Economies are facing renewed instability as AI-related debt, the conflict in Iran, and rising government bond yields trigger widespread concern.
During the height of summer, stock market climbed to record highs as investors gambled that a multitrillion-dollar spending spree would outweigh the economic impact of the war in Iran.
Now, warning signs are appearing. As Middle Eastern hostilities intensify without a clear path to peace, financial markets have been plunged into fresh turmoil. A deceleration in the AI arms race and volatile conditions within the government debt market are fueling further alarm.
Over the past week, US government borrowing costs reached their highest point since 2007, creating ripple effects for the finances of households, businesses, and governments globally. There is growing fear that Donald Trump’s war is driving higher inflation. The president’s tax and spending proposals—which are pushing Washington’s debt beyond $40tn (£29.9tn)—have also left investors uneasy.
But with global oil prices climbing above $100 a barrel and putting heavy selling pressure on the bond market, could equities be the next to face a crash?
With the S&P 500 index of major US firms sitting 3% below an all-time high, and the “magnificent seven” tech stocks—Nvidia, Apple, Google, Microsoft, Meta, Amazon, and Tesla—boasting a combined value exceeding $20tn, there is concern that markets are overextended just as economic storm clouds gather.
“These are febrile times,” Albert Edwards, a senior analyst at the French investment bank Société Générale, wrote in a note to clients. “The key worry for investors and policymakers alike is the extent to which the current oil price ‘shock’ will ripple through the global economy and whether it will necessitate sharply higher, recession-inducing, interest rates.”
Known for his pessimistic outlooks, Edwards believes the conditions for a financial crisis may be coalescing amid the precarious state of the US government debt market.
The anxiety surrounding the Iran war’s impact on inflation is so significant that the US Federal Reserve defied Trump this week by implementing its first interest rate hike since 2023. As households and businesses grapple with rising energy bills and fuel costs, central banks in other regions are also taking action.
Financial markets indicate that the Bank of England is expected to raise interest rates four times before the end of next year, even after choosing to hold borrowing costs steady this week. The European Central Bank increased rates last week, underscoring the damage the escalating conflict is inflicting on the eurozone, while the Bank of Japan raised its policy rate to a 31-year high on Friday.
The logic is that increasing borrowing costs will dampen economic activity, preventing short-term inflationary spikes from becoming permanent. However, this will place further strain on households and businesses already struggling with a cost-of-living crisis. Job losses are likely to increase, which will in turn exacerbate the difficulties faced by governments already burdened by debt.
Deutsche Bank’s Jim Reid has calculated that a US recession has historically followed the first rate hike by approximately three to 3.5 years. Markets tend to decline, or even crash, before a recession officially begins, and they often start their recovery before the broader economy does.
However, a major concern among investors is that the primary hope for economic salvation—AI—might prove to be a disappointment, amid fears that it has inflated a massive bubble in the US stock market.
One common metric used by investors to determine if a market is overvalued—the CAPE ratio, or cyclically adjusted price-to-earnings ratio—has climbed to its highest level since 2000, indicating that US stocks are unusually expensive relative to their earnings.
The CAPE ratio for the S&P 500 is currently near 41 points, more than double its long-term average of roughly 17, and is nearing the record high of 44.19 points seen in December 1999, just before the dotcom crash.
Highlighting the scale of the challenge, research from Fathom Consulting indicates that for the multitrillion-dollar AI boom to become profitable, AI-related sales for the involved tech companies would need to grow by between $600bn and $800bn within two years.
Against a volatile backdrop where investor patience is wearing thin, the consultancy estimates a 30% probability that the AI bubble will burst next year.
Brian Davidson, an economist at the consultancy, said: “For all the impressive advances in AI technologies in recent years, the economics behind the current capex boom do not work.”
“Yes, recent AI advances could yet unlock huge productivity gains; but sales of AI models need to increase by hundreds of billions of dollars per year over the next two years to justify the current spend. Such growth appears unlikely.”
Investors are clearly worried. More than 1,000 investors registered for an analyst call hosted by Jefferies this week regarding “AI Extinction Warnings,” following calls from leaders of the world’s top tech firms to slow down “reckless” development.
The current situation shares similarities with the dotcom crash of 2000, when many internet companies touted as the next big thing saw their values plummet. It serves as a reminder that even if a technology is revolutionary, investors can still lose their capital if they fund too much infrastructure too soon.
“It took a decade or more for demand to catch up with the infrastructure laid down in the British canal and railway and US telecoms and fibre booms – and many investors never recovered their capital,” points out Adrian Cox of the Deutsche Bank research team.
There are also sobering parallels to the period leading up to the great crash of 1929. A century ago, many small-scale US investors purchased stocks “on margin,” using borrowed money. They were wiped out during the market turmoil that preceded the Great Depression.
This year, South Korea’s army of traders has been buying shares in AI-linked chip manufacturers on margin, doubling the value of the blue-chip Kospi index. But once the market began to slide, they were hit by a massive wave of margin calls—where investors are required to provide more cash to maintain their loans. Many were forced to liquidate their holdings. According to Goldman Sachs, 1.2 million
“I don’t think outright collapse in a dotcom bubble type fashion. But could I see a slow release of air that doesn’t collapse the world economy, but slows it down? Yes, I could.”
Originally reported by www.theguardian.com. This article has been independently rewritten for republication.
