The impact of Artificial Intelligence (AI) optimism on capital markets has been the significant investment story of 2023 thus far. While each year, one concept or theme seems to grab investors’ attention (and headlines). Cannabis in 2018, the “Fed Put” in 2019, stay-at-home stocks, and crypto in 2020-2021. We can add Meme stocks and SPACs to the list of investment trends that dominated headlines during that period.
AI optimism has supported a few mega-cap tech stocks at the halfway point in 2023, which has resulted in technology fund outperformance. But outside of these few AI-related stocks, much of the broader market is flat or negative year-to-date. As we move into the second half of the year, let’s discuss how investors can think about AI through the lens of history.
In Alan Greenspan and Adrian Wooldridge’s excellent book Capitalism in America, the co-authors highlight the concept of Creative Destruction.
“Creative destruction is the principal driving force of economic progress, the “perennial gale” that uproots businesses-and lives- but that, in the process, creates a more productive economy.”
The book’s opening chapter is a well-written case study on American creative destruction in the nineteenth century, highlighting inventions such as Cyrus McCormick’s threshing machine, which produced a 500% increase in output per hour for wheat and a 250% increase in production for corn. During that period of our history, much of the innovation was industrial, building the foundation of American prosperity one invention at a time.
We all know how this story went. Quickly this upstart country full of immigrants grew into one of the most powerful economies in the world. Today we are the most dynamic economy in the world. I share this with you (and recommend the book) because history can help us understand AI’s potential on the economy and our future.
The “J Curve” of adoption
There is often a significant time lag between the invention of new technology and the boost in productivity that it produces. This phenomenon is the “J-Curve.” Four decades after Thomas Edison’s spectacular illumination of Lower Manhattan, electricity had done little to make the country’s factories more productive. It involved redesigning the production processes and building new factories to get the best out of the new power source.
To use a recent technology comparison, AI will be everything blockchain wasn’t. AI has real business and personal use cases. Workers are using these tools now to increase productivity and quality of output. For all of its hype, blockchain has yet to produce tools for the masses. AI has open-source tools being used everywhere, from classrooms to corporate boardrooms (possibly even in this article). That being said, for our economy to harness the productive power of AI fully, many processes will need to be restructured, laws will need to be written and amended, and businesses need to adopt the tools. AI has been around for some time, so perhaps the decline of the “J-curve” has already passed, and we are now on the upswing.
The Downside of Creative Destruction
The destructive side of creative destruction comes in two distinct forms: the destruction of assets as they become surplus (see 27.5 Million horses and mules in 1840 as automobiles took over) and the displacement of workers as old jobs become obsolete (see 124,000 travel agents in 2019).To quote Greenspan and Wooldridge again,
“The gale of creative destruction blows” away old certainties along with old forms of doing things: nobody knows which assets will prove to be productive in the future and which will not. New technologies almost always bring speculative bubbles that can pop, sometimes with dangerous consequences.
We are in the early innings of AI’s creative destruction. A recent report from outplacement firm Challenger, Gray & Christmas suggests AI was responsible for 5% of the total layoffs in May. AI may soon make data entry, banking, and marketing careers obsolete. China and US tension over technology highlights how nations are working to protect their access to the tools that power AI research and innovation. But perhaps another country will rise to become the most dynamic economy of the next century.
Fundamentals Matter Too
Yes, AI does have great potential and does appear to be the “next big thing.” But the promise of a future where intelligent robots replace hourly workers or AI assistants create a more productive workforce is likely not enough to power the capital markets through the reality of where we are in the market cycle. For 2022 and 2023, stocks have dropped as yields have risen. We saw it as recently as March when strong economic data and a blowout jobs number sent the 2-year yield above 5%, pushing the S&P 500 under 4,000. The Fed and interest rates are still the most significant market influences. As investors, we cannot ignore higher bond yields and the potential for future rate hikes from the Fed.
The most important driver of capital market performance is GDP growth, which is driven by consumers buying goods and services. Suppose consumers continue to lose purchasing power to job cuts, AI-related or otherwise, and higher inflation. In that case, it can threaten growth as consumer spending declines, setting up conditions for a pullback in all stocks, including the year’s biggest gainers.
If we look at the hottest investment trends of the past five years listed at the beginning of this article, not one has held up as a winner over time. AI will continue to grow in adoption and work into our everyday life. But picking stock market winners and losers of the AI revolution will be challenging.
We continue to review clients’ financial situations, investment goals, time horizons, and risk tolerance as we rebalance portfolios or put new money to work. We recommend readers stay focused on those fundamental principles of portfolio construction. They will help you navigate volatile markets as we have in 2023 and avoid the bubbles and busts that often come with this type of innovation.