Although the long-term potential of artificial intelligence (AI) will likely boost productivity and economic growth, it doesn’t justify current stock prices and won’t stop a looming recession.
This is according to Joseph Davis, global chief economist and global head of investment strategy group at Vanguard, the world’s second largest asset manager.
“I’m pessimistic that AI can justify lofty equity valuations or save us from an economic soft patch this year or next,” he said in a recent note.
“As is often the case with new technology, it’s likely to take many years to realize the full potential of AI,” he said. “While substantial benefits appear likely, a meaningful risk of disappointment remains.”
Stocks are expensive
He cautioned that US stocks – growth stocks in particular – are “richly priced”, as measured by the cyclically adjusted price-to-earnings ratio (CAPE) of the broad US stock market which is 32% higher than Vanguard’s estimate of fair value.
“My colleagues and I have been focused on the economic promise of artificial intelligence for some time,” he said.
“We are particularly curious as to whether AI-enabled growth in workforce productivity might help drive improvements in standards of living by offsetting the headwind of aging populations.”
“In brief, count me as a cautious optimist. But improbable, at best, is the rapid economic and earnings growth that would correct the current excess valuation of the U.S. stock market.”
He argued that corporate profits would have to soar about 40% per year for the next three years to unwind current stock market overvaluations.
“This is double the annualized rate of the 1920s, when electricity lit up the nation—not to mention economic output and corporate income statements.”
According to the most recent analyst estimates, earnings growth for the S&P 500 index is roughly 15% for 2025.
“With profit margins close to record highs, most of a hypothetical 40% annualized profits jump would have to come from soaring corporate revenues, Davis said.
“But slowing economic growth precludes soaring sales. My team’s forecast of U.S. economic growth in 2025 is 1%–1.5%, which would be down from our expectations of 2% growth this year.”
AI investments will take time to pay off
Although some investors expect that companies will spend over $1trn to advance AI technology in the coming years, Davis warned it won’t be enough to prevent a slowing economy.
He said: “Such a sum may be spent, but it’s not going to happen by the end of next year, by which time we expect the US economy to have slowed.”
According to Vanguard’s estimates, it would take $1trn in AI-related spending to push economic growth next year above the 2% trend.
“Even if investment in AI suddenly nearly doubled this year and next—mirroring the near doubling of NVIDIA Corp.’s data center revenues in recent years—AI spending would amount to ‘only’ about $129bn in 2024 and $248bn in 2025,” Davis said.
“Those would be tremendous outlays, to be sure. Perhaps unprecedented. But $1trn in AI investment by 2025 would require 286% growth.”
“That’s probably not going to happen, which means we’re unlikely to experience an AI-driven economic boom in 2025.”
This view is echoed by strategists at BlackRock, the world’s largest asset manager, who said in a recent note that “patience is needed in the AI buildout”.
“We see a disconnect between the short-term lens of some investors and the long-term visions of tech and cloud service providers,” the strategists said.
“Such plans take years – not quarters – to complete. So it may take some time for revenues to fully realize AI capital spending.”
Vanguard’s Davis suggested investors who are anticipating that corporate growth and profits will accelerate in the near term due to AI should “temper expectations” and be prepared to “endure periodic downturns that would push stock prices closer to their fair values”.
