• If AI catapults the US economy into a high-growth environment, the source of corporate profitability may broaden to sectors other than tech including health care, finance and manufacturing.
  
  
• Alternatively, if the impact of AI is slower than we project, a strategy that tilts towards fixed income and value stocks could be sensible.
  
  
• Investors should be well positioned for either scenario if they own a broadly diversified index fund. For investors willing to take some active risk, choosing the right active manager is critical.

Investor excitement about artificial intelligence (AI) has fuelled strong gains in US technology stocks over the last few years, although more recently the tech sector has experienced market volatility. While tech stocks including the so-called Magnificent Seven—Apple, Microsoft, Meta, Amazon, Alphabet, Nvidia and Tesla—have been the dominant force in the US equity market in recent years, we believe that a diversified strategy of investments across the entire US equity market has a greater potential to capture economic growth and productivity gains in the years ahead.

On this basis, our research suggests that investors should avoid overweighting tech stocks in their portfolios. Firstly, we would point to how tech stocks in general are very highly valued currently - much of that potential upside is already priced in. Secondly, the tech sector, as a whole, does not tend to outperform during these periods of technological transformation. We would expect some future stars to emerge, but there will be a larger percentage of those in the sector that flop too. For every Amazon that emerged from the internet bubble, there were dozens of start-ups that failed.

Furthermore, if our thesis on AI is correct, and AI is a transformative technology with positive economic outcomes, we would expect to see AI’s influence emerge more broadly, in sectors outside of tech—health care, finance, manufacturing, for example—driving increases in economic growth and productivity across the economy. Of course, electricity was once a transformational technology, and it influenced sectors of our economy well beyond energy itself. For that reason, we would suggest that if investors believe that AI can create investment opportunities across a number of different sectors then one way to access these opportunities would be to increase equity exposure, not to overweight the tech sector specifically.

What if the impact of AI is minimal?

Our megatrends research suggests that it’s unlikely that AI will only have a minimal impact on the broader economy. If that were to be the case, then your clients might think about reducing their exposure to equities and increasing their strategic allocations to fixed income.

In terms of equities, value stocks are likely to outperform growth stocks in this environment because growth firms would be facing a major headwind (a secularly low-growth environment). Historically, growth stocks that can’t grow earnings (for whatever reason) generally end up with a significantly lower equity market valuation. Value stocks, on the other hand, may come into favour (after a very long period of underperformance) and outperform the broader equity market.

What should investors focus on in the future?

Looking ahead, we believe that investors should pay less attention to headline-grabbing statements around concentration in just a handful stocks, such as the Magnificent 7, or a particular sector, like tech. When it comes to the stock market, two seemingly contradictory statements can both be true.

On the one hand, large-cap (generally growth) stocks have a lot of staying power and therefore levels of market concentration could remain for longer than some might think. On the other hand, these companies generally do not hold on to their position in the market or their growth trajectory for more than a few decades. This is clear from looking at a list of the largest S&P 500 index members from a few decades ago compared with today. Similarly, where were most of the Magnificent 7 stocks just 20 years ago?

How do investors navigate this landscape? A simple but effective way is to own the total stock market, with a broadly diversified index fund. Another way is for investors with active risk tolerance to choose an active manager who they believe will add value over the long term.
 

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