Can Artificial Intelligence Boost the Global Economy?
June 1, 2023
With the political debt ceiling circus out of the way, investors will likely focus again on the tailwinds supporting stocks. These include stronger earnings growth, diminishing banking sector stress, better housing data, early signs of increasing manufacturing activity, the prospect of an AI-driven productivity boom, and the fact that the labor market has managed to cool off without increasing the unemployment rate.
The Debt Ceiling Debate
Since the introduction of the Debt Ceiling in 1917, we have seen many political spectacles to increase it. What is important to keep in mind is that the debt ceiling does not have any economic meaning as it does not amount to additional budget spending. Congress has lifted the debt limit 78 times since 1960. The debt ceiling was last raised in December 2021 by $2.5 trillion. It is mostly U.S. political theater, which is used by both the Republican and Democratic parties from time to time to extract certain concessions from each other.
The debt limit does not authorize new spending commitments. It simply allows the government to finance existing obligations that Congress and presidents of both parties have made in the past.
As expected, the House and the White House managed to agree, just in time, to raise the debt ceiling into 2025, which will be in another Presidential term. In our view, the debt ceiling discussion creates a lot of noise in the markets but does not have any real impact on underlying economic activity.
Further Upside in Equity Markets
With the Debt Ceiling debate out of the way, we think that the path of least resistance for stocks is up. At the start of the year, many equity investors were defensively positioned for further downside. This remains the case today, suggesting that stocks can continue to climb the so-called wall of worry. According to Bank of America’s Fund Manager Survey, most fund managers were still underweight stocks in May. Stock market sentiment has improved since the start of the year but remains quite downbeat by historic standards. Historically, equity returns tend to be positive when sentiment is bearish but improving.
The failure of several regional U.S. banks raised the question whether we were on the brink of another financial crisis like in 2008, or a more contained problem like the Savings and Loan Crisis. The latter began in the mid-1980s but did not lead to a recession until 1990. We think it looks more like the latter.
Counterintuitively, the regional banking crisis might lift equity valuations. This is because the Fed wants slower growth, and slower growth resulting from more conservative bank lending would likely be better for stocks than slower growth stemming from much higher interest rates because the latter scenario would entail a higher discount rate for equity valuations.
A key difference between the Savings and Loan crisis and the GFC is that the residential housing market held up much better during the former episode. Housing is the most interest rate sensitive sector of the economy. Hence, the state of the housing market provides a good gauge of how tight underlying monetary policy is. The latest data hint at a stabilization, if not an outright improvement, in the U.S. housing market. Single-family building permits and housing starts have ticked up since the start of the year. New home sales are rising, as is homebuilder confidence.
There are also clear signs that the Canadian and the Australian property markets are showing signs of improvement. This is encouraging because these are among the world’s most expensive real estate markets and are often favored by Chinese investors. If these two overvalued housing markets can buck a recession-inducing downturn, that bodes well for housing markets in other developed countries.
Another positive is that it seems that the global manufacturing cycle may start to accelerate again. On average, manufacturing cycles last about three years, 18 months of accelerating growth followed by 18 months of decelerating growth. The ongoing manufacturing downturn began around June of 2021, as measured by the forward-looking new orders component of the ISM index. In January 2023, the new orders component hit a low of 42.5 and has risen somewhat since. It is too early to say whether this marked the low for the cycle, but if it did, the manufacturing downturn would have lasted 19 months, in line with previous cycles.
Lastly, the job market seems to be cooling off but so far without increasing unemployment. The employment market is still strong, but the number of job openings is clearly decreasing. Job openings are a reliable predictor of wage growth. If wage growth comes down without unemployment rising, that would lift the odds of a soft landing.
All this supports our view that a potential recession in the U.S. is still at least 6 months away. And as inflation will keep coming down, we think it is likely the Fed will stay on hold for the summer, and this could create a positive backdrop for equity markets in the coming months.
Corporate Earnings are Solid
Against very low expectations, 77% of S&P 500 companies beat earnings estimates in Q1. On a year-over-year basis Q1 earnings fell by only 1.1% and on a quarter-to-quarter basis they fell by 3% against initial expectations of a 5% decline. Encouragingly, 12-month forward earnings and sales estimates are now rising both in the U.S. and in Europe. U.S. profit margins have also returned to 2019 levels, suggesting that the worst of the profit margin squeeze may be over.
The Positive Impact of Artificial Intelligence (AI)
AI stocks account for a large share the S&P 500’s year-to-date gains. The recent rally in Nvidia shares has only reinforced this trend. Goldman Sachs recently estimated that AI could boost S&P 500 profit margins by 4 percent over the next decade, implying a substantial potential windfall for corporate America. AI hopes are coming at an opportune time. What the economy now needs is faster growth and lower inflation. With the labor market at full employment, the only way to achieve this is through higher productivity, which leads to higher profitability.
The beneficial impact on tech stocks from the AI revolution, though sizable, could be a lot smaller than the impact on economic growth in general. This is because rapid technological change could render many existing technologies obsolete, leaving most of today’s tech companies behind. The real power of an AI ‘revolution’ could be a sustained increase in productivity for the global economy. This would basically benefit everyone, although not in equal measure.
However, AI has been around for decades, and the AI industry has gone through several hype cycles. There have been many exciting AI milestones in the past that initially created buzz and excitement. Examples include IBM Deep Blue winning chess (1997), IBM Watson winning Jeopardy! (2011), Google’s DeepMind AlphaGO winning Go games (2017), and Apple launching Siri (2010).
