Beware of a dangerous scenario
Looking at recent figures on the European, and especially the American, economy, share prices currently appear to remain supported by a well-performing economy. In addition, enormous amounts are being invested in everything related to AI. Many investors expect this to bring great benefits in the future, both for the economy and for corporate profits. In any case, profits are currently rising sharply.
Many equity analysts therefore see little risk in current share prices. To the extent there is any doubt, it tends to be limited to the view that prices will remain roughly stable for now, or rise only modestly further. This is mainly because price/earnings ratios are very high and interest rates are not expected to fall much. However, hardly anyone talks about a substantial decline in share prices. In their view, the economy is simply performing too well for that.
We certainly do not want to claim that a deep decline in share prices is almost certainly imminent, but we do not want to rule it out either. In fact, the probability of a deep bear market is rising rapidly.
Where does the problem lie?
Our caution regarding the current situation stems from a combination of the following factors.
The recent figures on the US economy — and, to a lesser extent, the European economy — are indeed fairly favourable. This is especially true for profits. However, it should be kept in mind that, at this stage of the cycle in which the US economy currently finds itself, it would be quite normal to have a fairly large government budget surplus. Likewise, many companies should now be able to generate sufficient liquidity to finance most of their investments from their own resources.
This, however, is not the case. Both companies — particularly for AI-related investments — and the government are now borrowing very heavily. In the US, government borrowing amounts to well over 6% of GDP and is rising further as a result of the war in the Middle East, higher defence spending, and efforts to combat climate change (natural disasters). Higher interest costs also play a role here. Much of the current growth is therefore borrowed from the future.
A further aspect of this is that the economy is becoming increasingly vulnerable to a slowdown in growth, and in particular to a decline in asset prices. Assets serve to a large extent as collateral for loans. During the 2008 credit crisis, we saw what happens when this goes in the wrong direction.
The economy is performing well because of fiscal stimulus and heavy investment in everything related to AI. This is a self-reinforcing process: a well-performing economy drives up asset prices, boosts share prices, and keeps credit spreads low. This in turn allows for extensive borrowing, keeping the economy growing strongly, and so on.
However, this process can break down in two ways:
- If high growth generates too much inflation and central banks are forced to tighten monetary policy.
- Or if it turns out that expectations of returns on investment were too optimistic.
Initially, it was assumed that central banks would maintain an accommodative monetary policy for the time being. However, the war in the Middle East has thrown a wrench into this. It is driving up oil prices and, with them, inflation. As a result, central banks are no longer thinking in terms of accommodative policy, but rather tightening.
The expected return on the current enormous wave of investment is also not going well. Investors are suddenly beginning to realise that both domestic and foreign competition — particularly from China — could lead to disappointing results in this area.
Until now, it was assumed that companies were investing so heavily only because they were confident of future returns. In many cases, however, this is not the case. Much of the investment is being made because companies fear that if they do not invest, they will barely matter as a business a few years from now. How much return this will ultimately generate, however, remains entirely uncertain.
This is now clearly reflected in the development of share prices. Initially, it was precisely the AI-related stocks that went "through the roof," but these are now the ones declining in price. The stocks currently performing well are those of companies that benefit greatly from the investment boom. Only if doubts arise about the returns on these investments will these stocks quickly fall back as well — and suppliers would then also take a hit.
The conclusion, therefore, is that if the share prices of AI companies continue to decline, they will also receive less financing for further investment. This would immediately affect the entire economy, causing share prices to fall further and credit provision to seize up as a result.
