(The opinions expressed here are those of the author, a

columnist for Reuters.)

By Mike Dolan

LONDON, Aug 4 (Reuters) - Despite erratic politics and

global conflict, the U.S. economy is building a powerful head of

steam - and risks overheating. Step back from the daily noise

and the picture is clear: fiscal largesse, loose financial

conditions, booming business investment and near-zero real

interest rates are all stoking the economic engine.

If inflation returns to its target in that environment with

no tightening of either fiscal or monetary policy, that would be

extraordinary.

But it also explains why stock markets are refusing to retreat

in the face of wild single-stock swings, recent hedge fund

stress, and gnawing doubts about whether this is the high-water

mark of the AI wave. Investors pursuing "buy the dip"

strategies, or merely rotating portfolios across sectors, seem

unwilling to raise cash.

Stock markets remain close to record highs after a 50% gain in

major U.S. equity indexes over the past two years, and another

10% in the first half of this year. That's buoying asset wealth

for the richer cohorts of the populationwhoaccount for the bulk

of the consumption that drives the economy, encouraging greater

spending out of disposable income and allowing companies to pad

out margins in a circular flow. Only rising bond yields appear

to be a red flag.

Two big numbers stood out over the past week: estimated

annual profit growth accelerated to nearly 50% for S&P 500

firms through the latest quarter; and, despite an

underwhelming inflation-adjusted headline number, nominal U.S.

GDP clocked an annualised growth rate of almost 8% in the second

quarter.

Although the outsized 6.3% rise in the GDP deflator - which

accounts for overall inflation in the report - was largely

energy-related, demand components were strong. This nominal GDP

growth rate has only been topped twice over the past three years

and is almost twice the 25-year average. Consumer spending

surged 3.2%, while business investment in equipment raced ahead

at a 15% pace.

Fuelled by an AI frenzy that's drawing more than $1 trillion

in capex from the "hyperscalers" building infrastructure this

year alone, annual U.S. profit growth is tracking at a whopping

47%, more than halfway through the reporting season, LSEG data

shows. That's twice the rate expected just a month ago and three

times the January estimate. The surprise stems as much from

blowout quarters at major banks and Big Oil companies as from

stellar technology earnings.

With revenue growth running at a more modest 14%, the extent

of the margin expansion is clear.

"Margins have been the driving force as they reach new

highs," according to a Barclays readout of the earnings season

so far, which pointed to clear strength in the technology and

energy sectors, as well as in materials and consumer staples.

TRILLION AFTER TRILLION

Several factors are colliding.

Stephen Jen and Fatih Yilmaz at Eurizon SLJ reckon that the

sort of "demand destruction" that expensive energy and high

inflation would normally cause isn't happening to temper prices

this time. Consumers appear far less price-sensitive than in the

past. They blame the scale of fiscal spending still in the

system, which shows no sign of being reversed, and posit a

"fiscal stimulus-price spiral" rather than the traditional

"wage-price spiral" of past cycles.

Underlining their thesis, the note says that while

AI-related capex is topping $1 trillion, the federal government

is running budget deficits of more than $2 trillion a year.

Those deficits were further increased by last year's fiscal bill

of tax cuts and additional spending, with similar deficits

forecast through the next decade.

"Huge and persistent transfers through the government have

sustained aggregate demand in the U.S., preventing the demand

curve from staying flat and giving corporations and producers

greater pricing power. These variables are all linked; the

causality goes from fiscal stimulus to greater pricing power, to

inflation, we think," they concluded.

Of course, there is another loop too. High and rising

equities and real estate prices allow the top 25% of earners to

spend even more. Their asset wealth allows them to keep buying

regardless of 3% to 4% inflation or gas-price volatility. Their

collective spending power lets companies keep expanding margins,

while the resulting earnings and stock-price windfall further

boost equity wealth among richer households.

The obvious question is: where does it end? To the extent

that relatively unchecked corporate pricing power is

inflationary, the Federal Reserve could do quite a lot - and is

far from powerless in the face of supply or capex shocks. Two

quick interest-rate hikes over the remainder of the year could

cool equity values, spending and margin expansion and increase

the chances of tamping down inflation for asset-poor households,

who suffer most from it.

If the Fed doesn't want to do it, the bond market just

might.

(The opinions expressed here are those of Mike Dolan, a

columnist for Reuters.)

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