Capital Economics warns: AI bubble will burst in 2026

Capital Economics warns that the artificial intelligence-driven stock market bubble could burst in 2026.

The research firm said a stock market bubble driven by investor excitement about artificial intelligence will push the S&P 500 to a high of 6,500 by 2025, with technology stocks leading the charge.

But starting in 2026, stock market gains should fall back sharply as rising interest rates and inflation begin to drive down stock valuations.

“Ultimately, we expect equity returns over the next decade to be lower than the previous decade,” said Diana Iovanel and James Reilly, economists at Capital Economics. “We think , U.S. stocks’ long run of outperformance may be coming to an end.

The two economists believe that the increasing popularity of artificial intelligence will drive economic growth driven by productivity improvements. This economic stimulus should lead to higher inflation than most expect, as well as higher interest rates.

Higher interest rates and inflation are ultimately bad news for stock prices, as evidenced by the recent decline in stocks, which was triggered by the surprising March CPI inflation report.

The two economists said: "We suspect that the bubble will eventually burst after the end of next year, leading to a correction in valuations. After all, this dynamic was seen during the dot-com bubble of the late 1990s and early 2000s and the Great Crash of 1929. appeared."

The expected bursting of the stock market bubble will tilt investment returns toward bonds rather than stocks over the next decade. "With government bond yields stabilizing at higher levels, we expect higher returns," Capital Economics said of fixed income markets.

Capital Economics predicts that from now to the end of 2033, the average annual return on the U.S. stock market will be only 4.3%, far lower than the long-term average return of about 7% after excluding inflation factors. Capital Economics, meanwhile, said it expects U.S. Treasury bonds to return 4.5% over the same period, slightly higher than the stock market's gains.

These expected returns contrast sharply with the 13.1% average annual return for U.S. stocks over the past decade.

"American exceptionalism may be over in the next few years," Ivanel and Reilly said.

However, the two economists believe there is a major risk to their outlook: the inherent difficulty of accurately timing the peak of a stock market bubble, and how long its burst may last.

"When and how the AI-driven stock market bubble bursts is a key risk to our forecast. In particular, one downside risk is that the aftermath of the bubble burst lasts longer than a year, as was the case after the dot-com bubble," Ivan Nell and Riley say