the health of the economy, Fed expectations, recent market action, and opportunities in fixed income. We finished with a random round of questions.

Market Performance

U.S. stocks and bonds had a great month in August. What happened?

At the core of it, I think the Federal Reserve has set the table in September for the long-awaited interest-rate cut, and markets have responded accordingly. In August, the S&P 500 Index was up a little over 2% and is up almost 10.8% for the year. The S&P 500 Equal Weight Index was up 2.6% in August and nearly 8.7% for 2025. But the big mover was, surprisingly, small caps, with the Russell 2000 Value Index up 8.5% in August. Small caps outperformed large-cap growth with the Russell 1000 Growth Index returning only 1.1% during the month.

What about bonds?

It was an above-coupon month. Again, I think the market is responding to Fed setting the tone for rate cuts. The Bloomberg US Aggregate Bond Index (Agg) was up 1.2% for August. Investment-grade corporates finished up a little over 1%, and bank loans up about 0.5%. As for the year, high yield leads at 6.3%; next is investment grade at 5.3%; then the Agg at 5%; and finally bank loans at 4.4%. In general, portfolios should be having a very positive 2025.

Mag 7

The Magnificent 7?

For the Mag 7, it was a mixed bag. Apple, which has been a laggard this year, had a great month, up nearly 12%. They beat on second-quarter earnings largely due to iPhone sales and services. Google was a close second, returning almost 11%. But the story is Nvidia—it beat on second-quarter earnings with $46 billion in revenue and a 72% profit margin. But expectations were so high that even after announcing those amazing second-quarter earnings and a $60 billion share buyback, the stock’s been down since Aug. 27. That’s an indicator of the lofty expectations.

U.S. Treasury Yield Curve

U.S. Treasury yields fell across the curve. Does the market believe a September cut is a lock given Fed Chair Powell’s comments at the recent Jackson Hole Economic Symposium?

I think that’s an easy one. Yes, the market believes it and has reflected it. Bigger picture, we’re still at two rate cuts for the year. In 2026, I believe we’re going to see how the economy, jobs picture and tariff impacts unfold. The market is still digesting. But right now, expectations are for a cut in September and one in December. That should take us inside of 4% on short-term rates.

Fed Futures

Does the public fight to remove Federal Reserve Gov. Lisa Cook remind you of emerging-market monetary policy?

I would say we’re a step closer. So much of our financial system, including our banking, is based on trust. Fed governors have 14-year terms, which is designed to diminish political pressure so they can be as independent as possible. Firing Gov. Cook for what appears to be an unrelated issue regarding a mortgage application seems to me a cheap and unprecedented way to create cause to remove a Fed governor. A key feature of our financial system—and why countries use the U.S. dollar as reserves—is the level of trust and transparency it has, and the Fed is a major part of this. The move to fire Gov. Cook does erode that fabric in my opinion.

Economic Dashboard

What’s the current economic data signaling?

In the first half of the year, we saw parts of the economy weakening, but the job market stayed strong. Right now, we’re seeing the opposite. The Atlanta Fed GDPNow real GDP estimate for the third quarter stands at a decent 3%. Inflation seems to be settling around 2.7%, but the impact of tariffs may change that, at least in the short term. Consumer confidence hasn’t materially changed. Against this healthy backdrop, a troubling jobs' picture stands out and shouldn’t be ignored. The concern right now is about jobs and manufacturing. The ISM Manufacturing Index has been below 50 now for six months, which is a negative indicator as far as the economy goes. Again, all this means the Fed has room to cut, and assets are going to have a little bit of relief, which is what we saw in August.

Historical Timeline

Let’s talk about something that is more and more in the news: the AI arms race. Can you first give us a timeline on the development of artificial intelligence?

The term “AI” was first coined in 1955, but it didn’t really become widely known until 1997, when IBM’s Deep Blue computer defeated a world chess champion. Then came Siri and Alexa in the 2010s, which popularized the use of AI. The big breakthrough occurred in 2023 with the rollout of ChatGPT-4, which became immensely popular almost overnight.

To give you a sense of AI’s exponential growth in computing power since 2020, that year ChatGPT-3 rolled out with 3,600 petaflops—a measurement of computing speed. Three years later, ChatGPT-4 came with 200,000 petaflops—60x more than its predecessor. And this year, ChatGPT-5 was introduced with about nine-million petaflops—48x more than the previous ChatGPT version. The AI revolution is happening so fast that companies can’t keep up, and regulation can’t keep up. It makes for an exciting and unsure future of its impact.

The Leaders

Who are the leaders in this space?

Before ChatGPT-5 rolled out, Poly market had the odds at 75% that OpenAI—developers of ChatGPT-5—would be the AI leader. But ChatGPT-5s rollout has been met with better, but diminished incremental performance, and those odds have dropped to just 14%. OpenAI has lost its significant early lead on the performance side. As it relates to engines beyond OpenAI, in order—and these are closely bunched together—are Grok 4, Gemini, Claude 4.1, and China’s DeepSeek 3.1. Trailing those by a significant amount is Llama 4. The race is fast and furious.

