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I’m optimistic about the long-term potential of artificial intelligence (AI) to power big increases in worker productivity and economic growth. But I’m pessimistic that AI can justify lofty equity valuations or save us from an economic soft patch this year or next.
As is often the case with new technology, it’s likely to take many years to realize the full potential of AI. While substantial benefits appear likely, a meaningful risk of disappointment remains.
Here, then, is an attempt to connect the dots between the current level of share prices, an approaching slowdown in the U.S. economy, and the long-term promise of the latest technology to command the world’s attention.
A common narrative in AI circles is that tech firms, utilities, and other businesses will spend a combined $1 trillion or more to advance the technology in the coming years. Such a sum may be spent, but it’s not going to happen by the end of next year, by which time we expect the U.S. economy to have slowed. We estimate that it would take $1 trillion in AI-related spending to push economic growth in 2025 above the trend of roughly 2%.
As shown in the above chart, last year, U.S. investments in AI totaled an estimated $67 billion. To project such spending in the near term, we grossed up last year’s investments in AI by various annualized rates of growth ranging from 13% to 34%. Those hypothetical growth rates reflect the rate of growth in AI investments over the last decade as well as the rates of investment in three other broad technologies in their heydays. Those rates of growth would leave AI spending this year and next in the $76 billion to $121 billion range.
Even if investment in AI suddenly nearly doubled this year and next – mirroring the near doubling of NVIDIA Corp.’s data center revenues in recent years – AI spending would amount to “only” about $129 billion in 2024 and $248 billion in 2025. Those would be tremendous outlays, to be sure. Perhaps unprecedented. But $1 trillion in AI investment by 2025 would require 286% growth. That’s probably not going to happen, which means we’re unlikely to experience an AI-driven economic boom in 2025.
We have been cautioning investors for some time that U.S. stocks – and growth stocks, in particular – are richly priced. Indeed, the cyclically adjusted price-to-earnings ratio (CAPE) of the U.S. stock market stands at about 32% above our estimate of its fair value. While growth stocks and the broad stock market appear to be overvalued, small-capitalization, value, and non-U.S. stocks appear to be fairly valued.
My colleagues and I have been focused on the economic promise of artificial intelligence for some time. We are particularly curious as to whether AI-enabled growth in workforce productivity might help drive improvements in standards of living by offsetting the headwind of aging populations. In brief, count me as a cautious optimist. But improbable, at best, is the rapid economic and earnings growth that would correct the current excess valuation of the U.S. stock market.
Our final chart shows that U.S. corporate earnings growth since 1871 has averaged 4% per year. It also shows that, in strong periods, earnings growth has been much higher.
We wondered how fast profits would have to grow to unwind the excess in the U.S. stock market. Assuming a three-year horizon for a return to fair value, the answer is about 40% per year. This is double the annualized rate of the 1920s, when electricity lit up the nation – not to mention economic output and corporate income statements.
With profit margins close to record highs, most of a hypothetical 40% annualized profits jump would have to come from soaring corporate revenues. But slowing economic growth precludes soaring sales. My team’s forecast of U.S. economic growth in 2025 is 1%-1.5%, which would be down from our expectations of 2% growth this year.
The promise of AI is real. Our research suggests that the odds of an AI-driven surge in labor productivity are between 45% and 55%. In that scenario, we believe the U.S. economy would grow at a real (inflation-adjusted) annualized rate of about 3.1% between 2028 and 2040. The intervening years reflect the need for additional investments in the technology and time for them to pay off.
At the same time, we see meaningful risk – a 30% to 40% chance – that AI produces more modest benefits that are insufficient to overcome ever-larger government deficits driven by age-related spending. In that case, long-term economic growth might reach only about 1% per year.
Investors looking to connect the dots between the current level of share prices, probable levels of economic activity, and the widespread enthusiasm for AI would be well-advised to temper any expectations that economic growth and corporate profits are set for near-term acceleration. Instead, as ever, they’d be well-served to apply good sense in building and maintaining well-diversified portfolios that reflect their tolerance for risk and their investment horizons. Given growth rates, they should also be prepared to endure periodic downturns that would push stock prices closer to their fair values.
Joseph H. Davis, PhD, is a Vanguard principal, global chief economist, and global head of The Vanguard Group, Inc.’s Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, portfolio construction and related investment topics. As Vanguard’s global chief economist, Mr. Davis is also a key member of the senior portfolio management team for Vanguard Fixed Income Group.
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