For artificial intelligence to live up to the hype fueling today’s S&P 500 bull market, here’s how high the bar is. The AI boom will have to deliver not just superpowered corporate profits, but a jolt to productivity that’s big enough to keep budget deficits from running the U.S. economy off the tracks.
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Productivity growth like that spurred by personal computers and the internet probably won’t be enough.
“We need something greater” — closer to the transformation from electrification — for an AI boom to rein in a runaway budget that’s “going to weigh on the economy,” Kevin Khang, Vanguard Group’s head of global economic research, told Investor’s Business Daily.
As Vanguard chief economist Joe Davis put it in a co-authored paper, the outlook for the U.S. economy and S&P 500 hinge on the “horserace between AI-boosted productivity and worsening structural deficit dynamics driven by an aging society.”
Vanguard and others on Wall Street tend to think the odds favor the AI boom. Yet even the optimists seem to think that surging capital spending on AI will take awhile to ramp up productivity. Meanwhile, the Federal Reserve policy of keeping interest rates higher for longer to contain inflation may speed up the runaway fiscal train.
That combination — uncertainty over a productivity renaissance amid a deteriorating budget deficit outlook — likely spells volatility ahead for the S&P 500 in coming years.
U.S. Economy Skirted Recession
In 2023, the U.S. economy defied recession forecasts, despite the sharpest Fed tightening in four decades. Economists credited locked-in low mortgage rates and excess pandemic savings that let consumers keep spending. But GDP data tells a much different story.
Nonresidential investment, government purchases and health care spending kept the U.S. economy afloat, providing more than 2 percentage points of last year’s 2.5% GDP growth.
Manufacturing construction is booming, made urgent by growing China tensions and financed with federal government help via the Chips and Science Act and the Inflation Reduction Act. Geopolitical events from Ukraine to the Middle East and Taiwan are fueling defense spending. Meanwhile, aging baby boomers are using more medical care and consuming more in general as they become spenders, not savers.
On top of all this comes the massive spending to build out an artificial intelligence infrastructure. That includes boosting electric generation capacity to keep up with the expansion of data centers.
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Economic Growth Hazards: Supply Of Treasury Bonds
The U.S. is experiencing the opposite of the “savings glut” and “secular stagnation” of the past two decades, Sonal Desai, Franklin Templeton chief investment officer, told IBD.
Instead of a glut, “We’re looking at a point when potentially you’re not going to have enough savings,” Desai said.
The upturn in private investment — coaxed by government funding and incentives — has come as Treasury supply has exploded. The U.S. budget deficit has averaged an “unbelievable” 8% of GDP over the past six years. Deficits typically run high during and just after recessions. But for the past two years, the budget gap has held at 6% of GDP, even with unemployment below 4%.
Meanwhile, the Fed, whose Treasury holdings ballooned to around $6 trillion during the pandemic, has turned from buyer to seller. At the same time, capital flows have become less supportive of low rates as globalization backslides. China unloaded more than $50 billion in U.S. Treasury holdings in the first quarter.
U.S. Budget Deficit And Interest Payments Soar
At the start of 2024, when markets forecast six or seven quarter-point Fed rate cuts this year, the grim budget outlook looked far off. Yet higher-for-longer rates are fast-forwarding the fiscal alarm clock. A harsh reality check seems likely within 12 to 18 months.
Some rate relief is still likely as economic growth cools. Yet the U.S. economy isn’t rolling over. AI spending is taking off. Airports have never been busier. Fiscal policy, including infrastructure spending, remains “a significant tail wind,” wrote Torsten Slok, Apollo Global Management chief economist, in a May 29 note.
The bull market fueled by AI stocks has boosted S&P 500 market capitalization by $9 trillion in the seven months since the Fed pivoted from rate hikes. That’s supporting consumer spending.
“You can call this the Fed Cut Reflexivity Paradox,” Slok wrote. “The more the Fed insists that the next move in interest rates is a cut, the more financial conditions will ease, making it more difficult for the Fed to cut.”
Markets now expect a year-end Fed funds rate of 4.9%, It’s now at 5.25%-5.5%. Franklin Templeton’s Desai sees it eventually settling around 4%. That’s more than one percentage point higher than what the Congressional Budget Office assumes.
This year alone, $8.9 trillion in publicly held debt — nearly one-third of the total — is maturing and being reissued at high rates. That’s on top of a budget deficit that CBO just revised up to $1.9 trillion.
CBO projects that net interest outlays will rise from 2.4% of GDP in fiscal 2023 to 3.1% of GDP this year and average 3.5% over the coming decade. Yet with publicly held debt about to top 100% of GDP, if rates are one point higher than CBO projects, net interest would head to 4.5% of GDP.
U.S. Economy And Tax Cut Extension
Meanwhile, the U.S. is headed for a giant fiscal cliff. Except for the corporate income tax cut, tax cuts passed in 2017 expire at the end of 2025. Congress will have to act next year to avoid a massive tax hike. The impact on the budget outlook could be huge.
Extending those provisions would widen the budget deficit by 1.3% of GDP, even before the added debt service. A Center on American Progress analysis implies that it would take an immediate $1 trillion worth of spending cuts and tax hikes to stabilize the debt around 100% of GDP.
If rates remain high while tax cuts are extended, deficits could average 8% of GDP over the coming decade.
Hold Champagne On Fed Rate Cuts
Markets are hanging on every data release for assurance that the Fed will cut rates. A couple more soothing inflation reports could mean the first cut comes in September.
