AI rally set to trigger stock market correction, ECB researchers warn

Eurozone investors would be affected through direct exposure to so-called Magnificent Seven stocks including Apple, Alphabet and Microsoft, as well as over-exuberance in the region’s stock markets, the economists cautioned.

A stock market correction is likely after a “blistering rally” in technology and could carry severe consequences for the euro zone, researchers at the European Central Bank warned.

Even if current valuations are rational, an adjustment should be expected, economists including Malin Andersson, Stefano Corradin and Kalin Nikolov said in a blog post published Monday on the ECB’s website, offering two complementary explanations:

As wide-ranging AI adoption spreads risks from individual firms across the economy, investors will demand higher risk premiums. Unless profit growth is strong enough to compensate for that, stock prices will fall.

Overconfident, overoptimistic investors boost prices beyond fundamentals until sentiment turns and valuations correct.

"The rise of AI has driven a blistering rally in the tech sector, bringing stock market valuations to levels last seen during the dot-com bubble," they said. "Although AI is reshaping the economy, do today’s high valuations bear the risk of an abrupt and painful setback in the euro area?"

Eurozone investors would be affected through direct exposure to so-called Magnificent Seven stocks including Apple, Alphabet and Microsoft, as well as over-exuberance in the region’s stock markets, the economists cautioned.

“The euro area’s smaller, less richly valued tech sector limits the risk of a home-grown crash,” they said. “But this offers little reassurance: households, insurers and pension funds have significant exposures through global index trackers, and US equity stress has historically also had an impact on euro area stock markets.” 

The effect of a US correction could extend to sentiment, lending conditions and hiring, they added.

"Euro area households, which are increasingly channelling funds into low-cost ETFs, have around €440bn of exposures to US technology equities without necessarily being aware of the associated concentration risk," they note.

The researchers, who also include Johannes Breckenfelder and Maria Antonietta Viola, said policymakers have “markedly less room” to respond to market instability than after the dot-com crash as interest rates today are lower and fiscal policy is more stretched.

"Unlike in the dot-com episode, today's starting point leaves markedly less room to cut interest rates or use fiscal policy to cushion the fallout."

Expectations for an eventual correction don’t mean prices have hit a ceiling, though.

“If AI proves to be transformative enough, valuations could still be much higher in the future, even after a correction,” they wrote. 

“It is impossible to know in advance where we stand on this path. A US AI fallout would not remain a US problem."

Bloomberg