Technology and Communication Would new US AI chip restrictions upend the rally?

The Wall Street Journal on Tuesday reported the Biden administration is considering closing loopholes and taking new action to deepen export controls on advanced AI chip exports to China and elsewhere. More stringent restrictions could be enacted as soon as July on national security grounds, according to the WSJ, with options under consideration including export controls on Nvidia’s popular A800 AI chips and restrictions on cloud service contracts for Chinese AI companies.

This report comes amid a backdrop of strong outperformance for AI beneficiaries in 2023. The NYSE FANG+ index, which tracks the top 10 US stocks, has surged 66% year-to-date, in part on optimism about AI adoption. Generative AI technologies are going mainstream for both consumers and enterprises, with a long list of convincing use cases emerging across multiple major industries.

While the prospect of more stringent controls is not a surprise, we take the headlines as a reminder that there are downside risks for AI stocks too, and that a more balanced view on the sector may serve investors going forward:

AI may not be in a bubble, but a lot of positivity is priced in. Fast adoption, clear use cases, and significant investments suggest the shift to AI will be enduring. We expect the market for AI hardware and services to grow at a 20% CAGR to reach at least USD 90bn by 2025. At the same time, AI-related stocks are trading at around 30–40x price-to earnings, significantly above the broader tech average of 25x. While we agree that AI-related stocks deserve a premium versus the broader market, we believe select stocks have run ahead of fundamentals and are at risk of correction. We would not be surprised to see a 10–15% reset lower in AI-related stocks in the near term.

US-China is just one regulatory headwind. The report, while unconfirmed, underscores geopolitical and regulatory risks to AI beneficiaries. US President Joe Biden last week said he would seek to address AI risk to society, the economy, and national security. China, the UK, Europe, and other major economies have indicated they are crafting their own rules, underlining the unusually early stage at which global policymakers are seeking to regulate the technology and its impact on security, ethics, and employment.

Supply bottlenecks and increased competition are other risks. It’s too early to quantify the impact of a more stringent AI chip ban on data center chip revenue or demand. However, we think any gap this creates will quickly be filled by demand from customers in the US and other aligned economies. If anything, tight supply of both chips and top tier AI talent pose near-term risks to AI adoption, which may weigh on revenues. In parallel, the hype cycle for AI has seen many startups pivot to the category, and there are at least 10 generative AI-related unicorns. Intensifying competition, including from incumbents in subscription services, could cap AI margins.

So, with details on new US restrictions still uncertain, we think investors should expect elevated near-term volatility for AI-related stocks. Alongside geopolitics, rising consolidation risks support a more selective stance on the sector, in our view. Should we see a mid-teen percentage correction for the sector, we think investors would have a more compelling opportunity to revisit key AI beneficiaries. Within tech, we see bottom-up opportunities in select laggards, defensive names within software and internet, and in structured strategies that allow participation alongside capital preservation features. Those seeking equity exposure should also consider laggards beyond tech—such as emerging market equities over US, value over growth, equal-weighted US indexes over market-cap-weighted benchmarks, and consumer staples and industrials over technology.

Main contributors - Solita Marcelli, Mark Haefele, Jon Gordon, Sundeep Gantori, Delwin Kurnia Limas

Content is a product of the Chief Investment Office (CIO).

Original report - Would new US AI chip restrictions upend the rally?, 28 June 2023.