Since we identified AI and modern mercantilism as the key forces defining the new paradigm, they have accelerated and now increasingly dominate the global economy and markets.
In our recent quarterly letter to clients, we discussed (1) how the current economic cycle is evolving, shaped by these forces, and (2) the questions they are prompting us to wrestle with in portfolios. Below, we’re sharing some condensed highlights from that letter, as well an excerpt from our Q2 CIO call where Karen lays out where we stand today in the new paradigm and describes what investors can do to navigate this environment.
Bob, Greg, and Karen
Co-Chief Investment Officers, Bridgewater Associates
1. The Shape of Today’s Expansion
The historic AI capex boom is driving roughly a quarter of global growth. Continued improvements in model capabilities have kick-started an adoption cycle and highlighted the existential need to invest in AI; demand for inference compute is growing rapidly, outstripping even the rapid growth in supply, creating a very tight market for compute. Over the quarter, markets caught up to price in the exponential growth in capex to meet this deficit—raising the hurdle for outperformance.
Modern mercantilism has also alerted everyone that their choke points can and will be weaponized. So far, the level of spending to build domestic resilience and defense is still low in many countries, but the weaponization of choke points has led to shortages and inflationary pressures, most recently with the closure of the Strait of Hormuz. And while the outcome of the Iran conflict is uncertain, the strait looks likely to remain a choke point. The lesson established over successive geopolitical shocks in the post-COVID period is the strategic benefit of building domestic resilience across supply chains—exerting sustained pressure for modern mercantilist spending to keep ramping up.
The expansion created by these forces is structurally different than what came before. They are combining to create a regime of higher-than-target nominal GDP growth, propelled by massive capex investment where businesses and fiscal and industrial policy spend to deliver self-reliance and technological innovation.
The chart below puts the current paradigm of high nominal GDP growth and its drivers in the context of what came before it.
The outcome is a durable but uneven expansion, with different risks than prior cycles:
- Many of the drivers that tend to put expansions at risk—a tightening of interest rates, a moderate drawdown in equities, or a hiccup in consumer demand—are unlikely to disrupt companies’ and governments’ desire to spend on AI and resiliency. But concentration in AI comes with other vulnerabilities, including sensitivity to disappointment on scientific progress or government AI regulation. The expansion relies on the willingness to finance the AI build-out, which now requires substantial capital.
- Concentrated spending is creating an uneven “K-shaped” economy, fueling potentially destabilizing political pressure. A structurally uneven economy doesn’t lend itself to easy solutions, making radical policies that cause market disruption more likely.
- Government engagement with AI is crucial to allowing the technology to safely advance but also creates more uncertainty for investors. Regulation has an important role to play in reducing the probability of harmful outcomes (which would in turn slow adoption and progress)—but could also destabilize the AI capex cycle by reducing the return on capital or simply raising the uncertainty investors face when investing over longer horizons.
2. The Questions Shaping Every Portfolio in This Environment
Given the shape of the expansion, there are three key questions we are actively wrestling with as we believe they will shape any portfolio’s outcomes:
- AI exposure, including both sizing exposure to the AI capex boom (which is at least partly priced in) and exposure to disruption from AI adoption (mostly not priced in). With AI being such a dominant and important driver of growth in this cycle, any portfolio’s outcomes will be shaped by its exposure to AI. To have exposure to the beneficiaries of growth requires sufficient exposure to AI capex beneficiaries, though the potential upside in these has been reduced relative to a few months ago as the large boom in AI capex underway has become more priced in. Equally critical is assessing and managing a portfolio’s exposure to companies vulnerable to AI disruption, as the most damaging outcomes to investors are not priced in.
- Real assets exposure in an environment where AI and modern mercantilist spending are squeezing physical and digital world constrained resources. Surprise inflationary supply shocks are always wise to prepare for, and in this environment, they are more likely to become the norm than an outlier. Exposure to real assets, particularly those likely to get squeezed by the build-out of AI and national resilience, will similarly shape portfolios.
- Geographic exposure given modern mercantilism calls for reduced reliance on the US, but AI progress remains highly concentrated in the US. As the role of the US in the world is evolving, geographic exposure is bound to shape portfolio outcomes as well. Modern mercantilism continues to push capital from outward investment into the US to deployment across increasingly independent economic systems. At the same time, the “AI economy” is primarily a dollar system; the US is the center of the build-out, its external balance is supported by foreign AI profits saved in dollars, and the US offers the deepest markets for investors seeking AI exposure. China plays a special role given that it’s the world’s second-largest economy, continues to grow market share, and has a meaningful indigenous AI effort.
Because these questions will shape portfolio outcomes, we believe it is important to (1) define and measure a portfolio’s exposure to each and (2) create and utilize levers to actively manage these exposures as conditions shift.
Watch an excerpt from our Q2 CIO call below.
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