AI: which economies are set to benefit the most

20 February 2024
AI impact

Introduction

It’s not just tech firms that will harness AI to improve their bottom line. In fact, it’s not just firms at all. Entire economies are poised to benefit, albeit not all to the same extent. This blog post provides a deeper look at the latest report from research group Capital Economics, which reveals how AI will likely impact stocks and bonds, across different economies.

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How economies grow

Broadly speaking, economies have two ways to get bigger: increase the workforce, or improve its productivity (that is, the output per hour worked). The latter is where AI can help: improving productivity to spur economic growth. But productivity gains from AI are by no means guaranteed: they’ll depend on whether countries have the right factors in place: developing waves of complementary advancements (innovation), spreading the tech across industries (diffusion), and making changes that allow displaced workers and capital to be redeployed (adaptation).

The researchers at Capital Economics used 40 indicators to score 33 countries based on these three factors, and then combined those into a composite score to rank the countries.

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Capital Economics’ draw 6 main conclusions:

  1. The US will lead the AI revolution, with the “Asian Tigers” (Hong Kong, Singapore, Taiwan, and South Korea), the UK, and parts of the Nordics also well-placed to benefit. The US tops the chart and is expected to hold court as the global tech leader, as it has for much of the past 100 years. Capital Economics forecasts that productivity growth in the US will average 2.3% a year in the 2030s – slightly stronger than during the 1990s internet boom.
  2. China ranks around the middle of the group of 33 countries, with its strong innovation capacity and large investment in AI offset by a strict regulatory approach which is likely to slow the spread of AI technology. AI is therefore likely to help the US economy extend its size advantage over China – a gap that’s already been widening.
  3. AI is likely to hamper growth in India in the near term, partly because it will slow the growth of business outsourcing from developed countries. This whittling away of business process outsourcing could reduce India’s economic growth by 0.3 to 0.4 percentage points a year over the next decade.
  4. Emerging markets – particularly outside Asia – are expected to benefit less from AI compared to developed economies. That comes down to, as Capital Economics puts it, “limited dynamism” in the private sector, small and less-advanced tech sectors, relatively low investment in research and development, and the migration of top talent to wealthier places. It means these countries will likely fall behind across all three points and as a result, average incomes in these countries will likely take even longer to catch up with those in richer countries.
  5. AI will also have big impacts within economies, the report predicts has it as the potential to increase wealth inequality. That’s because the financial rewards of AI will go more to business owners and investors than anyone else.
  6. AI likely won’t lead to permanently higher unemployment, the report says. As in previous eras of tech advancement, displaced workers will likely be employed in new occupations that emerge either directly from AI or as a result of the stronger economic growth it produces. To put skepticism to rest, a recent MIT report estimates that 60% of workers in the US are now employed in occupations that did not exist in 1940.
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So what’s the investment opportunity here?

Let’s break this down into two big asset classes: bonds and stocks.

Bonds

Higher economic growth tends to stir up increased borrowing and spending, as businesses invest more in growth and consumers spend more on stuff. The heightened demand for funds pushes up the equilibrium interest rate (the rate at which the amount of money supplied in the economy equals the amount of money demanded). Records from the Bank of England show that “real” (that is, adjusted for inflation) long-term interest rates typically climbed after major technological breakthroughs, as the advantages of the innovations gradually spread through the economy.

Naturally, countries poised to gain more from AI are likely to experience a bigger increase in interest rates and, as a result, higher bond yields. In the US, for example, Capital Economics forecasts that the 10-year Treasury yield will rise from an average of 2.4% in the 2010s to above 4% in the 2030s. This rise in yields means that bond prices will initially decrease, since the two move in inverse directions. However, as yields stabilize at those elevated levels, investors will be able to reap the rewards of those higher bond returns.

Stocks

Those higher bond yields would typically put downward pressure on stock valuations. However, that’s expected to be more than offset by faster growth in corporate earnings, fueled by the economic pick-me-up that comes from higher productivity. Those gains will filter across many industries, because of all the ways AI can be used. So that’s good news for stocks: it means faster earnings growth, which should lead to higher returns. And stocks from the economies that are expected to benefit most from AI will see the biggest boost.

For a slightly closer look at that, consider the following analysis by Goldman Sachs. Its economists estimate that generative AI could lift US productivity growth by roughly 1.5 percentage points per year over the next ten years. And based on the historical relationship between productivity growth and corporate profitability, this boost could lift S&P 500 profit margins by roughly four percentage points over the next decade, all else being equal.

That would take S&P 500 profit margins from around 12% today to 16% in a decade – an increase of a third. On an annualized basis, that would represent a 3% boost to earnings growth, which alone could push up stock market returns by a similar amount. Further bolstering this positive outlook, the US stock market is home to many of the firms that are at the forefront of developing AI-focused software and hardware.

Having said that, the buzz surrounding AI has driven US shares to record highs, leaving their valuations way above historical averages. This suggests that exploring some of the other economies that are set to benefit from AI could unveil more attractive, affordably priced investment opportunities. The idea here is to invest in a stock market brimming with potential for AI-induced profit growth at a time when it presents a lower price per $1 of those earnings. The UK stands out here. It’s expected to get the third-biggest uplift from AI, according to Capital Economics. Its stock market valuation, meanwhile, is currently below it.

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