Could the AI boom be masking economic fragility?

It is not always a good idea to draw conclusions about the broader economy from your own financial choices. But sometimes what you do with your money, and your motivation for doing it, can provide insight into what is going on more generally.

A couple of weeks ago, I enjoyed a pleasant few days in Tuscany, doing the usual - art, wine and food, mainly. I also did something a little unusual for me. I bought a nice watch, taking advantage of one of the indisputable benefits of Brexit - not having to pay Italian VAT.

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That was one of the reasons for my uncharacteristic extravagance. But another was the warm feeling of financial security that only a once-in-a-generation stock market boom can provide to anyone fortunate enough to have some savings. When your financial cushion has been plumped up as much as ours have been over the past few years, discretionary purchases are a lot easier to justify.

My treat to myself is not going to move the dial on the global economy. But multiplied millions of times over among the world’s luckiest people, it certainly will. I suspect this wealth effect is making a bigger difference than is well understood.

There is a positive, self-reinforcing circularity to the current economic and stock market boom. The rising share prices of a few AI-related stocks are underwriting the big tech companies’ ability to invest in the infrastructure that investors believe will fuel their future growth. That is underpinning GDP growth directly, via sky-high capital expenditure, but also indirectly through the spending power of the world’s richest people.

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At the same time, it is highlighting the dependence of both the economy and the bull market on that narrowly-focused boom. The warm feeling that nudged me into opening the door rather than just looking in the window of the watch shop in Florence flows both ways. If cracks start to show in the AI story, the impact won’t be restricted to the 10 stocks that account for 43% of the value of the US stock market. It will ripple out into the broader consumer economy and magnify any downturn.

It would be an exaggeration to say that the AI stock market boom is the only thing standing between resilience and recession. But there is some truth in the observation.

The numbers tell the story. The US personal savings rate in April this year was 2.6%, down from 3.2% in March and 4.3% in January. It is well below the levels considered normal before the pandemic. Consumer spending is rising even as personal incomes are falling. There are two reasons for this. First, some Americans are spending more than they should because they have no choice - unavoidable costs such as energy and petrol haven risen sharply. But at the same time, other Americans are over-spending because they are feeling wealthier. They are spending because they can. Neither is sustainable in the long run.

Spending is increasingly being held up by the wealthy, while discretionary consumption by middle and lower income groups has flatlined for a couple of years since post-Covid ‘revenge spending’ ran out of steam. The top 10% of earners now make up half of all consumer spending. With consumption representing two-thirds of US GDP, the health of the world’s biggest economy is increasingly reliant on the durability of the ongoing bull market.

The spending power of the few who are benefiting from the surge in the value of their investments is disguising a more fragile economy for the many who are not. First quarter spending growth by American Express’s wealthy card holders was 9%, a three-year high, and much faster than spending on mass-market cards, where consumers are more cautious.

So, directly and indirectly, AI-related spending is delivering much of the growth in the US economy. It is hard to be precise about the impact of the wealth effect. But, given the size of the consumer economy compared to the spending on tech and real estate infrastructure, it is likely that AI-linked consumer spending is at least as important as the hyper-scalers’ widely reported capital expenditure plans.

Back in 2000, the US stock market was worth a little bit more than the US economy. Today it is valued at nearly twice as much. So, the stakes are commensurately higher. Oliver Wyman, a consultancy, recently estimated that a re-run of the 2000-2003 market crash could wipe out $33trn of value.

The fact that something might happen doesn’t mean it will. It also says nothing about when it could occur. There is a plausible case to be made for the current market to remain underpinned by strong earnings and far more reasonable valuations than ultimately punctured the dot.com bubble 25 years ago. As I pointed out last week, the real benefits of the AI revolution may just be emerging. The surge in global shares in the year since last spring’s tariff shock provides a salutary illustration of the risks of being too cautious.

But it is sensible to recognise the self-feeding linkage between the level of the stock market and the health of the real economy. The Goldilocks scenario we are enjoying today of rising share prices and a buoyant economy could easily go into reverse. No-one will ring a bell at the top.

I would rather be thinking through a wealth preservation strategy now than when the doom-loop has begun. The bigger risk investors face today is not a simply a correction in stock market valuations - although this would be damaging enough - but a consequential wealth-effect recession.

It is lovely to have a new watch. But you can only wear one at a time. It is a very easy purchase not to make. Whether I choose to spend or not is neither here nor there. But if the bull market hits the buffers and everyone in my position becomes more cautious, we will have a problem.

This article was originally published in The Telegraph.

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