The risk arising from geopolitical tensions and a fragmented global trade have increased the risk of a sharp market correction, particularly for technology companies focused on Artificial Intelligence (AI), according to a note by the Bank of England's Financial Policy Committee, shared on October 8.
"The uncertainty around the global risk environment increases the risk that markets have not fully priced in possible adverse outcomes, and a sudden correction could occur should any of these risks crystallise," said Bank of England.
Tech Valuations a Risk
The note mentioned that tech stocks are trading at steep valuations and global equities are at a risk of increased concentration, and "crystallization" of such global risks could materially impact the UK economy.
"On a number of measures, equity market valuations appear stretched, particularly for technology companies focused on Artificial Intelligence (AI). This, when combined with increasing concentration within market indices, leaves equity markets particularly exposed should expectations around the impact of AI become less optimistic," said the Bank of England.
In BoE's view, the stock valuations in the US are similar to the levels seen around the peak of the dotcom bubble on some parameters, with US bonds vulnerable to a weakening of the Fed's credibility.
"Forward-looking valuation metrics and compression in US equity risk premia also remained elevated relative to historical levels, with the S&P 500 at a one-year forward price-to-earnings ratio of 25 times, but remained below the levels reached during the dot com bubble," the BoE said.
The BoE FPC added that the global equity market valuations have risen to near all-time highs, partly due to US tech earnings, leading to increased concentration within US equities to record levels. "The market share of the top 5 members of the S&P 500, at close to 30%, was higher than at any point in the past 50 years," the record of the Financial Policy Committee meeting said.
Concentration Risk in Equities
This high concentration has resulted in some technology companies trading at valuations that imply high future earnings growth, thus at risk of a AI-led price 'adjustment'.
"...concentrations within US equity indices meant that any AI-led price adjustment would have a high level of pass-through into the returns for investors exposed to the aggregate index," the BoE said.
Goldman Sachs View
According to Equity Strategist Peter Oppenheimer, the high concentration of tech companies in US stock market certainly makes a case for diversification, even as he set aside fears of a bubble building up. He called the US stock market "unusually concentrated" towards a handful of large technology companies, though he attributed it to the "success of a few large companies that manage to dominate specific sectors". "Even so, higher concentration may be a risk for investors," Oppenheimer added.
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