Potential Paths Ahead

Assessing the macro implications of AI is exceptionally challenging, given the theme’s many moving parts and uncertain destination. What we know for certain is that AI has the potential to shift the macro regime because it reshapes the outlook for fundamental concepts typically assumed to be fixed, such as productivity, the capital-labor ratio, saving behavior, and government tax policies. These are all core, long-term determinants of asset valuations.

A capex-led boom that successfully raises productivity should be good for equities, credit, and commodities over both the near and medium term.

Potential Investment Implications
Both the journey and destination could be very positive for the cycle. A capex-led⁴ boom that successfully raises productivity should be good for equities, credit, and commodities over both the near and medium term. It would also imply higher real yields and a steeper curve.⁵

Potential Investment Implications
In the near term, we think a capex-led boom should be good for the cycle as well as equities, the credit market, and commodities, with rates becoming increasingly accommodative. Over the medium term, however, risk assets could become more vulnerable to sudden repricing and, if a recession were to materialize, may suffer across the board, while rates could fall significantly, particularly in the event of deflation.

Scenario 3: A Messy Transition
A messy transition marked by a high level of uncertainty is another plausible scenario. Markets currently seem inclined to favor this scenario as concerns grow about how AI could upend many business models—and even entire sectors—that were previously viewed as relatively insulated. If this uncertainty persists, it could undermine assumptions about the viability of businesses and jobs and significantly reduce visibility about future cash flows, returns, and even corporate lifespans.

In this type of environment, companies may freeze most new activity, with the possible exception of AI-related investment. The speed of associated job displacement could also outpace the ability of workers and organizations to adapt, pushing the unemployment rate higher. In such an environment, precautionary savings may rise faster than net investment, driving real yields lower. Ironically, this would feel more like a risk-off environment, even if the underlying shock ultimately raises productivity.

Markets currently seem inclined to anticipate a messy transition, as concerns grow about how AI could upend many business models.

Given the starting point of relative healthy corporate and household balance sheets, at least in aggregate, this path would most likely entail a shallow recession followed by a rebound that would resemble a boom.

Potential Investment Implications
In the near to medium term, likely margin compression, reduced demand, weaker profit visibility, and tighter credit conditions would be detrimental for risk assets, while real rates move lower on the back of higher savings. In addition, markets may focus more on the downsides for incumbents than on the opportunities created by new entrants, potentially driving heightened volatility and dispersion. Investors may also worry about the fiscal implications, meaning that highly indebted countries could face increased risk premia.⁶ Over the longer term, however, risk assets should benefit from productivity gains, with yields and rates ultimately moving higher.

Countervailing Forces

The AI revolution is not happening in isolation. Several other important forces should be considered in any macro framework, notably:

1. Demographics and deglobalization are rapidly lowering productivity and supply potential. It remains unclear whether the benefits of AI will accrue sufficiently quickly to offset their negative impact.
2. Income inequality and the concentration of wealth are already major political issues in many countries. If AI technology exacerbates these trends, there could be a policy response in the form of taxing the gains and raising general income thresholds, which would offset some of the productivity gains.
    

Which Indicators to Watch?

Markets may oscillate between the three paths outlined above, making it difficult to determine the ultimate direction. With macro data often viewed as less reliable by policymakers during periods of transition, signals may instead be found primarily in equity and credit markets.

Specifically, we are monitoring:

• The relative performance of AI infrastructure vs. AI application stocks, to help assess whether value is moving up the chain or is being compressed more broadly. Rising AI infrastructure valuations would point to a capital-deepening cycle. Conversely, a collapse in the valuations of AI application stocks would be a highly defensive signal.
• High-yield credit spreads⁷ to gauge whether the real economy is under stress.
• The performance of cyclicals⁸ relative to defensives⁹ to evaluate whether the market believes growth and capital spending will broaden across the real economy.
• Earnings revisions to assess whether AI is boosting profits and cash-flow expectations.
• Real yields as an indicator of whether the market believes AI will raise overall productivity or compress margins and be negative for the cycle. On balance, we think real yields will take their lead from the indicators above: yields are unlikely to rise if those signals are moving in the opposite direction.

As we transition to a new macro regime, investors may face a period of near-permanent uncertainty.

Bringing It All Together

Ultimately, we think that AI will be positive for the economy. But, as we transition to a new macro regime, investors may face a period of near-permanent uncertainty on the eventual direction that the economy will follow. In particular, we have identified three potential paths with very different investment implications. Rather than making a definitive call on the end point of that journey, we believe it’s more effective to track market indicators. These provide a clearer read on which macro regime the economy is heading toward and what that may mean for rates and risk assets.

Talk to your financial professional for insights on AI’s potential risks and rewards.

¹ Interest rates can be expressed in nominal and real terms. The nominal interest rate is the stated rate on a loan or investment, while the real interest rate adjusts for inflation to show the true cost of borrowing or the real return on savings.

² The yield curve is a line that plots interest rates of bonds having equal credit quality but differing maturity dates; its slope is used to forecast the state of the economy and interest-rate changes.

³ Risk assets refers to assets that have a significant degree of price volatility, such as equities, commodities, high-yield bonds, real estate, and currencies.

⁴ Capex refers to capital expenditures.

⁵ A steepening yield curve suggests stronger economic activity and rising inflation expectations, with long-term bond yields increasing faster than short-term ones.

⁶ Risk premia is the investment return an asset is expected to yield in excess of the risk-free rate of return.

⁷ In bond trading, a credit spread is the difference between the yields of two bonds that mature at the same time but are rated at different credit qualities.

⁸ Cyclical stocks rise and fall in sync with the economic cycle (e.g., car manufacturers and airlines). These companies often see increased sales as consumers spend more on discretionary items during economic expansion. Their stock prices can fall as spending contracts during recessions.

⁹ Defensive stocks offer stable earnings and consistent dividends, making them less risky and attractive during economic downturns. Typical examples of defensive stocks include companies in utilities, consumer staples, and healthcare sectors, which are less reliant on the economic cycle.

Important Risks: Investing involves risk, including the possible loss of principal. • Fixed income security risks include credit, liquidity, call, duration, event and interest-rate risk. As interest rates rise, bond prices generally fall. • Investments in high-yield (“junk”) bonds are considered speculative, involve heightened credit risk and greater risk of price volatility, illiquidity, and default than investment grade bonds. Investments linked to prices of commodities may be considered speculative. Certain investing styles may go in and out of favor, which may cause underperformance to other investing styles.

The views expressed here are those of Wellington Management, are for informational purposes only, and are subject to change based on prevailing market, economic, and other conditions. The views expressed may not reflect the opinions of Hartford Funds or any other sub-adviser to our funds. They should not be construed as research or investment advice nor should they be considered an offer or solicitation to buy or sell any security.