How sustainable is the AI investment boom after Thursday’s selloff?

The artificial intelligence investment boom is facing challenges as companies invest billions without matching revenue growth, potentially leading to a slowdown that could impact economic growth, Capital Economics warned. While Capital Economics remains optimistic about AI's long-term productivity benefits, it questions whether revenues will grow fast enough to justify the massive capital expenditure.

The firm expects AI investment growth to decelerate in 2027 before total investment falls by around 10% in 2028. The biggest US tech companies, including Amazon, Alphabet, Microsoft, Meta Platforms and Oracle, plan to spend $800 billion on capital expenditure this year, anticipating it could rise to $1 trillion or more by 2027. Much of the recent surge in investment has been directed towards AI infrastructure, such as data centers, servers and networking equipment.

However, to justify these spending levels, annual AI-related revenues from external customers would need to surge ninefold to 12-fold within four years, reaching $1.7 trillion to $1.9 trillion by 2030. This would require significant productivity improvements and a larger shift of income from workers to capital, which Capital Economics doesn't currently anticipate.

Physical constraints, such as semiconductor shortages and rising opposition to data centers due to their resource consumption, could also hinder expansion. Political pressure following the Democrats' gains in the US midterm elections might lead to tighter planning restrictions, particularly at the state level. The slowdown in AI investment could diminish the recent contribution of around 0.3 percentage points to US GDP growth, potentially shaving another 0.1 percentage point off next year.

Taiwan and South Korea could face even greater impacts due to their reliance on AI-related manufacturing and exports, with a potential GDP growth reduction of 5.5 percentage points in Taiwan and 1.5 percentage points in South Korea by 2028. Disappointing investment returns could lead to financial spillovers, exposing lenders and investors to losses as hyperscalers increasingly rely on external financing.

While the risks appear manageable if investment returns improve soon, a prolonged boom could create significant financial vulnerabilities if the investment is primarily financed through debt. Despite these risks, Capital Economics remains cautiously optimistic, suggesting that the AI investment boom will eventually adjust to a more sustainable pace rather than signaling the end of AI's economic potential.

The primary concern lies in the potential creation of financial and economic imbalances if the necessary productivity gains and revenue growth fail to materialize.