How Wall Street's all-in bet on AI blew up
Wall Street's surge to record highs this year in the face of war in the Middle East and spiralling borrowing costs has been powered by a single investment idea — a relentless boost to stocks from the AI boom.
After weeks of warning signals from credit markets, that dominant market narrative spectacularly combusted on Thursday in a $3.2tn rout sparked by the political fallout from the US midterm elections.
The sell-off was fuelled, investors say, by a brutal unwind of leveraged tech positions that had built up among hedge funds — with some hacking back their exposure at the fastest rate since Covid-19 — and an exodus of retail investors.
"It's like a chemical reaction," said one senior equities banker. "You have one, two, three elements, and then there's an explosion. The election was the explosive element."
The tech-heavy Nasdaq 100 fell more than 6 per cent on Thursday in one of the worst days on record for chip stocks, before rising 1.4 per cent on Friday to finish 4.9 per cent lower for the week.
The tech bloodbath stunned investors. Stocks had initially trended higher on Wednesday following Democrats' congressional "blue sweep", as investors took off their pre-election hedges after an indisputable outcome and bought back into stocks. That optimism was fed by a sharp drop in oil prices as hopes grew over an end to the Iran war.
"While risks surrounding both Iran and AI financing are likely to remain with us, we think that investors have de-risked sufficiently and equities can move higher," said Citi in a note on Wednesday, typifying the mood.
But the calm was shattered on Thursday as oil prices rebounded and the market fixated on the prospect that newly elected Democrats would slow down the pace of infrastructure development that is crucial to the $1tn of AI investment some expect next year.
"The midterms ended the assumption of a blank cheque for AI," said Ludovic Subran, chief investment officer of Germany's Allianz. "The market just discovered that 'the sky is the limit' is not a valuation methodology."
A tech-heavy stock market had this year enjoyed a double effect of the AI boom on share prices; it had lifted corporate earnings for the picks-and-shovels companies linked to the technology, such as chipmakers, and also provided significant support to the outlook for economic growth.
Now investors are faced with the risk that these twin forces go into reverse, and markets have to price in a hit to US economic growth just as delays and regulation crimp the earnings outlook for companies directly involved in AI infrastructure.
"The AI trade has been devalued," said Nikhil Srinivasan, chief investment officer of a newly launched macro fund at Singapore-based Benzaiten Macro and formerly CIO of institutions including Italy's Generali.
Stocks "discount the future and the future beyond the next few years is now a question mark", he added. He expects more modest US growth next year on slower AI investment and the knock-on effect for consumption.
The election of Democratic governors expected to curb data centre construction in states such as Texas, as well as the greater prospect of a broader AI backlash from a Democratic-controlled Congress, was enough to unsettle a market that had become increasingly worried about the effect of higher borrowing costs on the relentless spending by so-called hyperscalers funding the AI build-out.
The recent third-quarter earnings season had created volatility as Big Tech detailed vast investment plans but also soft revenues in their core business. And a slide in the debt prices of riskier borrowers linked to the AI boom such as so-called neoclouds fed fears of a credit reckoning.
Now fund managers are worried that the data centre build-out already baked into the stock market's fast-growing earnings estimates is in question. "The big thing we are worrying about is executing on all of this [capital expenditure] is going to be trickier with . . . more delays and all of these constraints," said Stephen Jones, chief investment officer at Aegon Asset Management.
Bank traders said one of the sparks for Thursday's sell-off came from retail investors, who had proved trusty dip buyers in previous bouts of volatility. Data from investor flow specialists Vanda Research shows $388mn in net outflows from single stocks by retail investors in the first two hours of trading on Thursday, briefly putting it on track to be the biggest day of retail single-stock selling since the Covid-19 pandemic, before investors bought some equities back in the final two hours of the day.
As stocks fell, hedge funds were forced to "degross", or close out leveraged positions to reduce their risks, amplifying the sell-off, investors said.
"Fear [was] ruling. It's classic human psychology," said one senior equities trader at a large bank. "People need to raise cash because they've lost on the AI trade."
In the turmoil, hedge fund Walleye announced it was shutting part of its equities business and returning some capital.
JPMorgan told clients Thursday was the biggest single-day loss for hedge funds since the aftermath of Donald Trump's "liberation day" tariffs last year, with its hedge fund clients being down 1.6 per cent. It added that the reduction of borrowing by hedge funds as they exited positions was the fiercest over a 20-day period since the Covid sell-off.
As tech stocks regained ground on Friday, some investors said the political risks were overblown and that it would take a significant dent in earnings or in the economic outlook for the market bearishness to last.
"This was a vote on data centres. It was not an indictment of AI," said Joe Zidle, chief market strategist at wealth group Cresset, Constraints to development will be a medium- to long-term problem given "there's a lot of construction that's already under way and it's unlikely that gets halted", he argued.
Jitania Kandhari, deputy CIO of solutions and multi-asset at Morgan Stanley Investment Management, said "the scale of the moves looks much larger than the fundamental impact . . . whether it means slowing down on hyperscaler capex or even some of the funding concerns".
The resilience of the US economy was then underlined by data on Friday showing it had added 165,000 jobs in October, well exceeding Wall Street expectations.
But looking further out, others said this week's turmoil was a sign that Wall Street's AI boom has peaked.
"I think the market is going down from here," said Benzaiten Macro's Srinivasan. "It can rally this week, next week . . . but the market is going down further."
Data visualisation by Ray Douglas
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