AI Stocks at Risk: ECB Warns of Potential Crash Despite Success
The European Central Bank stated in a blog post on Monday that an artificial intelligence-driven correction in stock markets might have an impact on the euro area even if the technology produces significant productivity increases and corporate profitability. The blog, titled The AI boom: rational enthusiasm or the next dot-com bubble, examined whether current stock market valuations are warranted by AI’s potential or if they might precipitate a correction akin to earlier technology booms. It concluded that economic research on past technological revolutions indicates a probable correction in current market valuations. The ECB indicated that stock prices may ultimately decrease, even in the event of AI’s success, due to the evolving nature of risk as the technology permeates the economy. “Even if the technology succeeds, stock prices may eventually fall,” the blog said. In the nascent phase of AI development, failures tend to impact specific firms, allowing for risk diversification across the sector. As adoption spreads, the uncertainty permeates the entire economy. “This risk cannot be diversified, so investors demand a higher risk premium,” the ECB said.
The elevated risk premium may exert downward pressure on valuations, even in scenarios where AI adoption bolsters cash flows. The ECB indicated that the increase in the risk premium has, in historical contexts, typically overshadowed the beneficial impact of enhanced cash flows, unless profit growth is sufficiently robust to offset this effect. The timing of such a correction cannot be established in advance. “The exact timing is unknowable in advance,” the blog said. The ECB has drawn parallels between the current surge in AI and previous technological revolutions, such as the railway boom of the 19th century, the proliferation of electricity and radio in the 1920s, and the internet boom of the 1990s. In these instances, transformative technologies drew significant investment, leading to a sharp increase in the valuations of companies that embraced them, followed by a subsequent decline. The ECB provided two explanations for the boom-and-bust pattern: rational and behavioural. The rational perspective posits that elevated valuations may stem from ambiguity regarding the efficacy of emerging technologies. The behavioural perspective posits that overconfident investors may drive prices beyond their fundamental values.
Both perspectives suggest a correction will occur at some juncture, according to the ECB. However, it did not indicate that current prices have hit a ceiling. If AI proves sufficiently transformative, valuations could rise further even after a correction. A correction in US technology stocks may have implications for euro-area investors due to their exposure to the Magnificent Seven stocks. Most euro-area exposure to the group is primarily through investment funds, encompassing mutual funds and exchange-traded funds, rather than through direct holdings. Households in the euro area hold approximately €440 billion in exposure to US technology equities, reflecting a growing trend of investing in low-cost ETFs. The ECB indicated that they might not be fully cognisant of the related concentration risk. Insurance companies and pension funds also possess considerable exposure to the Magnificent Seven. The fund-based structure of these investments may serve as a transmission channel in the event of a sharp correction. Funds may be compelled to liquidate assets to satisfy redemption requests. If the correction persists, they may initially liquidate their liquid holdings before proceeding to sell distressed assets. This may lead to a further decline in valuations and prompt additional redemptions. “This is why a Mag7 correction is a question of financial stability for the euro area, rather than just a private one,” the ECB said.
‘Mag7’ refers to the Magnificent Seven US technology stocks: Alphabet, Amazon, Apple, Tesla, Meta Platforms, Microsoft, and Nvidia. According to the ECB, the euro area’s technology sector poses a reduced risk of a domestic correction, as equity valuations in the euro area have increased, yet price-to-earnings ratios are still significantly lower than those in the US. Euro-area stock markets are predominantly influenced by “old economy” stocks, which constrains their direct exposure to the AI-driven gains observed in US technology stocks. However, the stock markets in the euro area and the United States have historically exhibited a high degree of correlation. The ECB indicated that the repercussions of a correction in the US might reach beyond financial markets, influencing sentiment, financing conditions, and employment within the euro area. “A US AI fallout would not remain a US problem,” the blog said. The ECB also indicated that the euro area has less capacity than during the dot-com episode to employ lower interest rates or fiscal policy to mitigate the effects of wider market instability.
