Could an AI bubble blow up the economy?

Rate cuts are on the horizon, but interest rates are emphatically not returning to zero any time soon. In one sense, this is positive. Paul Dales, chief UK economist at Capital Economics thinks that “a new era of higher interest rates will probably go some way to prevent new financial imbalances from forming”. This could mean that bubbles in housing and credit are less likely over the years ahead – good news given their place at the very crux of the economy.

You might also think that this would make stock market bubbles less likely too. After all, when interest rates are higher, investors don’t need to take on as many risks in their search for returns, even if the performance of US shares and cryptocurrencies in the past year may act as a counter-argument here.

But higher rates are not the only change that stock markets have had to contend with over the past few years. According to data from Bloomberg Intelligence, the share of US equity funds and ETFs that are passively rather than actively managed has nearly doubled over the past decade, and now stands at 60 per cent. Forecasts from Capital Economics suggest that passives' share could reach almost 80 per cent by 2030.

In theory, whether investors are invested in active or passive funds should not make much difference to how much money finds its way into equities overall. But Capital Economics’ chief markets economist, John Higgins, points out that the more people are invested in passive funds, the fewer people there are to bet against stock market patterns. Taken to an extreme, this could see bubbles in certain stocks and sectors inflate even further – and last even longer as a result.

Are we in the middle of an AI bubble? 

It goes without saying that bubbles mean huge trough-to-peak asset gains. Bank of America analysts calculate that, in the 1920s, the Dow Jones rose by 180 per cent before the Wall Street Crash. The Nifty 50 in the 1970s and Japanese stocks in the 1980s both gained 150 per cent, while the dotcom boom saw internet stocks rise 190 per cent. The Magnificent Seven are fast closing in on these figures.

As the chart below shows, the Magnificent Seven alone would now be the second-biggest stock market in the world by market capitalisation. Rather soberingly, the market caps of Apple (US:AAPL), Microsoft (US: MSFT) and entire markets in the UK and France are all remarkably similar. The transformative powers of AI may well be huge, but have markets got ahead of themselves? 

Dario Perkins, managing director of global macro at TS Lombard, said that so far “the excitement is justified” – at least in part. Nvidia (US:NVDA) has seen huge share price growth, but has also seen tangible revenues from AI via semiconductors. He thinks that this leaves today feeling very different to the dotcom era. Capital’s Higgins thinks that the AI bubble could inflate even further, and expects the S&P 500 to climb to 5,500 by the end of 2024, before hitting 6,500 at the end of 2025.

But what happens after that? 

TS Lombard’s Perkins sees scope for an optimistic scenario. As interest rates fall, we could see stock market gains broaden beyond AI, keeping the rally going but on a “healthier footing”. Higgins, on the other hand, thinks that the bubble will “inevitably” burst. 

This might not be as bad as it sounds – at least not for AI. “Just as the bursting of the dotcom bubble didn’t sound the death knell for the internet, we don’t expect the eventual bursting of this latest bubble to do so for AI,” Higgins said. But in a world with more passive investors, there would be fewer active funds left to catch ‘falling knives’. This could mean a more painful correction. 

According to Dales, the next big financial event is likely to look more like the dotcom crash of the early 2000s than the housing market crash and global financial crisis that followed later in the decade. Falls in equity prices also tend to have a far smaller impact on financial stability and economic growth than a housing or financial crisis would. From an economic perspective, this is good news. It would feel like cold comfort to investors, though.