Bhanu Baweja, chief strategist at UBS Group AG, has raised concerns about potential margin compression in 2027, which could pose a risk to the stock market rally. While the current market is supported by robust earnings, particularly from artificial intelligence (AI), Baweja suggests that this dynamic may shift. He notes that rising capital expenditures are likely to constrain free cash flow and subsequently reduce corporate share buybacks in late 2026 and 2027. Additionally, lock-up expiries for newly listed companies will increase selling pressure as their free floats expand.
Baweja explains that the market's reliance on earnings to drive returns will intensify as net equity issuance becomes less negative due to declining buybacks. This puts particular focus on profit margins. Currently, excluding the Healthcare sector, margins across the largest S&P 500 sectors are at or near record highs. While this contrasts favorably with the dot-com bubble era, the elevated expectations in the current market mean that these margins will not only need to hold steady but also improve further for equities to continue their strong performance.
Despite these future concerns, Baweja observes that strong earnings growth has been a defining feature of 2026. S&P 500 companies delivered nearly 35% year-over-year underlying earnings growth in the second quarter, with almost four out of five exceeding expectations. This earnings strength is also broadening beyond a narrow group of technology companies to include sectors like industrials, financials, and consumer discretionary. He emphasizes that the underlying AI investment cycle remains healthy, with AI-related companies reporting robust demand and major hyperscalers showing cloud revenue growth of 48% in the second quarter, up from 40% in the first quarter.
However, Baweja also cautions that a slowdown in US consumer spending poses a threat to equity markets. He attributes this potential slowdown to real disposable income growth nearing zero and the fading of fiscal support. Furthermore, he noted a dramatic rise in long-end bond yields, with the 30-year Treasury yield reaching levels last seen in 2007. Baweja interprets this as reflecting strong nominal growth in the US rather than inflation concerns, with real yields being the primary driver, particularly at the longer end of the curve.
For Europe, Baweja states that a sustained equity rally requires several conditions, including a broadening of capital expenditures beyond artificial intelligence. He also highlighted that despite a recent sell-off concentrated in strong performers like the Nasdaq and Philadelphia Semiconductor Index, the overall AI fundamentals remain intact, suggesting that the weakness is likely due to profit-taking and a momentum unwind rather than a fundamental deterioration.
