AI to the Rescue?

The summer is nearly over, temperatures are dropping and we have even had a bit of rain in Southeast England, but what to do with these financial markets? It has been a good year for the stock market so far, despite whatever the Trump administration wants to call its activities in the Middle East. The fact is that oil is up and so is inflation, which should keep investors wary for the rest of the year.

For bond markets, the battle may already have been lost. Yields are at their highest levels in many years, and the US now has more than $40 trillion of government debt. The average interest rate on that debt is currently around 3.5%. That’s roughly $1.4 trillion in annual interest payments. Over the next five years, that number could exceed $2 trillion as debt is refinanced at higher rates and new borrowing is added.

Thankfully, equities appear able to ignore such real-world problems. Markets are near all-time highs and valuations are at some of their most elevated levels in decades. Yet, even those valuations rely on some rather optimistic earnings expectations, not to mention the enormous paper gains being generated by companies owning shares in other companies. But who cares when we have AI?

The thing is that the AI bubble doesn't necessarily have to burst. Lest we forget, some once-lofty internet stocks now trade thousands of percent above where they stood before the dot-com crash. AI may actually deliver, unleashing productivity gains that prove hugely deflationary. That would be very good for interest rates. Alternatively, the bubble bursts, markets fall, growth slows and central banks are forced to cut rates. Either way, the war may not be over for fixed income.