AI Sparks a Rollercoaster Year: Surprising Upsides, Risks, and Market Implications
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The emergence of advanced AI systems such as GPT-4 from OpenAI is by far the most surprising event this year, turning everything upside down. The AI-hyped rally has pushed the US equity market to new extremes, and the benefits and risk of this new technology is hotly debated. AI will also become an arms race between the US and China.
The rollercoaster year continues
Going into 2023, pessimism had the upper hand, but China’s reopening optimism and early talk about AI released animal spirits, causing semiconductors, luxury and mega caps to rally double digits by mid-March. The banking crisis, led by the Silicon Valley Bank failure and takeover of Credit Suisse, reignited the calls for a recession, and the market began pricing an aggressive 150 basis points in rate cuts by the end of the year. The thinking was that the economy would finally crumble.
What happened instead was a new twist on this year’s rollercoaster. Around the same time of peak pessimism around the economy and bets of aggressive rate cuts, OpenAI released its GPT-4 AI system, and the year was never the same again. Every company related to AI saw its shares take off in an AI speculative fever in an echo of past bubbles. Our semiconductor theme basket was up 17.5% by mid-March and by mid-June the basket was up 39.8%. Even more impressive, the bubble theme basket went from being up 8% to 37.8% during that same time period.
Data on the US economy is still showing economic activity below trend growth but is also not showing recession dynamics, and earnings estimates have increased substantially, especially in Europe, since the Q1 earnings season started in mid-April. US financial conditions peaked in late March at levels that can still be characterised as loose given the economic backdrop and have fallen ever since to levels that are close to the loosest since March 2022, before the interest rate shock began to tighten financial conditions significantly. The previous rate cuts before year-end have been almost priced out. In other words, as markets enter Q3, the direction of forces are pointing more towards upside risks to inflation vs current market expectations and higher policy rates rather than the ‘back to low inflation and rates’ scenario.
While the AI hype has undoubtedly unleashed animal spirits and growing optimism around the boost to productivity, it has also created a growing risk to the US equity market. Valuations on the US equity market are back to the highest levels since April 2022 and with the free cash flow yield on the S&P 500 down to 3.9%, the market is beginning to look a bit more stretched. While it is too early to call for an overall bubble, the semiconductor industry is clearly showing bubble-like behaviour, and equity valuations on semiconductor stocks are the highest since 2010, measured on the 12-month forward EV/EBITDA metric.
Another risk that has come back, and something we thought would never happen again, is US equity market concentration. The rally this year has been carried by a narrow group of mega caps, as the emerging AI technology is expected to deliver the highest economic gains for the large technology stocks. The deeper issue is that the US equity market has moved to an index weight concentration we have never seen before, with the 10 largest stocks weighing 30.4% of the S&P 500 and the Herfindahl-Hirschman Index to a level 40% above the market concentration during the dot-com bubble peak. This makes the US equity market more fragile and sensitive to fewer risk factors. As a result, we have moved to a negative view on mega caps and overweight the long tail of equities vs mega caps.
The main question for global investors is still whether to reduce exposure to equities. Global equities measured by the MSCI All-Country World Index have a dividend yield of 2.3% and an estimated buyback yield of 1.2%. If we add expected real rate earnings growth of 2.2%, then the long-term expected annualised real-rate return on global equities is 5.7%. By comparison, global investment grade debt has a yield-to-worst of 3.8% but subtracting the 10-year inflation expectation of 2.5% takes the long-term expected return on investment grade bonds down to 1.2% annualised. In other words, if the investor wants to maximise long-term wealth, an overweight exposure to equities is still the most prudent.
