The AI Boom Drives Markets While Straining the Rest of the Economy
Artificial intelligence is driving stock market gains while squeezing the rest of the market amid rising bond yields, high oil prices, and high interest rates.
There is a new story in the stock market: if artificial intelligence does not touch you, good luck.
Artificial intelligence is sucking in capital and crowding out the rest of the market, where stocks are forced to deal with higher interest rates and high oil prices, without an exciting tech story to sell to investors.
The new trend established itself in September when U.S. government bond yields surged, creating pressures in other debt markets as well.
The leading indexes showed impressive resilience in the stock market given the jump in the 10-year U.S. Treasury yield from 4.7% to 5.3%. The S&P 500 fell only slightly, while the Nasdaq 100, which is heavily weighted toward tech stocks, rose 3%.
The Narrow Market Concentration
Beneath the surface, September's stock movements illustrate how gains in the market concentrated in a small number of stocks. Nearly 80% of the stocks in the S&P 500 fell, the average stock lost 5%, and only two of the 11 sectors in the index rose, led by the technology sector. The other sector that rose, communication services, increased only because tech giants Meta and Alphabet, which are not classified as tech stocks, offset declines in almost all media and telecommunications companies in the sector.
Smaller company stocks performed even worse, denting hopes that earlier gains this year signaled a shift to a stable path. The Russell 2000 index, which tracks small companies, fell 5% during the month, while the 50 largest stocks rose 2%. The same trend was evident within the S&P 500: of the 100 largest stocks in the index, 41 rose, while only 10 of the 100 smallest stocks managed to post gains.
The common denominator for the rising stocks, even if not the only one, was exposure to artificial intelligence and the data center supply chain.
Rising Bond Yields and Economic Pressures
In theory, bond yields can rise alongside stocks when a strengthening economy pushes both upward. And the U.S. economy is indeed strong: according to the Atlanta Federal Reserve's GDPNow model, data released so far points to a 3.7% growth rate in the third quarter, even though employment data released on Friday was weaker than expected.
However, the strong economy led the Federal Reserve to resume interest rate hikes in an attempt to slow activity, because the economy lacks sufficient spare capacity to support such a growth rate without triggering excessive inflation.
As a result, outside of the artificial intelligence field, companies and consumers are absorbing a triple blow: high interest rates, high fuel prices, and competition from AI companies for workers, equipment, and capital.
"Excluding AI tech companies, the growth rate in capital expenditures stands at zero," said Arend Kapteyn, chief economist at UBS investment bank.
This is a bad sign for companies simultaneously dealing with high financing costs. In addition to the rise in U.S. government bond yields, the additional spread that companies must pay on their bonds has also begun to rise.
The weakest borrowers, rated CCC, were hit particularly hard: the yield spread on their debt compared to U.S. government bonds jumped by more than a percentage point in September, surpassing the level recorded during the sell-off following U.S. tariffs in April of last year. The deterioration in credit conditions also led to widening spreads in municipal bonds and mortgage-backed securities, and in the euro zone also in bonds of weaker governments, led by France and Italy.
Earnings Momentum Fades
On Wall Street, analysts estimate that the earnings momentum that helped stocks earlier this year has also come to an end. Analyst forecasts for company profits next year have risen steadily since February, but in recent weeks have remained unchanged.
"In the first half of the year we saw a rapid and sharp increase in both profits and profit expectations," said Christian Mueller-Glissmann, head of asset allocation research at Goldman Sachs. "Since the summer, the factors supporting profits have begun to weaken. Profits are still strong, but the pace of change—meaning updates to profit forecasts—is very important to the market."
The question for investors is whether bond yields and oil prices will moderate or continue to exert pressure on the rest of the economy. The problem is that profit expectations from artificial intelligence are so high that high financing and energy costs are not slowing investment plans. As a result, the parts of the economy driven by artificial intelligence continue to grow at a dizzying pace.
As long as there is no peace in the Middle East, the benefits of artificial intelligence do not spread rapidly across the economy, and investments in the field do not recede, a drop in yields and energy demand will require the rest of the economy to slow down to a degree that balances the demand generated by artificial intelligence. In this process, stocks outside the tech sector are expected to underperform, profit growth is expected to slow, and concerns over credit risks are expected to rise.
