Strong US AI investment masks downside

US-based investment manager, T. Rowe Price is maintaining a neutral weight in US stocks versus bonds despite elevated valuations believing that any weakening in the fundamentals will carry significant downside risk.

The company’s latest Monthly Market Playbook has acknowledged investor nervousness about US stocks having become too expensive whilst noting that the US market is heavily tilted toward the ongoing build-out of artificial intelligence (AI) where growth is booming.

“This has led to strong and improving market fundamentals,” the analysis said.

T. Rowe Price capital markets strategist, Tim Murray noted the AI spending is driving growth and valuations despite the economic outlook in the US being relatively modest.

“In addition to concerns about a sharp rise in tariffs, the interest-rate-sensitive sectors of the U.S. economy have exhibited significant weakness since the Federal Reserve hiked rates in2022. For 31 of the past 33 months, the Institute for Supply Management’s index of manufacturing conditions has been below 50, a level that indicates contraction rather than expansion,” Murray wrote.

“Such an extended period of U.S. manufacturing weakness is unheard of outside of a recession. The housing sector also has been notably weak, as mortgage rates have remained stubbornly high.”

“Capital expenditures on AI, on the other hand, have boomed, driven by four mega-cap tech companies known as the “hyperscalers”. Companies servicing the AI buildout— such as semiconductor producers and cloud computing, data centre, and networking equipment provider have enjoyed exceptional earnings growth.”

Murray writes that the booming AI sector carries a much heavier weight in the U.S. stock market than the interest-rate-sensitive sectors. This means that U.S. stock market fundamentals can be strong despite modest overall economic growth.

He concludes that US equity valuations appear expensive but are supported by strong and improving fundamentals.

“In our view, this means stock market returns can remain strong as long as the fundamentals hold up. However, if those fundamentals were to weaken, the potential downside risk would be more significant than normal,” Murray’s analysis said.