The fragile foundations beneath the AI boom

The last few years have given investors no shortage of competing narratives to wrestle with. AI optimism, stubborn inflation, geopolitical tensions, slowing growth, higher interest rates, and now renewed concerns around oil prices and the Middle East.

For Chris Watling from Longview Economics, however, the story underneath markets may actually be much narrower than many investors realise.

Watling argued that much of the apparent strength in the US economy and equity market remains heavily tied to the AI theme, from earnings growth through to capital expenditure and profit margins.

“All of that is about the AI theme.”

That concentration leaves markets vulnerable if enthusiasm around AI eventually fades before broader economic growth properly reaccelerates.

Discussing global energy markets, Watling said the US is still playing a major role in offsetting supply disruptions.

“At the moment, the pinch is being made up mainly by what you're seeing in the States.”

In the full episode of The Rules of Investing, Watling discusses why he believes markets may be underestimating economic fragility beneath the AI boom, along with the outlook for inflation, oil, rates, housing and global growth.

Watch / listen to the episode via the players or read a summary below.

Inflation may not be the real problem

One of the more surprising aspects of the discussion was Watling’s relatively relaxed stance on inflation, despite rising geopolitical tensions and renewed pressure on oil prices.

Rather than seeing inflation as the dominant risk, Watling argued that many central banks may still be “fighting yesterday’s battle” after being caught off guard during the post-COVID inflation surge.

Instead, he believes weak growth and deteriorating labour markets across much of the developed world are the more important forces.

“When you haven’t got a lot of money in your bank account and someone puts the oil price up, you care a lot,” he said. “It’s ultimately a tax on the consumer.”

Watling contrasted Australia’s still-resilient housing market and labour market with the much weaker backdrop in parts of Europe and the US, where housing activity and consumer sentiment remain subdued.

The world may be weaker than markets think

One of the more striking parts of the discussion was Watling’s argument that many developed economies remain far weaker beneath the surface than headline market performance suggests.

While investors remain focused on AI enthusiasm and record highs in parts of the US market, Watling argued that much of the underlying economic strength is concentrated in a surprisingly narrow part of the economy.

Outside of AI-related sectors, he pointed to signs of stress in areas such as US housing, consumer spending, and lower-income households, alongside slowing disposable income growth and rising delinquencies in areas like auto loans and credit cards.

That contrast also extends to Australia, which he argued appears to be in a very different position to much of Europe and the US.

Watling pointed to Australia’s comparatively resilient housing market and stronger labour market as evidence that the local economy may still be operating at a different stage of the cycle.

“Whilst the AI thing continues, we don’t need to worry about it. But I think when that comes to a conclusion… there’d be a real vulnerability in the US economy.”

Why complacency may be the biggest risk

Watling also warned that investors may be underestimating how concentrated and fragile the current market environment has become.

While he stopped short of calling an imminent top in AI-related assets, he suggested the trade may become one of the defining asset allocation questions of the next several years.

“I think investors are a little bit too complacent about the construct of US economic growth,” he said.

Watling argued that markets often become most vulnerable when investors grow overly confident in a dominant narrative and positioning becomes too one-sided.

“The sell-off almost always starts when markets are greedy and market participants have overdone it on the upside,” he said.

Over his career, Watling said he has found that major market turning points are often driven by a combination of liquidity, economic cycles, and shifts in investor psychology.

Listen to the full episode

In the full conversation, Watling discusses:

• The outlook for oil and the Strait of Hormuz
• Why he thinks markets may be misreading inflation risks
• The fragility beneath the US growth story
• Australian housing and negative gearing
• Lessons from major macro calls over his career
• The one investment he’d make if markets closed for five years