The Bank of England has issued a stark warning that the AI-driven stock market rally may be unsustainable, echoing fears of a repeat of the dot-com crash. In its latest Financial Stability Report, the Old Lady of Threadneedle Street highlighted that valuations in the tech sector, particularly among firms specialising in artificial intelligence, have reached levels that 'stretch credulity'.
For those of us who remember the late 1990s, the parallels are uncomfortable. Back then, it was pets.com; now it's companies with 'AI' in their name seeing their share prices triple on little more than a press release. The Bank's analysis shows that the price-to-earnings ratios of many AI stocks are in the stratosphere, far above historical averages. When you strip away the hype, you're left with firms that have promising technology but scant revenues and even thinner profits.
The warning comes as gilt yields remain elevated, with the 10-year yield hovering around 4.5%. Higher yields are a headwind for growth stocks, as they discount future cash flows more heavily. Yet the market seems to be ignoring this basic arithmetic. Investors appear to be betting that AI will deliver productivity gains so vast that they will justify any valuation. That may be true in the long run, but as Keynes quipped, in the long run we are all dead.
Capital flight is another worry. Global investors have poured billions into US tech stocks, creating a lopsided market. If the bubble bursts, the fallout will not be contained to Silicon Valley. London's own tech-listed names will suffer, and the ripple effects could hit pension funds exposed to these assets. The Bank's warning is a reminder that market efficiency is a myth when herd behaviour takes over.
Fiscal responsibility is also at stake. The government has been keen to tout the UK as a hub for AI, offering tax breaks and subsidies. But if valuations correct sharply, the fiscal arithmetic will look uglier. Lower corporate tax receipts and potential bailouts would add to the national debt burden. The Chancellor should be wary of backing a sector that may be in the grips of manic exuberance.
Central bank policy is caught in a bind. The Bank of England cannot prick the bubble directly without risking a crash. Raising rates further would choke off the froth but could also tip the economy into recession. Instead, the Bank is using its bully pulpit to warn investors. Will they listen? History suggests not until the pain is real.
The question for readers is whether this is a bubble ready to burst. My view is that the AI sector is real and transformative, but the current pricing assumes perfection. When interest rates stay higher for longer, as they likely will, the discount factor will bite. The bubble may not burst tomorrow, but the air is getting thin. Prudent investors should take profits and look for value elsewhere. The bottom line: when the Bank of England waves a red flag, it pays to pay attention.
