Michael Batnick and Ben Carlson interview Michael Aroney, Chief Investment Strategist at State Street Investment Management, discussing the record-breaking ETF industry growth and market dynamics.

The conversation covers the incredible rotation happening within the S&P 500, with leadership shifting away from the Mag 7 technology stocks toward industrials, materials, and other sectors as AI investment patterns mature.

Aroney explains how the structural shift from globalization to deglobalization is driving market leadership changes, while examining whether AI productivity gains can sustain corporate profit margins that have doubled this century.

The discussion touches on geopolitical risks, the sustainability of the current bull market, and what factors could potentially derail the economic expansion, with particular focus on the role of long-term interest rates.

ETF Industry Hits Record Trading Volumes and Growth

ETFs set a quarterly record with $22 trillion worth of shares traded in Q1, with March being the biggest volume month ever, and volume is on pace to beat last year's record by 50%.

SPY launched in 1993 as the first U.S. ETF when investors could only own the S&P 500 through buying all 500 stocks or a mutual fund, spawning an industry now worth over $13 trillion in the U.S. and $20 trillion globally.

The ETF industry reached $500 billion in new flows faster than ever before, driven by the shift from commission-based to fee-based wealth management and the growing U.S. wealth management community.

Market Rotation Away from Mag 7 Technology Dominance

The Mag 7 stocks were down 16% year-to-date at their April lows and remain down 7% for the year, while the S&P 500 is flat, demonstrating incredible rotation within the index.

The rotation began in November when AI bubble fears emerged around hyperscaler capital expenditures and whether businesses would achieve return on investment from AI spending.

"We're moving from efficiency to resiliency" - Michael, explaining how the shift from globalization to deglobalization is driving leadership toward real assets like gold, industrials, energy, and materials.

Using the TMT bubble as a corollary, only Microsoft from the "four horsemen" (Cisco, Dell, Microsoft, Intel, plus Nortel) successfully reinvented itself, while the others still struggle to recoup their highs.

AI Investment Cycle Still in Early Stages Despite Concerns

Only 20% of U.S. companies on a labor-weighted basis have started meaningful AI investments according to Census Department estimates, suggesting the cycle is far from saturated.

The 1990s CapEx cycle lasted 7-8 years and represented upwards of 5% of GDP, while the current AI cycle is only in year three and hasn't reached those spending levels yet.

Technology companies are expected to deliver 45% earnings growth year-over-year this quarter on revenue growth of 27%, trading at barely above market multiples despite the recent rotation.

Drawing from The Rational Optimist by Matt Ridley, AI could be disinflationary and help solve labor force challenges as both demand and supply for labor are falling due to demographics and immigration reform.

Corporate Profitability Doubling Driven by Four Key Factors

U.S. corporate profitability has almost doubled this century due to four factors: lower interest rates reducing cost of capital, lower corporate tax rates, globalization efficiency gains, and technology company dominance.

The top 10 contributors to SPY's performance over the last decade have return on invested capital and return on equity both above 30%, representing "U.S. exceptionalism" that "doesn't exist anywhere else."

Three of the four profit drivers are potentially reversing: interest rates are higher, taxes may need to rise due to deficits, and globalization is shifting to deglobalization, making AI productivity gains critical for sustaining margins.

Geopolitical Risks Overshadowed by Strong Earnings Growth

The market has largely shrugged off the U.S.-Iran war because earnings are forecasted to grow 13% year-over-year, ultimately coming in closer to 19% on revenue growth of 10%.

"The market is convinced that there will be a negotiated resolution without mass casualties and a short-duration war" - Michael, explaining why geopolitical risks haven't derailed markets.

Net operating profit margins have rarely been higher, overshadowing concerns about geopolitics, inflation, monetary policy, and private credit risks that could weigh on markets.

Long-Term Interest Rates as the Key Market Risk

"The arbiter of whether this bull market and economic expansion continue is long-term interest rates" - Michael, identifying the primary risk that could derail the current cycle.

During August-October 2023, Treasury rates surpassed 5% for the first time since 2007 when Treasury Secretary Yellen extended debt maturities, but the "plunge protection team" intervened with rate cut talk and shorter-term refinancing.

Governments have "far less control over longer-term interest rates than they think," and higher rates would force re-rating of all assets based on present value of future cash flows using higher discount rates.

Debt interest expense is now on par with or exceeding defense spending, reducing policy wiggle room, though bond vigilantes haven't existed "like unicorns and the Loch Ness monster" in recent years.