Market Volatility

Global equity markets experienced an exceptionally volatile session on Thursday, 5 November, against a backdrop of concerns surrounding artificial intelligence (AI) and, more specifically, the semiconductor sector, whose components are essential to AI development.

Since the beginning of October, investors have become increasingly cautious regarding the funding requirements and profitability of AI-related investments. In particular, concerns have emerged over the ability of hyperscalers such as Alphabet, Amazon and Meta to generate sufficient free cash flow to justify the substantial capital deployed into data centres, which provide the computing power and storage capacity required for AI applications.

Put simply, these companies are currently investing in AI at a rate that exceeds the direct financial returns generated by the technology. Although their core businesses continue to produce significant cash flows, the scale of these investments could lead them to rely more heavily on debt markets and, potentially, equity markets, thereby fuelling investor concerns.

At the same time, the outcome of the US midterm elections has done little to improve market sentiment. The Democratic landslide, which secures control of both chambers of Congress from next January, has raised fresh doubts regarding the pace of future data-centre development.

Indeed, a segment of the Democratic Party has expressed reservations about such infrastructure due to its substantial electricity consumption, which could contribute to higher costs for households, its environmental impact, the large volumes of water required for cooling systems, and the potential noise pollution associated with these facilities.

Given the shift towards Democratic control in several states where data centres are heavily concentrated, markets are concerned that investment in these facilities could slow materially as a result of tighter regulatory requirements or delays to new projects.

Adding to these concerns has been the excessive use of leveraged products, which magnify both gains and losses. The market decline triggered position liquidations, in some cases forced, which in turn amplified the scale of market moves.

Nevertheless, we believe Thursday’s sell-off, during which the S&P 500 fell by more than 4%, the Nasdaq 100 by approximately 6%, and the semiconductor index by over 12%, overstated the potential impact of these political concerns.

First, a slowdown in investment, rather than a complete halt, appears to be the more plausible scenario. Despite the challenges associated with data centres, they remain an important source of tax revenue for host states and a significant driver of economic activity. More broadly, AI-related spending has become a meaningful contributor to US economic growth. According to some estimates, it accounted for almost one third of US GDP growth during the most recent quarter in terms of overall contribution.

From a political perspective, would Democrats wish to assume responsibility for an economic slowdown only two years ahead of the next presidential election? Equally, would they be willing to risk undermining household wealth when American households collectively represent the largest category of equity owners in the United States?

From a fundamental standpoint, growth across companies operating throughout the AI value chain remains exceptionally strong. At the same time, technology sector valuations now appear highly attractive. The sector is currently trading at around 18x forward earnings, compared with approximately 24x for consumer staples companies, a sector that typically delivers lower growth and narrower margins.

In other words, based on these valuation multiples, investors are currently paying less for expected earnings growth in the technology sector than for earnings generated by a sector whose long-term growth prospects are generally more limited.

Conclusion

Given a macroeconomic environment that remains supportive, easing expectations for further central bank rate increases, the continued strong growth of technology companies, and increasingly attractive valuation levels, we believe that capitulating and closing AI-related positions would be a strategy best avoided.

To conclude, while financing concerns and political uncertainty may continue to weigh on market sentiment in the short term, we believe that abandoning AI-related investments would be premature. Against a backdrop of supportive macroeconomic conditions, easing expectations for further central bank tightening, robust earnings growth across the technology sector and increasingly attractive valuations, a wholesale exit from AI-related positions appears unwarranted.