Fears of a credit crisis, AI bubble overshadow positive indicators

The phrase “wake up the echoes” originated in the University of Notre Dame fight song, evoking memories of crisp fall Saturdays, pageantry, and the enduring spirit of college football. It’s a call to summon the greatness of the past. This week, however, the echoes we’ve heard are of a different kind, less nostalgic, more cautionary. Echoes of the tech bubble, the credit crisis, and the 2018 government shutdown.

And yet, the S&P 500 Index sits just shy of an all-time high.¹ The backdrop appears supportive: positive outlook for growth,² falling oil prices,³ contained inflation expectations,⁴ yields that aren’t prohibitively high,⁵ and a Federal Reserve seemingly poised to ease further.⁶

Still, the questions linger.

Could something be lurking that might derail what looks like a constructive environment for risk assets still? The fact that these concerns are being raised suggests that the markets are still climbing a wall of worry. The time to worry is more typically when nobody else seems to be worrying.

Let’s explore those key worries.

Are we in an AI bubble?

Our short answer: Not yet.

Some concern stems from the nature of today’s artificial intelligence (AI)-driven investment cycle. There are parallels to past bubbles, particularly in the circular relationships forming between suppliers, customers, and investors. But there are also meaningful differences. The companies leading the charge today are well-capitalised, have been generating strong cash flow, and operate proven business models.⁷ Valuations, while elevated, are far from the extremes of the dot-com era. For instance, NVIDIA trades at roughly 23x forward earnings — far below the 80x multiple Cisco commanded at the peak of the 1990s bubble.⁸

Back then, infrastructure was built without a clear use case. Today, demand is overwhelming. NVIDIA has essentially said it can’t ship chips fast enough. Taiwan Semiconductor (TSMC) echoed that sentiment in its latest earnings report, delivering better-than-expected results and announcing plans to increase capital spending. While we make no comment on the stock itself, the report reinforces the idea that large-scale tech investment is continuing unabated.

That said, risks remain. Some firms, like OpenAI, have committed to substantial spending and are reliant on continued access to capital markets. Meta’s Mark Zuckerberg recently stated that the risk of misspending a couple of hundred billion dollars is better than not spending it⁹ — we can all relate. If funding dries up, particularly for companies that are deeply interconnected, it could trigger a meaningful repricing of stock valuations. There had been few signs of stress in the capital markets, but late in the week, there were concerns that investors were assessing closely.

Are we headed for a credit crisis?

Our short answer: Last week’s banking issues appear to be isolated events.

Recent defaults and select regional bank stress have investors worried about the implications for the financial system. But we don’t believe the recent defaults by First Brands and Tricolor are “canaries in the coal mine.” (No, coal miners don’t use canaries anymore, but “electronic sensors in the coal but “electronic sensors in the coal mine” isn’t quite as evocative.)

These appear to be idiosyncratic events, albeit ones that have drawn outsized media attention.

• First Brands is a frequent issuer with limited financial transparency, while Tricolor operates in the subprime auto space. Neither case, in our view, reflects broader stress in the credit markets. The former is thus far believed to be a case of alleged fraud.
• Then this week Zion and Western Alliance reported losses, which they attribute to cases of fraud on funds that invest in distressed commercial mortgages. The numbers are small — Zion Bancorp reported a $50 million charge-off.

The signs of overall credit deterioration remain limited. The major money-center banks are well capitalised and reported strong earnings this week — we’ll get to that below. While the above losses capture headlines, other regional banks have reported lower credit provisions than analysts had anticipated.

Investors are right to monitor developments closely, but for now, these defaults seem isolated, not systemic. It’s worth remembering that defaults happen all the time. If they didn’t, everyone might borrow at a risk-free rate.

What are bank earnings suggesting about the state of the US economy?

Our short answer: We’re hearing good things from major banks.

Earnings season is underway, with many of the largest US banks reporting results for the most recent quarter. Commentary from management teams offers valuable insight, not only into the performance of their own businesses, but also into the broader economic landscape. The general message from the banks that have reported so far is encouraging, in our view.

Earnings are coming in ahead of consensus forecasts. Loan growth and trading activity remain strong. Customers are largely keeping up with their debt obligations. Morgan Stanley, for instance, recorded zero provisions for credit losses last quarter. While there are signs of slowing activity among lower-end consumers, the wealth management segments of these institutions appear to be thriving. That’s not surprising — asset prices are near all-time highs,¹⁰ which can give affluent households more capital to allocate and money to spend. As long as this dynamic holds, we believe the positive wealth effect that has helped sustain the US economy should remain intact.

When will the US government shutdown end?

Our short answer: We don’t know. (This is pretty much our long answer as well.)

Keep in mind that historically, government shutdowns have concluded without significant incident to the economy and financial markets.¹¹