Bubbles good and bad

Bubbles good and bad

Last week US chipmaker Nvidia became the first company in the world to reach a market value of $5tn, equivalent to £3.8tn. At this staggering valuation Nvidia’s shareholders could buy every one of the 600 or so companies in the UK equity market.

• Over the last three years, Nvidia has evolved from a niche graphics-card designer to an AI behemoth, with the boom in AI driving demand for its chips. You get a sense of the scale of enthusiasm for AI from the fact that Nvidia reached a market value of $1tn in June 2023, hit the $4tn level three months ago and has now reached $5tn.

• It's not just Nvidia's shares that have benefited from AI euphoria. The so-called Magnificent Seven US tech giants, which include the likes of Apple, Microsoft and Alphabet alongside Nvidia, have returned 275% since ChatGPT launched in November 2022, more than three times as much as the return on the S&P 500 index.

• Such stellar outperformance has prompted talk of an AI stock market bubble and numerous comparisons with the dotcom crash of 2000. How worried should we be?

• Asset bubbles are a recurring feature of market economies, often sparked by technological innovations. A 1998 US study examined a sample of 51 major innovations spanning the period 1825 to 2000, starting with the steam train and ending with the smartphone. About three-quarters of these technologies generated stock market bubbles. Some transformational inventions, such as the electric washing machine, the colour TV and the digital camera, emerged bubble free. It is perhaps unsurprising that the electric toaster, which hit the market in 1908, or the electric can opener, which arrived in 1956, were not accompanied by bubbles.

• It is counter-cultural to think of stock market bubbles as benign. Bubbles, after all, distort the allocation of capital and, in the bust phase, wipe out investors and can cause recessions. The memories of the 1929 Wall Street crash or, on a lesser scale, the dotcom bust of 2000, haunt policymakers to this day.

• Yet many of the greatest innovations of the last 200 years, everything from trains, to cars, radio, the PC and the internet, have generated stock market bubbles. By sucking capital into a sector and fuelling investment, market euphoria accelerates the exploitation of new technologies, boosting growth and spreading prosperity.

• For all the distortions and risks they cause, stock market bubbles can be beneficial. The question is whether the gains in terms of growth and human welfare from the rapid deployment of a new technology more than offset the collateral damage to the economy during the bust phase.

• How does the dotcom bubble fare on these criteria? The US Nasdaq tech index dropped almost 80% from peak to trough during the dotcom bust, pushing the US economy into recession and triggering widespread business failures and layoffs in the tech sector. But the recession was short and shallow, and the economy and productivity bounced back, aided by new tech and internet infrastructure. Telecoms giant Global Crossing, for instance, laid 100,000 miles of undersea fibre-optic cables during the boom before collapsing into bankruptcy in 2022. But those cables support the internet to this day. For the US economy, so complete was the recovery that by mid-2004 the Federal Reserve was raising interest rates in an attempt to dampen US growth.  

• The technologies of the dotcom boom were, like the railway, automobile and the aircraft before them, transformational. The accompanying stock market booms and busts were, at least to me, a price worth paying to get these technologies deployed quickly.

• Not all booms have benign outcomes. Investors can shovel capital into technologies and businesses that fall far short of expectations. As The Economist drily observes of Japan’s tech boom in the 1980s, “much of the capex by Japanese electronics firms… ultimately served no useful function”.  The past is littered with revolutionary ideas, from nuclear-powered vacuum cleaners to Betamax and 3D TV, that failed.  

• The case for the AI boom ending up in the bad sort of bust runs as follows. Vast levels of investment in AI have not yet delivered demonstrable gains in productivity or commensurate growth in revenues. A widely cited MIT survey of 300 companies released in August found that 95% of US AI pilot projects fail. Data security concerns, shortages of technical expertise and poorly organised data seem to be hampering the successful deployment of AI. Meanwhile, the assets created in today's tech boom are not likely to be as long-lived as the internet networks or railways of the past. The advanced semiconductors and GPUs that make up the bedrock of modern AI systems are likely to be obsolete in around three to five years. The AI boom, so the argument runs, is investing in a fast-depreciating hardware infrastructure while the technology is not yet cutting the mustard in the workplace. 

• If the market mood changes, things could turn nasty. Last month, Gita Gopinath, the former chief economist at the IMF, estimated that a stock market correction of the scale of the dotcom crash could wipe out over $20tn in US household wealth, equivalent to roughly 70% of US GDP, given the significantly higher exposure of retail consumers to US equities these days. This is far larger than the losses incurred in 2000 and could have a devastating effect on consumer confidence and spending.

• This is alarming stuff. But at least for me the case for the bust, should and when it comes, being less apocalyptic, is more persuasive.

