Irrational exuberance version 2.0?

Investors this week pondered the risk of a market meltdown caused in part by the potential burst of what could be an AI bubble. This followed a warning from International Monetary Fund (IMF) economist Pierre-Olivier Gourinchas of “a significant AI-related, tech-related investment surge,” which is creating echoes of the early 2000s Dot.com boom. Earlier in the week, the chief executives of Goldman Sachs, JPMorgan Chase and Citigroup also raised the prospect of financial markets entering bubble territory, even as their banks announced record results.

Nonetheless, markets remained robust. The S&P 500 declined slightly, falling 1.6% for the week to Thursday’s close. This was partly in response to the bankruptcies of two auto industry companies and fears of contagion in private credit markets. US Treasuries yields slipped.

The equity CIO’s view

Stephen Auth, Federated Hermes CIO of equities, notes how much the AI sector has contributed to the market rally following April’s lows. “Any sudden shift of sentiment on whether AI will ‘work’ or not would be treated poorly by investors, and would likely lead to at least as large a drawdown as a deepening trade war with China,” he says. “Our own read from our teams’ dozens if not hundreds of company meetings across the economy is that a sudden shift here is unlikely. Too many really smart people have invested too many hundreds of billions of dollars to be utterly wrong on this call.” 

In addition, many companies are already achieving productivity gains from early AI innovation, across multiple sectors of the economy. “So any news flow here, in our view, would be noise at worst, and if the market reacts, a buying opportunity,” he says.                      

The global equity manager’s view

Senior Portfolio Manager for Global Equities at Federated Hermes Limited Lewis Grant notes how this year’s stock rally has been primarily sentiment driven, with fundamentals an afterthought. This is understandable, he says, as there are reasons to argue “this time it’s different” — not the least being how the rally has been led by established, well-capitalized, mega-cap companies. 

Even so, he adds, fundamentals and valuations can only be ignored for so long. “The IMF’s warning of a bubble will embolden those proclaiming a market top,” he says. “Such intense capital expenditure, with payoffs uncertain in terms of quantum and timeframe, leave the AI rally vulnerable to sudden shifts in risk appetite.”

He adds: “We remain bullish on the long-term investment case for AI, but with such a high concentration in the market we see attractive overlooked opportunities across the market that are more driven by the fundamentals. Whilst tariffs add uncertainty to growth, we believe that there are plenty of under-loved stocks set to benefit from a broadening out — watch out for US GDP growth, interest-rate decisions, and earnings as catalysts. We also see opportunities in Europe as the industrial machine begins to turn, although, admittedly, that may take time to get into full swing and comes with its own set of potential challenges.”