Google introduced the transformer model in 2017, which created a breakthrough for Large Language Models (LLMs). Other firms have since created ever more powerful LLMs, but OpenAI was arguably the first one to launch a version for mass use. What really opened the world’s eyes to the potential of generative AI was OpenAI’s ChatGPT, a conversational AI chatbot based on a Large Language Model. ChatGPT was launched on November 30th last year and had more than 1 million users after 4 days, and 100 million users after 2 months. ChatGPT ignited the imagination of both consumers and businesses.
History shows that it can take a long time for revolutionary technological innovations to filter down to the economy. While spreadsheets, word processors, and the graphical user interface boosted business productivity in the 1980s and early 1990s, it was not until the world’s computers were integrated into what eventually became the Internet that the true potential of computers was realized. If AI follows the same trajectory as other major technological revolutions, we may not see major economy-wide productivity gains from AI until the 2030s. But there are reasons to think that AI’s impact could come much sooner. Most discussions of AI extrapolate linearly from what AI can do today to what it can do tomorrow. But AI’s progression is following an exponential curve, not a linear one, meaning that advances could come much faster than expected.
A recent study showed that productivity rose by 14% among customer service workers at a major software firm after they were given access to generative artificial intelligence tools. The thing about those earlier technological revolutions is that they were focused on the application of pre-existing knowledge. In contrast, the AI revolution has the potential to lead to the creation of new knowledge – knowledge generated by machines rather than humans.
What is important to keep in mind is that AI works differently than the human brain and it has much more computing power. The key thing here is that tasks that we, humans, would find difficult, like speaking 10 different languages or making complex calculations, is easy for AI. At the same time, what we find easy, like riding a bicycle or understanding a person’s emotions, is generally difficult for AI. So, although AI might replace certain jobs, it will not replace all jobs, especially the ones where creativity and human interaction is needed. At the same time, AI will create new jobs that don’t even exist today.
The good news is that developments in AI could significantly boost economic productivity, which could become a major positive driver for the global economy in the years ahead.
Unexpected AI Winners
Commodities and real estate may be unexpected winners of an AI-driven economic boom. One can think of AI as enhancing the amount of labor and capital in the economy by increasing the number of digital workers and robots. Basic economics teaches us that if you increase one factor of production, the other factors become more valuable. People would probably like to buy land with their additional income, only to discover that it is the one thing that AI cannot produce more of. In short, anything valuable that remains in limited supply will probably become more valuable in time.
It’s Not All Rosy in China
The Chinese equity market had a great start to the year with a strong rally in January. However, since the peak in January the market has lost 20%, despite hopes for a strong economic recovery in China.
One of the reasons is that profits of Chinese industrial firms dropped by 20.6% y/y in the first four months of 2023, extending the contraction that began in the second half of last year. Notably, the weakness remains particularly pronounced across the manufacturing sector, which experienced a 27.0% y/y profit decline through April. Declining profits at industrial firms are consistent with the ongoing decrease in producer prices, which fell by 3.6% y/y in April. The latter are weighing down on earnings. Ultimately, these dynamics underscore that despite the economic reopening, demand for Chinese manufactured goods remains weak.
There are two forces at play. First, the zero-Covid policy had a relatively limited impact on manufacturing activity, and the reopening process mainly benefits domestic service providers, who benefit from pent-up spending. Second, weak global demand for manufactured goods remains a headwind. The ongoing global consumption shift to services following pandemic overspending on goods is negative for Chinese exporters. Separately, there is also geopolitical tension, but it is unlikely to be solved in the near future.
On the positive side, consumer spending continues to be strong, especially on services, just like elsewhere post COVID. Another positive is that the housing market seems to have stabilized, which is evident in the recent strength of Chinese bank shares. In our view, the equity market might have turned too negative, especially as stock valuations remain at low levels, therefore any uptick in economic growth data could trigger a rebound. The government is surely eyeing the weak stock market and economic data, including large unemployment levels among college graduates, and we would not be surprised to see both monetary and fiscal action to encourage growth in coming months.
For now, given that we don’t expect to see a recession in the very near future, we are maintaining our neutral duration recommendation over a tactical 3-month horizon. Treasury yields will remain rangebound until the unemployment rate starts to rise. However, yields are now near the top-end of that trading range, making this a good entry point to initiate long duration positions.
Over the month, the U.S. dollar strengthened against most currencies, reflecting a widening in interest rate differentials in favor of the U.S., somewhat weaker PMI data in Europe and China, and a deterioration in technical indicators. While we are maintaining our long-term bearish view on the U.S. dollar, we are near-term neutral.
The U.S. economy is still stronger than many had forecasted, while at the same time inflation is cooling off. It is possible that we could see a recession next year, or that economy stays so strong that inflation re-accelerates, which would force the Fed to raise interest rates higher, eventually leading to a recession.
In either scenario, we think there is the possibility that equity markets keep ticking higher in the coming months on the back of decent economic growth and better than expected corporate earnings. We should not forget that the U.S. equity market is still more than 10% lower than where we started last year, while corporate earnings have risen. Therefore, we keep focusing on quality stocks, which are large cap profitable companies, as we think these will do well in the current climate.
Within fixed income we are still slightly underweight duration, and we still keep part of the portfolio in short-dated bonds, but we might increase duration in coming months. To sum up: there will be a time to turn bearish but we don’t believe we are there yet.
DISCLAIMERS & DEFINITIONS
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.
Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Institute for Supply Management (ISM) Manufacturing Index shows business conditions in the US manufacturing sector, taking into account expectations for future production, new orders, inventories, employment and deliveries. It is a significant indicator of the overall economic condition in US. The ISM Prices Paid represents business sentiment regarding future inflation. A high reading is seen as positive for the USD, while a low reading is seen as negative.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value-weighted index with each stock’s weight in the index proportionate to its market value.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.