In One Chart: AI is a ‘baby bubble’…for now, but a Fed ‘mistake’ could pop it, says Bank of America

Investors have piled into chip maker Nvidia NVDA, -1.75% which is up 116% so far this year. Founder and CEO Jensen Huang has predicted significant revenue from AI platforms in the next 12 months. Similar fervor has driven a 39% gain for shares of Alphabet GOOGL, +0.50%, and helped push the tech giant back above the $1.5 trillion market-capitalization threshold.

Microsoft MSFT, -0.38%, which also has a stake in the AI game, has seen its stock surge by 32% this year. And then there’s C3.ai AI, -1.67%, the enterprise software AI provider whose shares have exploded 144% higher this year.

Still, as the below Bank of America chart shows, the growing AI bubble has nothing on bitcoin, or even the once-hot theme of biotech. But Hartnett and the team remind investors of one common thread that has run through all hot-then-not themes: “bubbles in right things (e.g. internet) and wrong things (e.g. housing) [are] always started by easy money, always ended by rate hikes.”

Hartnett and his team predicted that “new AI mania,” alongside 5% inflation, 3% unemployment and 7% budget deficits in 2023 means the biggest “pain trade” in the next 12 months will be a fed-funds rate at 6%, not 3%. Most investors who are counting on Federal Reserve interest rate cuts in coming months, which is helping to drive stock markets SPX, -0.23% higher, could get blindsided by another rate hike.

The analysts said that machine learning is basically inflationary because there is “no way politicians in 2020s would allow AI to cause widespread unemployment, even if transitory.”

Should companies follow in the path of BT BT.A, +3.20%, which this week revealed plans to cut 55,000 jobs by the end of the decade in a shift to AI and automation, “expect regulation and/or another push for universal basic income policies, funded either by windfall taxation of corporations and/or Fed yield curve control to fund bigger and bigger government budget deficits,” said the strategist.

Indeed, Goldman Sachs warned this week that AI could deliver major long-term support for profit margins, but a question remains over what governments will do to rein in that technology.

Bank of America suggested investors only need to look at 1999, when the Nasdaq Composite COMP, -0.30% “bubbled” to 5,000. Internet stocks and a strong economic backdrop forced the Fed to restart tightening monetary policy, and the bubble popped nine months later. At present, AI is replacing the internet part of that equation and if the Fed has mistakenly paused its interest rate hikes, then U.S. bond yields will wave a red flag by heading above 4%. If that’s the case, “we certainly ain’t seen the last Fed rate hike of this cycle,” said Hartnett and co.

Read: 20 AI stocks expected to post the highest compound annual sales growth through 2025