• Tech valuations are not yet as high today as they were in the 1990s. Unlike some of the big players in the dotcom boom, today’s tech majors, like Meta and Alphabet, have huge revenues and are profitable. Corporate cash, not borrowing, is funding much of the AI capex boom. As a result, banks are less involved in the provision of capital than in the dotcom era. That reduces the risk that an AI bust could bankrupt numerous tech behemoths and, by hitting bank profits, collapse bank lending. Given their low levels of debt, strong balance sheets and other established sources of income, the tech majors would be better placed to absorb a hit to valuations than many of the dotcom players.

• Even the depreciation story is more nuanced than it first appears. The powerful chips being installed in data centres depreciate quickly, but the clean energy infrastructure needed to support this data centre expansion will last.

• The IMF is hardly complacent about the risks posed by AI valuations. But its latest Global Financial Stability Report, released last month, judges that the risks of a deep, systemic crisis are lower than in previous bubbles, largely because corporate cash, not debt, is a major driver of investment.

• Most major new technologies generate asset bubbles. When valuations return to earth, many investors lose their shirts. What matters is whether the boom leaves behind productive, growth-enhancing knowledge and assets.

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index ended the week up 0.7% at 9,717.

Economics

• The US and China agreed a one-year temporary trade truce. The deal will see China pause restrictions on exports of rare-earth minerals and the US reduce the average tariff on Chinese imports from 57% to 47%, ease controls on technology transfers and halt an investigation into China’s shipbuilding industry among other measures
• The US and South Korea agreed a trade deal that will see reciprocal tariffs cut from 25% to 15% in return for South Korea agreeing to invest $350bn in the US
• The US Fed cut its interest rate target by a quarter point to a range of 3.75%-4.00%, in line with expectations
• Fed chair Jay Powell said that another rate cut this year was “…not to be seen as a foregone conclusion — in fact far from it”. Market expectations of a rate cut fell on the news. The Fed is next due to meet on 10 December
• The US government shutdown continues, with the loss of wages for federal workers likely to impact growth
• The euro area economy grew by 0.2% from the second to the third quarter driven by growth in Spain and France. Output was flat in Germany and Italy
• The European Central Bank kept its benchmark interest rates on hold, commenting that the outlook for inflation is “broadly unchanged”
• Euro area inflation slowed by 0.1 percentage points to 2.1% in the year to September
• The UK government’s review of disability benefits will focus on changes in line with existing spending projections rather than finding new savings, according to official documents
• UK house prices rose by 0.3% in October, according to estimates from Nationwide
• Hurricane Melissa caused severe damage and at least 49 fatalities across Cuba, Haiti and Jamaica
• Argentinian bond prices rallied sharply following a surprise strong showing by president Javier Milei in mid-term elections

Business

• Food group Princes and British lender Shawbrook both listed on the London Stock Exchange last week, a pickup after initial public offerings hit their lowest level in the last 30 years
• Russian oil company Lukoil announced it would sell its foreign assets following new US sanctions
• Virgin Trains was granted approval to run passenger services through the Channel Tunnel; Eurostar had until now been the sole provider of such services since the tunnel’s opening in 1994
• Volkswagen reported a €1.3bn loss in the third quarter and said that US tariffs and knock-on impacts could cost it €5bn this year
• The UK House Builders Federation warned that the government’s target to build 1.5m homes in England by the end of the decade is too optimistic
• UK regional airline Eastern Airways suspended its operations and said it would enter administration
• Oilfield services group Petrofac entered administration following the loss of a major contract

Global and political developments

• A planned summit between US president Donald Trump and Russian president Vladimir Putin in Budapest was scrapped after Russia reportedly refused to back down from its longstanding demands
• Russian infantry is massing around the strategically important city of Pokrovsk in the Donetsk region of Eastern Ukraine
• The centrist D66 party edged out the far-right Party for Freedom to win elections in the Netherlands. Thirty-eight-year-old leader Rob Jetten is set to be the country’s youngest ever prime minister in a coalition government
• Mass killings have been reported in the Sudanese city of el-Fasher amid conflict between the paramilitary Rapid Support Forces (RSF) group and the military
• The UK government confirmed that British-made military items had been found in Sudan but resisted calls for an arms embargo on the United Arab Emirates amid suggestions that the country may be responsible for arming the RSF
• A number of deadly Israeli strikes in Gaza raised concerns that the fragile ceasefire with Hamas may not endure

And finally… the journal Science reports that pumpkins may have gone extinct if it were not for human intervention. The seeds of the ancestors of pumpkins, gourds and squashes were spread by large mammals such as giant sloths and mammoths that have since gone extinct. Were it not for the domestication of plants by the peoples of the Americas it is likely we would not have the orange fruits to enjoy today – carving out an existence