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In November 2022, ChatGPT, a chatbot based on large language models, was launched and quickly garnered 100 million users in less than two months. Following this, similar software applications were introduced by companies like Google, Meta, and others in 2023. Thus, the artificial intelligence (AI) boom began.

Prior to this, AI had primarily been a tool harnessed by major tech giants, often referred to as the “Magnificent 7” – the seven largest US companies. By 2023, AI technology became accessible to both the general public and smaller enterprises.

Despite these advancements, investors remained relatively cautious, often comparing the rise of AI to other recent hypes like SPACs and cryptocurrencies. However, AI is more than just a passing trend. It has the potential to revolutionize the way we work and significantly boost economic growth. From an economic standpoint, this feels like the dawn of a new era.

Impact on the Economy

The potential of AI to boost economic growth is significant, evoking memories of the productivity surge that the ICT revolution ignited nearly three decades ago. Capital Economics points out that from 1995 to 2005, technologies such as the Internet increased US productivity by 1.5% annually. According to both Capital Economics and Goldman Sachs, the influence of AI might achieve similar heights in the upcoming years.

However, the magnitude of this impact will vary across countries and industries. While there will be winners, there will also be losers. Countries where innovation is robust and where companies actively invest in research and development are poised to emerge as frontrunners. Presently, the US appears to be the evident leader in this domain.

Moreover, there are prevalent fears among humans about this emerging technology. A recent US survey shows that a quarter of Americans fear AI could replace their jobs. Although these concerns are not unfounded, AI is also projected to pave the way for newer, more efficient roles. An MIT report highlights that 60% of the job roles in America today didn't exist in 1940, as noted by Capital Economics.

The Investment Case

Naturally, AI presents investment opportunities. Investors should distinguish between the AI hype and genuine investment ideas. While many AI-centric firms have risen in value, technology companies' growth outlook has concurrently been revised positively. For example, Goldman Sachs predicts that potential earnings for software firms could rise by 46% from current baseline levels, driven by AI.

At present, the most promising AI investment opportunities are in US growth companies, predominantly within the tech sector. As AI evolves, opportunities will diversify across sectors and countries.

The early beneficiaries of this technological wave are businesses like semiconductor and cloud companies. As previously noted, the software sector is also poised to lead in the development of AI products and solutions for both businesses and consumers. In time, AI is expected to pave the way for new industry leaders, much like the Internet did with firms such as Google and Meta.

However, there remains a looming risk of an investment bubble in the horizon. A recent report from Goldman Sachs, though, shows that the tech sector's valuations are currently far from bubble territory. While certain individual companies might exhibit very high valuations, the overall market valuations are only moderately above their 10-year averages, coupled with an enhanced growth forecast.

AI Trends

The AI narrative is predominantly American at present. Most AI-related innovation, R&D, and investments are concentrated in the US. In the long run, many global companies will benefit from AI, with varying degrees of impact.

Economic growth appears stronger in the US compared to other regions, and another boost may come from AI investments already in 2023 and 2024. We believe an overweight stance in US equities is logical. While sticky inflation and rising interest rates present challenges, the current economic and earnings growth, supplemented by the AI momentum, favor the US over other regions.

US growth stocks have excelled in 2023, even with rising bond yields, which usually challenge such companies. However, a specific subset of growth stocks, the unprofitable ones, has been impacted by higher interest rates. In contrast, many profitable growth firms are capitalizing on the AI trend.

AI is likely to influence markets for an extended period, bolstered by an improved economic and earnings growth outlook. Therefore, at least for the present, AI emerges as an investment theme that seems somewhat insulated from the effects of rising interest rates and a potential economic downturn.

Market Outlook

Since 2022, rising interest rates and inflation have troubled equity markets, causing concerns over surging rates. Despite 2022's inflation-related setbacks, 2023's economic growth has surpassed expectations. Contrary to anticipated recessions in the US and Europe, global growth in 2023 has been robust, inflation is declining, and earnings growth has been resilient.

The current earnings season looks promising against modest expectations. Challenges from rising bond yields since July have been evident, but US Q3 GDP growth is set to surpass 3%. While Europe and China may lag, the global economy remains strong. Earnings estimates suggest stability in the US and a drop in Europe due to the prior year's energy sector performance. Yet, potential positive surprises, especially from the US tech sector benefiting from the 2023 AI wave, are on the horizon.

In conclusion, equities' near-term outlook is more positive than recent trends indicate. Prevailing pessimism might trigger an investor rush back to equity markets if bond yields drop, sparking a potential rally through late 2023 and early 2024.

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