What the 'AI Bubble' debate may mean for Europe

November was a ‘continuity’ month with reasonable market appreciation. Europe including the  UK (MSCI Europe index) was up 0.9% with some of the same trends as prior months, namely another strong showing by banks/financial stocks, but also decent returns from consumer staples, healthcare and utilities suggesting a slightly more defensive tilt to the market. It is interesting in that defensive context that bank stocks outperformed (again) suggesting the market is increasingly treating them as lower risk, lower beta investments.

Economic data remains mixed / bifurcated, with weak industrial activity continuing across many sectors in Europe, the US and China, partly offset by the extraordinary AI, data centre and tech- related spend. Consumer spending growth in Europe remains modest in the large economies with weak consumer confidence offsetting the benefits of low unemployment and real wage growth, whilst a continued very weak consumer trend in China and mixed trends in the US (depending on income decile) were also notable. Smaller & medium-sized European economies, particularly the peripheral economies that made impressive adjustments in the Eurozone crises, continue to grow robustly in line, or ahead of, the US economy, and we retain large overweight positions towards these economies.  

'Bubble pop'?

Within equity markets the key debate moved more strongly to whether the US equity market is experiencing an ‘AI bubble’. ‘Bubblers’ claim that excess investment by a small number of technology companies is inflating earnings to unsustainable levels within parts of the market funded by increasing amounts of debt financing, thereby further increasing risk and the consequences of a ‘bubble pop’.  Added to this, the high valuations of the MAG7 stocks and the ever-increasing levels of concentration in the US market have added to jitters surrounding US/Global equities, leading to price volatility and a mini sell off in the Nasdaq & S&P 500. There were knock-on effects of this in Europe with the semi- capex equipment and electrical stocks exposed to AI/data centre spending also selling off. There are a few points that are relevant in the context of how we think about our European industrial-electrical and semi-capex stocks:

1. The huge levels of investment in semiconductor capacity, AI capacity & AI data centres and all of the associated infrastructure spend (electricity generation, network expansion etc) cannot be taken outside of the geopolitical context and the geopolitical moment; this is a global competition, perhaps even an economic war, between the US and China and the US political system (i.e., a consensus across both political parties) is determined to win it, as is China!  It is no news to anyone that China is a centrally directed economy, and that President Xi has tilted China firmly towards high value added tech and industrial services, away from consumption (and property speculation), but it would also be a mistake to underestimate the growing efforts to marshal the US tech, industrial and technology ecosystems into what some are calling a ‘second Manhattan project’.  In short, we think there is strong impetus in both economic blocks to continue to invest very heavily in technology and advanced industrial services to dominate the industries of the future and to improve national resilience. 
2. It is right to think through and question ‘likely’ revenue models, and the risks that the revenue models that emerge do not generate sufficient returns to justify the huge amounts of investment being undertaken, but it is far too early to form any definitive views yet; it may be the case that much capital is wasted but it is also the case that the necessary infrastructure has to be built before monetisation can occur, and given the determination of both China and the US to win this war, we doubt investment spending will crack or slowdown in the short-term.  We are still open minded as to the likelihood that all of this investment is productivity enhancing as we can see many areas ripe for automation in legacy industry and services.  We do not share the confidence assertions of those who proclaim “bubble” but nor are we ignorant of the risks.
3. We do not see an issue of financial capacity to finance these investments as some claim; this of course does not mean that money will not be lost, or that some financial agents won’t absorb losses.  But the fact is the large US technology companies have large net cash balance sheets, generate prodigious operating free cash flow, the US financial system is huge and deep, and the US economy is still sucking in large amounts of capital from the rest of the world – so we believe the extraordinarily large AI investments can be financed.  However, that does not mean that are no financial consequences: exceptionally large investments in cutting-edge US technology crowd out investment opportunities elsewhere and along with a large ramp up in sovereign spending on defence, and the energy transition, may keep upward pressure on global real interest rates as the new, higher levels of investments shift the global supply and demand for savings & investments.  The elevated levels of company capex may also lead to reductions in Free Cash Flow (as opposed to Operating Cash Flow) for US tech stocks, and that may well have implications for their ability to do buybacks and their valuations – but that is a different point.   

What does all of this mean for Europe? Well sadly, as an economic continent Europe is largely not at the races and some of the large economies countries such as Germany and the UK have greatly handicapped themselves in the AI opportunity with some spectacularly unwise energy policies (no, offshore wind generation capacity is not 9x cheaper than gas powered electricity generation capacity – it really, really isn’t). But as we never tire of saying – European equities and European economies are not the same thing. Many of the companies we invest in are very globally exposed to the key trends and operate in spaces where they are the global number ones. Given all of these points, we think the structural growth outlook for European semi capex equipment electrical equipment and data centre infrastructure companies remains strong and intact.  

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