The dress rehearsal for an assessment of AI

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Last week was a lively and very useful dress rehearsal for what a bursting of the AI ​​bubble might look like in the markets.

First, we had an idea of ​​what would likely be causing it: not a cold, hard economy, not a blown fuse in some obscure piece of financial wiring, but vibrations. This is what really did the damage this week.

Every investor on the planet knows the problems here. We have a very concentrated global stock market that moves almost entirely on the fumes of speculative enthusiasm around this big theme. We have staggering levels of borrowing, often coupled with some rather creative ways of getting debt off balance sheets and where rating agencies and investors struggle to spot it. The so-called brightest minds in the industry blame “agents” and “worms” when their technology wreaks havoc, and no one yet knows if it can all bring in enough money to pay the bills when they come due.

We all know it. And we know that global financial markets, and all our pensions and savings nestled within them, are vulnerable if something goes wrong. Surveys of professional investors now put AI exuberance and hyperscalers’ debt spree at the top of their lists of concerns. Just to drive the point home, some effort must be made to avoid hearing the constant warnings from central banks and bodies such as the IMF and the Bank for International Settlements that we should not assume this will last forever and that we should be prepared for systemic shocks when the music stops.

All of this was true a few months ago just as much as it was in the second half of this week – nothing had really changed. But trade nonetheless faltered considerably. The South Korean stock market, known for its numerous tokens, fell 8% in one day. Bonds issued by specialist data center companies have taken a beating and, worryingly, credit default swaps – a kind of derivative that acts as a hedge against payment defaults – on some issuers have soared. A reasonable rule of thumb in the markets is that any time you hear the letters C, D, and S in a sentence, something bad is happening.

This is not a total reversal of the market: obviously, the United States still managed to hold on. But the second big lesson was a taste of what a real AI shock could have on financial markets.

We saw two clear signs that investors were really spooked: interesting, boring, non-tech stocks such as those in the UK’s FTSE 100 outperformed. Moreover, U.S. government bonds, heavily bruised after a series of hits, finally recovered — a sign that investors want safe assets and believe an AI implosion could derail the miracle that is U.S. economic growth. Data from earlier this week showed that U.S. inflation simply wasn’t falling — a dynamic that would typically hurt debt markets — but bonds rebounded anyway, pushing benchmark 10-year yields back toward 5 percent.

Unusually, given this tantrum, the dollar has weakened quite significantly – the DXY dollar index is down almost 1% since mid-week – lending weight to the theory that the AI ​​bubble being punctured would lead to a global withdrawal from US markets and dollar assets.

So here’s the broad outline of what the end times might look like: a weaker dollar, stronger bonds, a blow to markets addicted to the semiconductor boom, and a preference for old-economy stocks. Good to know.

But determining when to reach these safety plays is harder because traders and investors can’t pinpoint a solid event that shook markets this week. They point to several things: the alarm ringing inside the house, in the form of Broadcom’s chief executive officer’s warning that chip investors are treating the markets like a “casino”; CoreWeave’s light-hearted ambition to appeal to insurers for financing because “it’s all the money in the world”; and the failure of efforts to list data center companies on stock markets in Australia and Asia.

None of these things matter as much in isolation. But put them all together and you get a growing body of evidence that the brightest days of AI business are behind us. The easy money has been made and investors are now asking harder questions.

This vague feeling that “something could go wrong” is starting to really eat away at investors, as Deutsche Bank’s George Saravelos observed in a recent note. Systemic risks could come from “a security event, a (listing) failure or disappointing earnings,” he said. “The concentration risk is immense, and it is this event risk that is currently the most undervalued on the markets.”

The good news for investors struggling to shake the feeling that we are long overdue for a major pullback in the frenzied AI trade is that the classic safe haven – developed market government debt – is buried deep in the bargain basement. Even after this week’s sharp rise in bond prices, long-term yields are still around their highest level in decades. It’s not clever or sophisticated, but sticking to tried-and-true bets like this stands out among the options.

The trickiest task is determining where the next swing might come from and what might cause it to go from a stumble to a crash. The AI ​​business has lived by the vibrations, and it will die by the vibrations.

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