Near term, inflation heading back to 2% and the U.S. economy cruising in second gear looks like a win. That could keep the S&P 500 bull market intact, though it would be on shaky ground. Nominal GDP growth might slow to about 4% a year, even as budget deficits ramp up toward 8%.
Desai sees the risk of a “very vicious spiral” — but one that ultimately forces both political parties to come together to solve the problem.
“As we get to a point where the government is desperately trying to fund a higher amount of debt at higher interest rates, that part is going to be very volatile for markets,” Desai said.
How High Will Bond Yields Go?
“Eventually when rates get high enough, something in the financial system blows up,” Jim Bianco, president of Bianco Research, said in a recent podcast.
“Look to the U.K. in 2022,” Bianco said. After new Prime Minister Liz Truss proposed tax cuts and spending hikes, the 30-year bond shot up an unprecedented 140 basis points in five days.
Truss stepped down after just seven weeks. “The bond market put its foot down and the spending stopped,” Bianco said.
But without a Truss-like rate shock, things may play out differently in the U.S.
“No one knows when the bond market reaches that point” in the U.S., Bianco said, whether later this year or in 15 years. Still, he suspects that such a “dire circumstance” won’t happen until long-term Treasury yields go much higher than last year’s peak near 5%.
That suggests a window to change the budget deficit trajectory. Washington may not be up to the challenge, but AI could be a game-changer.
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AI Boom And Productivity
An AI productivity boom could be the antidote to the current trajectory.
The ultimate question, according to Vanguard’s Davis: “Will we have a future of too-few jobs due to AI or too-few workers due to a demographic drag?”
The former would raise the economic speed limit by removing the constraint of a tight labor market. Faster growth should produce more revenue, shrinking the fiscal deficit. Plus, the rate of GDP growth should remain comfortably above the government’s borrowing rate. So federal debt wouldn’t balloon relative to the size of the U.S. economy.
“We expect technology to prevail,” Davis wrote, estimating 45% to 55% odds of this positive scenario coming to fruition.
That could see U.S. economic growth from 2028 to 2040 of around 3%, maybe more, as the AI boom delivers a productivity boost along the lines of the nearly one-percentage-point jolt to GDP growth from electrification from 1910 to 1929.
The downside scenario, of which Vanguard estimates a 30% to 40% chance, would come if AI lifts annual productivity by 0.3% to 0.4%. That would be in line with the productivity boost via PCs and the internet from 1970 to 2006. Real GDP growth would slump to 1.5% or less — even lower than the real interest rate on government debt. That means the stock of debt would rise relative to the size of the U.S. economy.
What The Generative AI Boom Means For Your Job, The Economy And The S&P 500
AI Boom: S&P 500 To 8,000?
Market strategist Ed Yardeni places even higher odds that an AI boom fuels big productivity gains. He sees 60% odds that productivity will grow over 2.5% per year for the rest of the decade, above the lackluster 1.5% pace since 2005.
“In our Roaring 2020s scenario, the technology boom should continue to shrug off the Fed and power productivity, economic growth, and the stock market higher,” Yardeni wrote.
He sees strong growth, low inflation and high profits driving the S&P 500 to 8,000 by 2030. Perhaps the biggest risk Yardeni sees is that the surge in AI stocks could get out of hand. In one of his low-probability downside scenarios, Fed rate cuts trigger a market melt-up. Booming asset prices could stoke inflation, leading to renewed rate hikes that eventually burst a valuation bubble.
When Will AI Boom Boost Productivity?
Goldman Sachs economists Joseph Briggs and Devesh Kodnani are just as bullish on a generative AI boom. They predict a boost in U.S. productivity growth of 1.5 percentage points per year for a decade. S&P 500 profit margins could widen by four percentage points, a huge increase from the recent 12% trend.
The two last year estimated that “generative AI could substitute up to one-fourth of current work.” They envisioned a disproportionate impact on high-wage knowledge professions largely shielded from automation before ChatGPT’s release in late 2022.
Yet the question of when productivity growth will take off looms large.
The PC era was a productivity dud until the Netscape Navigator browser in 1994 unleashed the internet’s potential, wrote Solita Marcelli, chief investment officer of UBS Wealth Management in the Americas.
Optimism over a quicker AI productivity ramp has ChatGPT playing a similar role, “bringing AI to the masses in an accessible and intuitive way,” Marcelli wrote.
Still, in a May update, Briggs noted “very small increases in adoption that we’ve seen in the one year since we wrote our initial report.” That’s consistent with the Goldman economists’ forecasts that “don’t assume any AI boost at all before 2027.”
About 5% of firms use generative AI “in daily production,” Briggs estimated. So far, he says, fewer than 20,000 layoffs have been attributed to artificial intelligence. Meanwhile, job listings seeking AI-related skills have picked up noticeably.
Artificial Intelligence ‘Low Hanging Fruit’
“There’s a lot of things that need to happen” for AI to be deployed widely and for productivity to ramp up, Briggs argued.
Current usage is focused on “low-hanging fruit,” like marketing and chatbots. To automate a broader set of tasks will require the build-out of industry-specific applications and data sets. But AI infrastructure investment has to lead. The includes getting the AI chips in place to train large language models like ChatGPT. Network capacity and electric power also need to be in place.
“We’re in the beginning of making significant investments around this potential GPT,” or general purpose technology, Vanguard’s Khang said. For that to drive faster productivity will require “a significant rearranging of the way we go about producing things,” not just tinkering around the edges.
“It’s going to be a number of years to see how that plays out,” he said, “and all the while the headwind of a fiscal deficit that’s only growing with the aging demographic situation. You put that together and the path to hopefully a positive, optimistic long-run outcome could be bumpy.”
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