The AI Rally Will ‘Likely’ Lead To a Market Correction, An ECB Post Warns

A European Central Bank blog post warned that the U.S. stock market will "likely" face a correction following the latest AI-fueled rally.

The publication, which does not necessarily reflect the position of the central bank, noted that even if AI becomes a transformational technology, stock prices could eventually fall because the "nature of uncertainty shifts from a 'single sector' to the "entire" economy."

"As adoption spreads, the same uncertainty becomes economy wide. If something then goes wrong with that technology, the whole economy suffers," reads a passage of the report.

The post did note that if AI " proves to be transformative enough, valuations could still be much higher in the future, even after a correction." It added that psychological trends also point to a correction, as overly optimistic investors can bid up price beyond fundamentals. When optimism fails, prices tend to fall more than what could rationally be expected.

"The effects of a US correction could extend beyond financial markets to euro area sentiment, financing conditions and hiring. A US AI fallout would not remain a US problem," the publication concluded.

Elsewhere, Bank of American strategist Michael Bartnett said surging government debt and persistently higher Treasury yields could end up threatening the rally.

The first is America's rapidly expanding national debt. The U.S. budget deficit reached $432.3 billion in July, its largest monthly shortfall in more than five years, with rising Medicare costs contributing to the increase. Hartnett said the national debt is on the verge of surpassing $40 trillion and is on course to reach $50 trillion by 2029.

The second threat, rising bond yields, is closely connected to the first. The yield on the 30-year Treasury hovered around 5.24% Friday, near levels not seen in more than a decade. Thursday's auction of 30-year Treasury bonds produced the highest yield since 2001, underscoring the pressure in the government debt market.

Higher Treasury yields can become a problem for stocks because they raise borrowing costs throughout the economy while making bonds and other fixed-income investments more competitive with equities. If investors can earn increasingly attractive returns from relatively safer government securities, the valuations they are willing to pay for stocks can come under pressure.

The situation could become more complicated if energy prices remain elevated because of the ongoing war in the Middle East. Higher energy costs can contribute to inflationary pressure, potentially keeping interest rates and Treasury yields elevated for longer.

For now, however, investors appear willing to look past those risks. Hartnett described several investment "rules of the road" that have characterized markets in the 2020s, including "Anything but Bonds," "Anywhere but China," "Anything but the US Dollar" and an "all-in on AI" mentality.