Short-Term Challenges, Long-Term Tailwinds: Global AI Race Wars, the New Frontier

Market Insight by Belal Mohammed Khan
Published on 6^th July 2023

Summary:

• Our previous month’s Insights document, “Peak Time,” emphasized the improved risk environment and outlook. We asserted that inflation had peaked and, as a result, policy rates were at or near their highest point. Additionally, we predicted a decline in geopolitical fragmentation and a shift toward pragmatism. Thus, we stated that pessimism and uncertainty had also reached their zenith.

• In our July View, titled “Short-term Challenges, Long-Term Tailwinds: Global AI Race Wars, the New Frontier,” we further build upon our positive outlook from June. We highlight significant strides China and the U.S. made towards adopting more pragmatic geoeconomic strategies.

• Geostrategic pragmatism is profoundly more constructive than geostrategic policies that further geopolitical fragmentation. The move to pragmatism and the potential of, and race to Generative A.I. places the planet on the verge of a new secular growth phase.

• Putting all the pieces together, ‘Peak Time,’ geopolitical pragmatism and a global Generative A.I. race create a positive base case scenario.

Portfolio Implications – Short-term challenges exist, while simultaneously strong long-term tailwinds, especially from the generative AI race wars are picking up speed.  Positioning the portfolio requires a barbell approach across fixed income and equities.  As such, we continue to selectively take risks across asset classes, regions, and sectors while holding on to a small overweight in cash and gold for diversification. Please see our tactical asset class positioning section below for the details of our strategy across fixed income, equities, alternatives, and currencies.

Short-Term Challenges, Long-Term Tailwinds: AI Race Wars, the New Frontier

Our asset allocation strategy extends beyond near-term concerns of slower growth. While we acknowledge the presence of significant headwinds for risk assets, it’s important to note that these challenges are primarily cyclical, short term and not evenly distributed across regions, assets, or sectors. As we enter ‘Peak Time’ (GMG Monthly Insights, June 2023), we anticipate a gradual dissipation of some of these adverse factors, allowing for a clearer emergence of several favorable secular tailwinds.

One such encouraging secular trend is the global shift towards pragmatic geostrategic and geoeconomic positioning.  Our previous month’s analysis emphasized the need for major powers to adopt a more pragmatic approach and de-risk. Today, concrete evidence supports this view, exemplified by the China-US senior-level meetings held on June 19-20. These meetings signify a breakthrough moment, a historical development, and a significant milestone, irrespective of the specific outcomes. The symbolism behind these discussions is potent, suggesting a willingness to communicate and prevent further deterioration in relations between these influential superpowers. This thaw in relations brings about a positive change in the outlook for uncertainty. We expect this to trigger a more pragmatic policy posture, globally. This we believe will is positive for global markets. But this is not the only secular tailwind.

“The two countries should act with a sense of responsibility for history, for the people, and for the world, and handle China-US relations properly.” 
President Xi Jinping, June 20, 2023

The other phenomenal development has been the breadth and speed of adoption of Generative-AI. Indeed, the transformative power of generative A.I., which, according to studies, has the potential to unlock trillions of dollars¹ in economic activity in the years ahead, is still not well or fully understood. However, many investors are wasting no time and are eagerly trying to put cash to work in this space, not only across the big tech firms directly or indirectly involved, but also allocating to opportunities across the entire production and use case possibilities in, what Elon Musk said, “is probably the most disruptive technology ever.”

As Jensen Huang, CEO of NVIDIA, said, this is indeed a “monumental moment”².  Generative AI is unlike anything our generation, or any other generation has experienced. It has unleashed a race for AI resources ranging from human to hardware, and software. Regarding its rate of adoption, take the example of Twitter which took nearly two years to reach one million subscribers, while ChatGPT got to one million subscribers in only five days! (see chart below)³. The expected economic impact of this technology is predicted to be massive. Taking the example of Facebook’s impact on the economy, Facebook’s expenditures on U.S. data center construction and operation contributed $ 5.8 billion to U.S. GDP and 60,100 jobs from 2010-2016. This equates to $835 million in U.S. GDP annually and 8,600 jobs per year³. Generative A.I., we expect, will far outstrip anything yet witnessed in its contribution to economic activity. Goldman Sachs Research states that as tools using advances in natural language processing work their way into businesses and society, they could drive a 7% (or almost $7 trillion) increase in global GDP and lift productivity growth by 1.5 percentage points over ten years.

“For a lot of people in the industry who have been working on this, we have been waiting for this moment… this is the iPhone moment of artificial intelligence.”
Jensen Huang, CEO NVIDIA, February 1, 2023

Unprecedented adoption speed, and it’s only the beginning
While there are headwinds to the global economy, there are, as mentioned, several extraordinary tailwinds, including the real possibility of widespread and swift enterprise adoption of Generative A.I. The anticipation, hope, and optimism over the benefits of this technology should far outweigh shorter-term concerns about the economic cycle and monetary policy direction. All this taking place in a more productive environment of geopolitical pragmatism.

Risk and Investment Strategy 

Regarding risks, indeed, there are many; however, our organization believes that the concerns surrounding these risks have been overdone, and we believe we have reached a point of peak pessimism (see our June view, ‘Peak Time’). As a result, we maintain a positive outlook. This optimism is fueled by the now more constructive dialogue between China and the U.S., as well as the rapid advancements in generative A.I. We expect these developments to trigger a historic transformation and increase productivity, thus contributing positively to global growth. Nevertheless, given the significant year-to-date, June end, moves in major markets (MSCI ACWI +13.04%, MSCI Europe +9.21%, NASDAQ 100 + 38.75%, S&P500 +15.91%),  we acknowledge the need to temper our positive view and adopt a highly selective investment strategy.

Investment Strategy: Positioning is “risk-on”, selectively, across regions, asset classes, sectors and style.

• Cash /Liquidity – We hold a small overweight in higher yielding major currencies, i.e., USD or GBP.  While yields are attractive, especially from a risk adjusted perspective, when taking into consideration opportunity cost, when holding a constructive macro view perspective, cash is clearly no longer “king”. Cash is king only when the opportunity cost is low. Given our constructive macro and market outlook, for the past three months we have been reducing our cash overweight.
• Fixed Income – We currently maintain a cautious and underweight position, considering the anticipated increasing impact of the higher interest rate environment on investment-grade and high-yield markets in developed economies. However, as we foresee a more favorable monetary policy environment in the long run, we anticipate shifting our stance on core government bonds from underweight to overweight.
• In equities – We hold an overweight with a preference for large, quality companies exhibiting a growth factor bias, and our sector allocation has a mild cyclical sector tilt. Our overweight sectors include Industrials, Materials, and Technology and our key underweights include Consumer Discretionary and Healthcare.
• For commodities, as our base case calls for a gradually improving growth outlook in the longer term, we hold a commodity overweight. On gold, we took partial profits on our large overweight three months ago and now have a small overweight for diversification benefits.
• For absolute return funds, the complex macro and market environment is ideal for select hedge fund strategies such as relative value and CTA/Systemic where we hold an overweight.
• On major currencies, we expect the USD to remain robust, benefiting from relatively high real rates and relative certainty.Please reach out for our full tactical asset allocation details across all asset classes.

Source: Data Chatham Financial 1. Dean’s Speaker Series | Jensen Huang Founder, President & CEO, NVIDIA 2. The economic potential of generative A.I.: The next productivity frontier, June 2023, McKinsey 3. Goldman Sachs Research report 4. RTI.Org

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