The spending bubble driving corporate profits looks set to burst

Headlines are warning that stocks are too expensive and the AI trade too euphoric. That is likely true. But the real issue might not just be the level of asset prices, but also with the corporate profits that underpin them.

The price-to-earnings ratio of the S&P 500 is at a historically rich 30.4.¹ Many market watchers correctly point to this high P/E as evidence of the market’s over-exuberance. Their concern, however, stems from the level of the numerator rather than the sustainability of the denominator. Industry forecasts feed into that thinking. According to Bloomberg, forecasters expect earnings per share for the S&P 500 to grow by a robust 13% in 2026. But what if they are wrong?

Decades of government deficit spending, share buybacks, dividends, and overconsumption have buoyed profits and inflated US economic output. These profit drivers are all looking increasingly vulnerable. That would dent the profit growth that markets have long used to justify lofty valuations.

Since the end of the global financial crisis of 2008-09, US stock market performance has been the envy of the world. The S&P 500 index has outpaced the global MSCI ACWI ex-US index on an annualized basis by 10.6%.

We can understand this exceptionalism by revisiting an important but overlooked macroeconomic framework: the Kalecki-Levy profits equation, which breaks corporate profits down by their sources. According to this framework, business investment spending, dividends, government deficits, and trade surpluses all add to economywide profits. Household savings subtract from them.

When the financial crisis hit, corporate earnings and stock prices collapsed as investment spending dried up and households rebuilt their balance sheets by increasing savings to offset plunging home values. In response, governments deployed massive fiscal stimulus and reduced interest rates to near zero, cushioning the blow to corporate profits and markets overall.

As the worst effects of the crisis began to wane in 2011, fiscal expansion gave way to restraint. Congress reached a budget deal that capped spending. European policymakers embraced austerity amid sovereign debt fears, and China tightened lending standards. While bond yields fell on fears of weak growth, US corporate profits proved surprisingly resilient compared with peers abroad.

The reason for that was leverage. US companies took advantage of a low-rate environment to issue debt, pay dividends, and repurchase shares. Profits rose and P/Es returned to normal levels. Fast forward to 2018, when Congress passed the Tax Cuts and Jobs Act. That bill increased deficits, slashed corporate tax rates, repatriated foreign capital, and allowed companies to return more cash flow to investors. It once again increased aggregate corporate profits flowing through the economy.

This held true up until the Covid-19 pandemic, which delivered another massive economic shock followed by an even greater policy response. Household savings nearly doubled, from 6.2% at the end of 2019 to 12% a year later. Ordinarily, such penny-pinching would have crushed corporate profits, but the US government took on a leverage mantle, supporting profits by pursuing record deficit spending.

The government’s stimulus checks and transfer payments swelled household and business’ balance sheets, prompting consumption to rebound quickly. By 2024, the US savings rate had fallen to just 4.3% of disposable income — a nearly 65-year low. At the same time, the burgeoning AI boom pushed the tech-heavy S&P 500 to new highs. The powerful wealth effect for market participants further dampened savings rates and bolstered consumption.

Taken together, these longstanding drivers of exceptional US earnings growth look increasingly tenuous. For more than 15 years, elevated government spending and corporate debt have boosted profits. But the fiscal room to maneuver is tightening. The deficit will grow because of the Trump administration’s One Big Beautiful Bill Act. But a fiscal contraction will likely occur in late 2026, particularly if the midterm elections deliver a divided Congress.

The AI cash-flow is likely to tighten as well. Rising capital expenditures to build data centers and other AI-related infrastructure theoretically supports corporate profits. However, many tech giants have curtailed dividends to fund these projects — offsetting the profit boost.

As job insecurity rises amid AI-enabled automation, households may begin to rebuild their savings as a precautionary measure. A higher savings rate would, by the logic of the Kalecki-Levy equation, reduce corporate profits, thereby reversing the feedback loop that created US market exceptionalism.

For now, those worried about a potential AI bubble fixate on soaring equity valuations, focused primarily on rich asset prices. There is a cognitive dissonance in their argument, however, given that many of those same forecasters assume that strong corporate profit growth will continue unabated.

Those profits have been inflated by massive government deficits, ambitious business investment, and debt-funded shareholder returns. If fiscal stimulus subsides and household savings rates rise — whether because of AI or any other reason — the Kalecki-Levy equation suggests the bubble that has sustained US corporate profits since 2008 might burst.