The European Central Bank (ECB) reported in a blog published on Monday that a correction in stock markets driven by artificial intelligence (AI) could affect the eurozone, even if the technology delivers significant productivity and profit growth for corporations. Furthermore, there is a possibility of the sell-off of American tech stocks spreading to European markets due to rising systemic economic risks.
In a blog post titled 'The AI Boom: Rational Enthusiasm or the Next Dotcom Bubble,' the ECB examined whether current stock market valuations are justified by AI's potential or if they could lead to a correction similar to previous tech booms. The study concluded that economic data from past technological revolutions indicates a high probability of a correction in current market valuations.
Reasons for a Potential AI Stock Decline
The ECB noted that stock prices may eventually fall even if AI proves successful, as the nature of the risk changes as this technology spreads throughout the economy. According to the blog, 'Even if the technology is successful, stock prices may ultimately fall.'
In the early stages of AI adoption, a failure affects individual companies, and the risk can be diversified. However, as adoption expands, the uncertainty becomes macroeconomic. The ECB emphasized that 'this risk cannot be diversified, so investors demand a higher risk premium.'
An increase in the risk premium can put pressure on valuations even when AI adoption supports cash flows. The ECB stated that historically, the rise in the risk premium has tended to outweigh the positive impact of stronger cash flows unless the profit growth is large enough to compensate for it.
It is impossible to predict the exact timing of such a correction, as the blog indicated that 'the exact timing is unknown in advance.'
Historical Analogues to the AI Boom
The ECB compared the current AI boom to earlier technological revolutions, including the 19th-century railway boom, the development of electricity and radio in the 1920s, and the 1990s internet boom. In these cases, breakthrough technologies attracted investment, and the valuations of companies adopting them rose sharply before beginning to fall.
The ECB proposed two interpretations of the 'boom and bust' pattern: rational and behavioral. The rational view suggests that high valuations may arise from uncertainty about the performance of the new technology. The behavioral view posits that overly confident investors might push prices above fundamental metrics. The ECB noted that both views imply some correction at some point, but it did not assert that current prices have reached their limit. Nevertheless, if AI proves sufficiently transformative, valuations could continue to rise even after a correction.
Eurozone Households' Exposure Amounts to 440 Billion Euros
A correction in American tech stocks could affect eurozone investors due to their holdings in the 'Magnificent Seven.' Most of the eurozone's exposure to this group is through investment funds, such as mutual and exchange-traded funds, rather than direct ownership. Eurozone households have approximately 440 billion euros in exposure to US tech stocks, with households increasingly investing in low-cost ETFs. The ECB noted that they may not be aware of the associated concentration risk. A significant portion of the 'Magnificent Seven' exposure also belongs to insurance companies and pension funds.
How a US Correction Could Spread to Europe
The structure of these investments, based on funds, could become a transmission channel during a sharp correction. Funds may have to sell assets to meet redemption requirements. If the correction continues, they might first sell liquid assets and then troubled ones. This could further lower valuations and trigger new redemption demands. The ECB stated: 'This is why the Mag7 correction is a matter of financial stability for the eurozone, not just a private issue.'
'Mag7' refers to seven American tech stocks: Alphabet, Amazon, Apple, Tesla, Meta Platforms, Microsoft, and Nvidia. According to the ECB, the eurozone's domestic tech sector poses a smaller risk of internal correction because eurozone stock valuations have risen, but price-to-earnings ratios remain significantly lower than in the US. Eurozone stock markets are also largely composed of 'old economy' stocks, which limits their direct exposure to growth driven by AI in American tech companies.
Nevertheless, eurozone and US stock markets have historically shown high correlation. The ECB noted that the consequences of a US correction could extend beyond financial markets, affecting sentiment in the eurozone, financing conditions, and employment. The ECB blog concluded: 'The AI downturn in the US will not remain just a US problem.'
Furthermore, the ECB pointed out that the eurozone has fewer tools than during the dotcom episode to use interest rate cuts or fiscal policy to mitigate overall market instability.