Economic expansions don’t die of old age, and stock market rallies rarely do either. Some catalyst is needed to burst the bubble. In the case of the current AI boom, that may well be rising interest rates.
Economist Rudi Dornbusch famously said that aging expansions are killed by the Federal Reserve. Given the U.S. equity market’s sharp pullback on Friday – particularly the move in tech – it looks like investors fear the Fed may strike again, only this time the main victim will be Wall Street.
The Nasdaq fell more than 4 per cent on Friday, its biggest drop since the tariff turmoil around “Liberation Day” in April last year. Even more strikingly, the “SOX” chipmaker index plunged 10 per cent, its biggest fall since the pandemic in 2020, and the fourth-largest drop since the index was launched in 1994.
True, the SOX had nearly doubled this year, but Friday’s move was still seismic. All in all, some US$2-trillion was wiped off the value of U.S. equities, more than half of that in chip stocks.
The selloff was notable not only for its ferocity but also its trigger: bumper U.S. employment data. The rise in job growth in May came in at 172,000, double consensus expectations, while hiring in the previous two months was revised up sharply too.
Typically, this would be good news, a reflection of a strong economy and buoyant consumer demand that should, theoretically, boost firms’ profits.
But Wall Street deemed the non-farm payrolls report to be “bad news” because it screamed “higher interest rates.” Combine that with a market priced for perfection, and you have the recipe for a major reversal.
Signs have been multiplying that the AI mania is getting out of hand.
For one, there’s the massive increase in AI capex forecasts, which naturally raises questions about future returns on that investment. Analysts at Goldman Sachs last week said they now expect US$5.3 trillion of capex spending in 2025-2030 from the four largest hyperscalers, Meta, Microsoft, Amazon and Alphabet. That’s up from US$4.5 trillion before the first-quarter earnings season.
Then there’s the eye-popping IPO blitz. The public listings of SpaceX , Anthropic and OpenAI are expected to deliver a combined market cap valuation just under US$4 trillion.
That’s a staggering figure, especially when you consider these firms’ current revenues. SpaceX’s 2025 sales were less than US$20-billion, OpenAI’s annualized revenue barely topped US$20-billion, and Anthropic’s first-quarter take this year was less than US$5-billion. These figures will undoubtedly grow, but enough to justify these eye-watering IPO valuations?
Then there’s the fear-of-missing-out or “FOMO” trade, with stocks recording huge one-day moves almost wholly divorced from fundamentals. Exhibit A: shares in Marvell Technology, a US$100-billion company, rose 33 per cent in one day last week after Nvidia CEO Jensen Huang said the smaller chipmaker would soon be a trillion-dollar company.
Bubble signs are flashing – to put it mildly.
Equity strategists at Citi last week warned that their global “bear market checklist” was at its frothiest level since the global financial crisis in 2008 - and getting frothier.
The checklist comprises 18 “red flags,” including earnings forecasts, fund flows, valuations, capex, investor sentiment, and equity issuance. Currently, on a global level, 10 out of 18 red flags are flashing, with 11.5 on the U.S. checklist.
The checklist is not yet signaling the “overexuberance” that precipitated the 2000 and 2008 bear markets, Citi notes, but the direction of travel is worrying: “Once the count reaches double digits, it has historically tended to rise more rapidly, signaling a potential acceleration in risk.”
Before Friday, it seemed like nothing would stop this equity juggernaut. Sure, rotation within tech and across sectors has picked up in recent months and some large tech companies had registered big short-term share price declines. But the benchmark indices continued to hit new high after new high.
So why might this pullback be different?
Bubbles tend not to be burst by a single trigger, but by a range of indicators moving into more extreme territory at the same time. Yet some triggers pack more of a punch than others. The cost of money is one of them.
Bond yields are rising, and so too are policy rate expectations. A quarter-point rate hike from the Fed by December is now almost fully priced. That doesn’t sound like much, but before the Iran war, traders were expecting nearly three cuts.
Add an increasingly solid labor market to the U.S. economy’s high inflation and loose financial conditions, and the cost of money seems set to rise.
If so, history suggests economic growth is at risk. So is the runaway stock market.