As the fervor around artificial intelligence collides with the sounds of conflict in the Middle East, the global economy is undergoing a rare, multi-faceted stress test. In a recent interview, the global head of macro research at Nomura observed that the world is navigating an unusually complex period where many challenges are unfolding simultaneously, with economic resilience being tested from multiple angles at once.
Despite a series of shocks in recent years, from geopolitical tensions and surging energy costs to rising bond yields and vast fiscal deficits, the global economy continues to show remarkable endurance. This resilience stems from two main pillars: governments responded swiftly and flexibly to the initial energy price spike, mitigating a more severe stagflationary blow, and crucially, the massive wave of AI-related capital expenditure has provided powerful support, especially for the US and many Asian economies, offsetting weakness in traditional demand.
However, this resilience is not a sign that risks have faded. It represents a fragile balance between opposing pressures. The conflict involving Iran means crude oil, diesel, gasoline, and electricity prices remain high, indicating that the transmission of energy costs to the real economy is not yet over. The longer energy exports from the Middle East are disrupted, the greater the risk, as the buffer provided by government reserves is finite. Once depleted, the room for policy maneuver will shrink rapidly. China, notably, has played a significant role in reducing oil imports, offering some cushion to global energy demand.
Focusing on AI, the path ahead is not linear. While long-term prospects are transformative, the short-term journey is fraught with risks. The question of whether colossal AI investments yield expected returns depends on the speed of adoption, particularly by enterprises, which in turn hinges on the broader economic climate and token prices. Some US firms are facing intense competition from cheaper AI models, which could compress profit margins for frontier model developers. Bottlenecks in chip supply and power generation may also slow progress, and cybersecurity threats remain a significant concern.
Therefore, at some point, the AI boom is likely to hit a temporary setback; it is only a question of when. This uncertainty is a risk that markets must price in. Should a phase of disillusionment occur, the vast global investment in AI would face a major repricing, impacting not just the US but also nations like Korea, Singapore, Malaysia, and Japan that are highly dependent on AI-related capex and exports. The market reaction could be severe, with the Federal Reserve likely cutting rates aggressively, global equities suffering a substantial correction, and US Treasury yields falling as investors shift assets away from stocks. This would be a classic risk-off trade.
The most critical dynamic to watch is how foreign investors handle their vast dollar-denominated assets. Concentration risk on US assets has increased dramatically, fueled by heavy investment in AI-related stocks like the Magnificent Seven and significant wealth effects from rising US equities. With foreign investors holding a staggering $37 trillion in US portfolio assets, a setback in AI could trigger a de-risking of these positions. Given the high concentration of these holdings, such a move could drive the dollar lower, push gold to new highs, and see cryptocurrencies rally, while equities fall and interest rates decline.
Turning to the US economy, it has shown strength in the first half of the year due to AI investment, a resilient labor market, and positive wealth effects from stocks. However, the country faces upward pressure on bond yields and persistent cost-of-living challenges. With midterm elections approaching in November, a divided Congress could lead to more fiscal stimulus, but with limited policy space, this could add further upward pressure on yields. On monetary policy, comments from the Fed Chair were notably hawkish, citing a very tight labor market with unemployment around 4.1% and inflation running above the 2% target for 65 consecutive months, suggesting the central bank needs to see price growth cool sufficiently.
More than the federal funds rate, the rise in global bond yields is a key concern. This is driven by stubborn inflation, massive fiscal deficits requiring heavy government debt issuance, and large tech companies issuing bonds, which draws investment away from Treasuries. The Treasury Secretary is keen to prevent yields from rising further as it impacts mortgage rates and small business borrowing costs. Measures like increasing bond buybacks or shifting towards shorter-dated debt come with trade-offs, including more frequent refinancing risks. More aggressive options, such as forcing banks and pensions to buy government bonds or pressuring the Fed to restart QE, could carry long-term negative consequences for the dollar.
In this global landscape, China stands out. Aided by a thriving open-source AI model ecosystem, abundant electricity, vast data from its large population, and a leading position in robotics, China is well-placed. Robotics acts as a bridge to physical AI, creating a powerful "flywheel effect" that could establish China as one of the most compelling stories in the global AI transformation, a development that would eventually be reflected in market valuations.