AI-Driven Tech Rally Triggers ECB Warning of Stock Market Correction

Researchers at the European Central Bank have warned that a stock market correction is likely after a 'blistering rally' in technology, particularly driven by AI adoption. The economists, including Malin Andersson and Kalin Nikolov, point to two possible explanations for this correction: one being that investors will demand higher risk premiums as risks from individual firms spread across the economy, leading to a fall in stock prices unless profit growth is strong enough to compensate.

The other explanation suggests that overconfident and overoptimistic investors have driven prices beyond fundamentals until sentiment turns and valuations correct. The researchers highlight that the rise of AI has brought stock market valuations to levels last seen during the dot-com bubble, raising concerns about an abrupt and painful setback in the euro area.

The impact of a US correction could extend to sentiment, lending conditions, and hiring, and policymakers have 'markedly less room' to respond to market instability due to low interest rates and stretched fiscal policy. The researchers also note that euro area households have around €440bn of exposures to US technology equities through global index trackers.