My wife, a former teacher, instilled the love of reading in our kids. It amazes me that all 4 kids, while extremely active, can sit still and read for hours at a time. Right now, one of the series my 4- and 6-year old boys are deeply engaged in is a series called “Who Would Win”? It’s a fun series that looks at what would happen if 2 animals got into a battle. Shark vs. Tiger. Crocodile vs. Python. Fun combinations that would never happen in real life, but fascinating to think about. The authors do a great job of highlighting different strengths and weaknesses of each, and then simulate the battle.
Right now, we are seeing a battle in the equity markets. The matchup? Artificial Intelligence vs. the Macro Backdrop. Equities have been rising on optimism over the impact AI may have on future growth and productivity, while debt ceiling woes, recession fears, and geopolitical risks have all been pushed to the side. But how significant might the impact of AI really be? According to Goldman, the technology has the potential to increase annual global GDP by 7% and boost profit margins by 4% over the next 10 years. Even a partial delivery on those estimates would be significant. But right now, how should we view the longer-term tailwind in light of a near-term backdrop that doesn’t look rosy? Who will Win? In this month’s newsletter, we examine this question and look at how investors can potentially position portfolios for success.
A Concentrated Rally
There has been a lot written about the lack of breadth in the recent rally and how a few mega cap names are carrying the index. While this dynamic shows up as a mega cap vs. everyone else story, it’s really been more about near term AI beneficiaries vs. everyone else. The chart below looks at the performance of the S&P 500 Index ex-AI stocks (list in chart source below) vs. just the AI names. +3% vs. +56%...a glaring gap to say the least, and one that highlights just how excited investors are over the potential opportunity.
Is this the 1990’s all Over Again?
But is this all just hype and speculation? Many are drawing parallels to the industrial revolution in late 18th to early 19th century or digital revolution of the 90’s. The Industrial Revolution saw the shift from manual labor to mechanized production, the Digital Revolution connected people, made the exchange of information quicker, and introduced e-commerce, and other digital services. Both revolutions disrupted the labor market, created new industries, and drove economic growth. The AI revolution is seeking similar benefits, but on the backs of automation, content creation, and enhanced decision making.
How might equities react if this is a similar story? Looking back to the Digital Revolution, as an example, the equity market enjoyed significant gains. Growth kicked up in the back half of the decade, profit margins widened, and from the start of 1990 through the end of the decade, the S&P 500 Index produced an annualized total return of 18%; significantly above the long run average.
Can AI Tailwind Combat the Macro Headwinds?
Longer term, the economic benefits of generative AI are real. Like the Digital Revolution, the technology will likely spur faster growth, lower inflation, and greater efficiencies, all of which will likely be positive for equities, and not just the recent beneficiaries. The reality of it is, however, that benefits are not going to be realized overnight. Integration and adoption will take time and investors can’t bank on an AI bailout from all the near-term macro headwinds.
Looking again at the comparison to the Digital Revolution, the introduction of the World Wide Web had little impact on economic growth or equity returns in the first few years of existence. From 1990-1995, GDP growth actually fell from the decades prior, before seeing a significant jump from 1995 through the end of the decade. For the first 5 years, annualized returns on the S&P 500 were just over 8%...in the final 5, 28%. Integration and benefits of technology take time.
Could this time be quicker? Absolutely. As shown in the chart below, adoption of AI has already been significantly faster. Language processing platforms such as Chat GPT have gained adoption faster than any other online service in history…but that doesn’t mean economic benefits will come right away. And with a US economy already showing signs of fatigue, they are unlikely going to be realized in time for AI to be the savior.
Higher rates, tighter lending standards, and a lower supply of money are still likely to weigh on growth and equity prices. As we continue to highlight over and over, the impact of monetary tightening always shows up with a delay, and we are now entering that critical point in the cycle where the impact is starting to rear its head. As shown in the chart below, many leading indicators are already starting to roll over. While a recession isn’t a foregone conclusion, the AI tailwind isn’t likely to be the catalyst to avoid one. That lies in the hands of how quickly inflation dissipates and how long monetary policy remains restrictive.
For the Portfolio
Given the push pull of near-term macro headwinds and long-term benefits of generative AI, there are two objectives I think are prudent in the context of a portfolio:
First, continue to focus on being risk aware in the near term, hedging equity risk. Recession risks are real and should not be ignored.
Second, find ways to cautiously increase exposure to equities for the longer term at the expense of other asset classes like fixed income. If the estimated impact of generative AI, mentioned earlier, is in the ball park, the last thing investors will want is to be overweight fixed income. Buffered or hedged equity strategies, that produce a bond like volatility, may lend investors the ability to tie their low-risk dollars to the equity market, and capture a greater benefit from the AI tailwind.
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