Are we in an AI bubble - or just at the beginning of a productivity boom?
There are cautionary lessons from the dotcom era — but the investment boom of the late 1990s also laid the foundations for technology that still benefits consumers and companies today.
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Global equities have rallied strongly over the past few years, driven by the rapid investment in AI infrastructure, and the potential future benefits it may bring. However, the eight largest companies in the S&P500 are all technology businesses and now account for almost 40% of the value of the US stock market. Many investors are asking the question: are we in a bubble?
The conditions for a financial bubble can be defined as follows:
- A rapid rise in asset prices. Check.
- A rapid rise in valuations. Evident in some parts of the market, but less apparent in the large US technology companies funding the investment.
- A rapid rise in the use of leverage. Leverage is now entering the equation. Meta and Oracle recently issued bonds to fund AI spending, and there is inherent circularity in the investment in leading AI companies, such as OpenAI and Anthropic, by their suppliers. This isn’t widespread enough at this stage to be flashing red, but it requires close monitoring.
So, there are some signs that we may be in a bubble, but the light is only flashing amber at this stage.
Strategists at research firm Gavekal make the useful distinction between unproductive and productive bubbles; unproductive bubbles inflate on speculation, whereas productive bubbles see asset prices rise in anticipation of profits from heavy infrastructure build-outs (think railways in the late 1800s or the internet in the 1990s). Today looks closer to a productive bubble. It is important to recognise that even if we are in a bubble, it has the potential to ultimately benefit many companies and the overall economy.
The good news is that the majority of the spend so far has come from the operating cash flows generated by tech behemoths thanks to their very profitable existing businesses. They have also shown early returns from their investment, with Meta and Google reporting higher revenues as a result of AI-enabled ad targeting, as well as a big increase in demand for cloud services. Cloud demand has been driven by both existing enterprise customers and new AI start-ups, with the latter generating an estimated $55bn in revenue over the last twelve months,1 and suggesting high end user demand for these new services. This is vital if tech companies are to generate a return on investment (ROI) from their datacentres.
Comparisons to the dotcom bubble are understandable, but today’s investment cycle is not a mirror image of that era, as funding is coming more from profits than leverage. The internet eventually had a profound impact on the economy, and it is highly plausible that AI will too - even if evolving supply and demand dynamics result in market volatility along the way.
1 Source: CLSA
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