Trillion-Dollar Battle

AI capital expenditures are forecasted to be massive in the coming years. Can you give a sense of how large?

Alphabet, Amazon, Meta and Microsoft are spending a combined $88 billion on capex for AI. To put that into context, spending on AI infrastructure will surpass office construction this year in the U.S. And that’s not counting the breathtaking amounts of money being thrown at AI engineers. For example, Meta’s Mark Zuckerberg is offering compensation packages worth $100 million over several years. The size of these investments is something we’ve never seen before.

AI Compute Needs Storage

What are the broader implications of AI on energy, infrastructure, and the workforce?

The computing power used by AI requires an enormous amount of power, which means we’re in an energy race to fuel AI data centers. One solution in the works is building small nuclear reactors for data centers, which gives you an idea of how much power is needed. As for the workforce, it’s very early, but companies seem to be rapidly adopting the technology with about 80% using AI for at least one business function. It will be fascinating to watch this play out in real time.

Meet the Newest Hire - Generative AI

The Price of Intelligence

Let’s pivot to something fun. Why is chess useful in assessing AI capabilities?

It can be a good yardstick on how far the technology has come. In August, an AI chess tournament was held with the leading models, and ChatGPT-3 won, though all the matches were close. It’s interesting to me that AI models are still behind computers singularly devoted to chess playing. Why? Because as it stands now, AI is not programmed to think many moves ahead, which is what serious chess players and the computers who beat them do. AI’s chess-playing ability currently is only that of a club player, at best. It shows how far there is still left to go.

Who Wins a Game of Chess?

What is the real significance here with all these AI developments?

There is a broad camp of decision makers that believe for the U.S. to remain a global superpower, you want to secure three things: the strongest economy, the strongest military, and the strongest technology—and the emerging AI wave is the center of technological strength. It’s all interrelated. When we think about military, the center of military strength is technology. And the best military and technology are anchors to a dominant economy. Going hand-in-hand with this is the need for open markets, data centers, energy to fuel them, and deregulation. The bottom line is the AI race is critical for us to remain the superpower that we are.

Fixed Income Yields and Year-to-Date Returns

Turning back to investing, where are you seeing opportunities in fixed income today?

With what’s expected from the Fed, I would lean a little more into duration. I'd say from a fixed-rate standpoint, you’re seeing a weakening jobs market and manufacturing picture, and the Fed is opening up. I feel yields are still a little elevated, and the 10-year Treasury going into high threes is more fair value, in my opinion. Investment-grade corporates are appealing to me right now, though I would balance that with some floating rate exposure as rate cuts could propel the economy higher.

Time for our random. I’ll give you a word or phrase, and you tell me the first thing that comes to your mind. First: Gold at $4,000 an ounce at year’s end. Yes or no?

I'll take the under.

Government taking equity stakes in Intel and defense contractors.

This is an interesting one. President Trump’s style has been: Jam the CEO publicly, strike a deal and call it great. It is an interesting pivot for us. The danger is the U.S. government may now have a favorite student and start to tilt the playing field to favor this quasi-government entity. At the same time, if we’re going to help support companies through government contracts, having a piece of that business I think is fair as well. It’s going to be interesting to see the ripple effects. In a vacuum, I don’t have a problem, but it’s too early to tell.

Travis and Tay’s engagement.

Good for them.

Will legendary NFL Coach Bill Belichick lead North Carolina football to greatness?

If he can get Tom Brady as the quarterback, then yes.

Super Bowl pick?

I like Buffalo Bills quarterback Josh Allen. I’m rooting for him and therefore his team.

A 10-year Treasury note is a debt obligation issued by the United States government with a 10-year maturity period.

The Atlanta Fed GDPNow provides a running estimate of real GDP growth for the current quarter using available economic data.

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.

A bond is a fixed-income instrument and investment product where individuals lend money to a government or company at a certain interest rate for an amount of time. The entity repays individuals with interest in addition to the original face value of the bond.

Capital Expenditure (CapEx) is the money a company spends to acquire, upgrade, or maintain long-term, physical assets.

Consumer Confidence measures consumers’ attitudes and optimism about the economy and their personal financial situation.

Coupon refers to the interest payment that a bond issuer promises to pay to a bondholder.

Fixed income refers to assets and securities that pay a set level of income to investors, typically in the form of fixed interest or dividends.

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.

An investment-grade bond is a type of bond that is considered to have a relatively low risk of default.

The ISM Manufacturing Index is a monthly economic indicator published by the Institute for Supply Management (ISM) that gauges the health of the U.S. manufacturing sector.

Treasury rate (or yield) refers to the interest rate at which the U.S. government borrows money by issuing Treasury securities.

Yield is the income returned on an investment, such as the interest received from holding a security.

A yield curve plots the interest rates of bonds that have equal credit quality but different maturity dates.

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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.

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