Investors are underestimating an AI-driven inflation spike that could pop the bubble in growth stocks, strategist says

• AI may fuel inflation, impacting the stock market and economy, warns MRB Partners.
• The firm notes AI infrastructure raises energy costs, contrary to expected disinflationary effects.
• Right now, investors largely anticipate AI will be a disinflationary force.

Investors have been grappling with the prospect that the AI trade could actually be bearish if the new technology puts millions of people out of work.

But AI might first pose another risk to both the economy and the stock market: higher inflation.

That's the warning MRB Partners was sounding to clients last week. Phillip Colmar, a partner in global strategy at the firm, said in a February 25 note that the AI infrastructure buildout would lead to higher consumer costs. His outlook bucks the conventional view that productivity gains will lead to lower price growth — and the view that AI could even be deflationary if it sparks higher unemployment.

"While AI brings hope for a future disinflationary tailwind (mostly for services), there is no evidence of this yet and any such outcome likely will take years to gain a head of steam," Colmar wrote. "Instead, related capex spending is leading to higher prices for electricity as well as computer and electronic products. Indeed, the AI boom is likely to be inflationary for a number of years before any meaningful disinflationary benefits are realized."

There are two other drivers behind Colmar's view of higher inflation. One is that the economic output gap as a percentage of GDP is positive, meaning the economy and labor pool are operating above their full potential.

Another is that the US trade war with most of the world continues to reverse globalization, which had acted as a disinflationary force in recent decades.

As Colmar sees it, investors have not yet realized that structurally higher inflation is here to stay. Once they do, it will likely deflate growth stocks and cryptocurrencies, two assets that are in bubble territory, he said. Rising inflation tends to weigh on stocks as it pushes up both long-duration and short-term interest rates.

"As the consensus gradually shifts (and eventually capitulates) to accept the higher inflationary backdrop, policy rates and/or bond yields should rise further and help dampen speculative tendencies in financial markets, as well as deflate many of the bubbles that were fueled by previously abundant liquidity conditions."

A few things signify that growth stocks are in a bubble, Colmar said.

For one, valuations have soared amid optimistic expectations for growth. Second, growth stocks' market cap as a percentage of the broader market's has risen while their profits as a share of overall US corporate profits have not increased to the same degree. Tech investment as a percentage of GDP has also reached dot-com era levels, and competition in the space is fierce, making firms vulnerable to disruption.

"These asset classes are now extremely inflated," Colmar said of growth stocks and cryptocurrencies in the February 24 note. "Indeed, we have profitable relative short bets on both asset classes, and recommend underweight exposure within our asset allocation."