This week in the markets: correction or rotation? Volatility in the tech sector has so far not translated into a broader based market fall. But it sets up a nervous backdrop to a crucial week in the US as mid-term elections give Americans their first opportunity to pass judgment on Donald Trump’s second term.

Big falls in a handful of the most high-profile US technology stocks last week painted a worrying picture, four years into an AI-fuelled bull market. But look beneath the surface and a more reassuring narrative emerges. The optimistic view of recent volatility is that investors are not abandoning the equity market but shifting their exposure away from recent market leaders into a broader set of themes and geographic exposures.

The numbers tell an interesting story. Last week the S&P 500 fell by 0.6% and the tech heavy Nasdaq index was 2% lower. But the Russell 2000 small cap index was 1.3% up on the week.

Looking at the market another way, the S&P 500 has gone sideways since June as the rally since last April’s tariff scare has run out of steam. But the equal weighted benchmark, that removes the S&P’s bias to big tech stocks, has caught up with the headline index.

It’s too early to tell whether the underperformance of the market leaders is part of a healthy broadening out of the bull market or the start of a wider correction. Unfortunately for investors, we will only know that in hindsight - and a case for both interpretations can be plausibly made.

Tech wobble

Certainly, last week marked a dramatic shift in sentiment toward the US’s dominant tech stocks. Alphabet unveiled disappointing advertising numbers, and it was punished for still heavy AI investment. Likewise, Amazon suffered at the hands of increasing scepticism about whether high infrastructure spending will ever generate a satisfactory return.

Intel delivered disappointing forward guidance and saw its shares tumble. And Nvidia came under pressure as investors questioned the durability of the AI investment boom.

The AI boom is demonstrating many of the characteristics that saw internet stocks soar and then plunge 25 years ago. Clearly, AI is economically significant but there are growing doubts about where profits will accrue. The technology can be transformative without necessarily rewarding its pioneers.

Investors are no longer in doubt about whether growth is coming but they are questioning whether they have already paid too much for it.

Increasingly the investment boom is running up against a rising cost of capital because companies are burning through even the massive cashflows of America’s tech giants and relying increasingly on equity and bond funding for their huge capex plans. These become much harder to justify to investors at today’s higher cost of borrowing.

Where next for interest rates?

Which links the AI story to the other big investment theme at the moment - inflation and interest rates. Last week, the Federal Reserve left rates unchanged at 3.75% to 4% but, with inflation persistently above target, and likely to stay there with the oil price staying above $100 a barrel, the direction of travel is most likely up from here.

Likewise, the Bank of England is expected to raise interest rates by a quarter point this week to 4% as forecasts for inflation here, too, are pushed higher. Last week we heard from the Office for Budget Responsibility that price rises will average 3.4% next year, well ahead of the Bank’s 2% target.

It’s the same story in Europe, where consumer prices data on Wednesday is expected to show inflation rising to almost 4% last month. That’s the fastest rate in three years and the eighth month in a row that Eurozone inflation has been above the ECB’s target.

In part, inflation is a reflection of stronger economic growth than expected. GDP growth of 0.4% in the third quarter was surprisingly strong in Europe. And in the US, the economy is still buoyant. On Friday we will see non-farm payroll data showing an estimated 60,000 new jobs in October, solid enough to argue for a rate hike at the Fed’s next policy meeting in December.

But, increasingly, good economic news is turning into a mixed blessing for investors if it makes the case for interest rates to stay higher for longer. Higher rates, coupled with ongoing nervousness about government spending and debt levels suggest that bond yields will stay elevated until cracks start to show in terms of lower economic growth.

The political cost of high bond yields

Which leads to the other big market moving story this autumn - politics. Last week we saw just how constraining a high cost of borrowing can be. The UK’s Budget, the first of the Andy Burnham era, was a timid affair. It proved how even big political ambitions can be curtailed by the unsentimental hand of the bond market.

As it happened, the fixed income markets took the budget in their stride. Yields edged lower as new Chancellor John Healey bowed to the harsh reality of a £109bn annual interest bill for the government. When funding the national debt is that costly, the best way of balancing the books is not raising taxes or cutting spending but keeping a lid on the cost of borrowing. Broadly speaking he achieved that.

The other big takeaway from the Budget was that an early general election in the UK is probably more likely than it was a week ago. A broad array of small, relatively cheap but politically appealing measures such as £100 for most people to offset the higher cost of heating and fuel this winter suggests the new Prime Minister may be looking to secure a new mandate in the spring.

Election watch

Politics is the big story on the other side of the pond this week too, with one of the more consequential mid-term elections in many years taking place tomorrow. Current polling suggests a high chance that the Democrats will regain control of the House of Representatives and a slimmer chance that they will win back the Senate.

Either way, the Republican sweep of two years ago looks likely to end. Whether that is good or bad news for the financial markets is unclear. More friction in the passage of legislation can be good for investors but the most influential drivers - trade and tariffs, and foreign policy - remain in the President’s hands so a change in Congress may make less difference than expected.

Perhaps more important this time around could be elections for many state governors. These could have a bearing on the massive build out of data centres across the US, unpopular with many voters and at the same time important drivers of GDP growth.

The other potential consequence of this week’s mid-terms and last week’s election in Israel is a resumption and intensification of the US/Israeli alliance war with Iran. The economic impact of that would be most obvious in the oil price, linking politics to the other main market drivers of inflation, interest rates and the funding of the AI boom.

Historical record:

Market up in 6 and 12 months after mid terms ever since 1946

Performance better than interquartile range for all mid-term years since 1942.

Usually weakness in mid-term years because of uncertainty, 18% peak to trough fall, 9% this year

Valuations different this year. Much higher CAPE. Tends to lead to lower future performance.

But split Congress is best possible outcome, better than Dem or Rep Congress, although under a Republican President is less good than under Democrat President

Three big questions

So, the main unknowns in the markets this week are:

First, whether the recent AI stock correction will remain narrowly focused or spill over into a wider equity correction or bear market. The answer to that will continue to be determined in large part by the ongoing third quarter earnings season, in which company results are in full flow again this week.

Second, will the mid-term elections change the economic outlook or be interesting politically but less consequential for financial markets? Gridlock might constrain fiscal expansion but have less impact on the key issues of tariffs or the oil price.

Third, can central banks control inflation without undermining economic growth? The trade-off is becoming more difficult to manage.