AI: The Next Wave

Leonie Mac Cann Head of Client Investment Solutions

Ronan Bradley Head of Quantitative Research

Technological developments, especially in the field of AI, have driven stock market returns in recent years but this has led to high index concentration. The application of the technology should lead to a broadening out of the stocks and sectors driving earnings growth and, while the US is best positioned to benefit, we believe it is important to maintain diversified equity exposure to optimise long-term returns.

Advances in technology have driven economic growth and improved living standards throughout history, including the first three industrial revolutions of mechanisation (end of 18^th century), electrification (start of 20^th century) and automatisation (from the early 1970s). These advancements are estimated to have contributed 35-40% of the growth in US GDP per capita over the past 130 years^[1]. We believe this trend is set to continue with AI – the fourth industrial revolution. Specifically, it is expected to enable cyber-physical systems involving areas like robotics, virtual reality interactions and 3D printing. These technologies could combine to alter supply chains and production methods, allowing for increased automation, productivity and corporate profitability. This is underpinned by the technology having applications across the economy and it is already impacting industries from agriculture to healthcare, unlocking new ways for companies to add value.

The broad application of the technology has resulted in vast amounts of capital being invested in AI by large multinationals as diverse as Microsoft, Tesco and Pfizer, with the aim of raising productivity and profitability. US tech giants including Google, Amazon and Meta have led the way and are competing to release superior AI models in the hope of boosting user numbers and revenue. This phase of the AI revolution is set to lead to efficiency gains across sectors and could see the US maintain its dominance in the field. America is setup to benefit to a greater degree compared to other regions given its lower levels of regulation and union membership compared to the likes of Europe and Japan.

Equity markets have taken notice and the AI theme has been a key driver of returns over the past two calendar years, with the so-called Magnificent Seven[2] returning 161% over the period compared to 58% for the S&P 500. This has led to greater concentration with the Magnificent Seven making up around a third of the S&P 500 and 25% of global developed market equity indices. Moreover, US equities now account for approximately 75% of the global equity market compared to 52% in 2004 and analysis shows that the 10 largest stocks accounts for 33% of global equity market risk compared to 19% in 2004.

While increased concentration risk has become a characteristic of the equity market, it is not, we believe, something investors should be overly concerned about. Our research shows that global developed market equity indices still provide investors with exposure to a well-diversified set of earnings - the proportion of profits derived from the top 20 stocks is comparable to that in 2004 when the index was less concentrated. Fundamentals are also robust as mega cap US tech companies are well established with strong balance sheets and superior profit growth compared to other sectors, justifying a valuation premium over the rest of the market. The price/earnings-to-growth (PEG) ratio based on long-term earnings estimates of the Magnificent Seven is 1.97, not too far above that of the market (1.85), while the 12-month forward P/E for the former of 28.5x does not appear stretched compared to the levels of some tech stocks during the Dot-com bubble.

The dominant position of the Magnificent Seven has been challenged recently given new models like those from DeepSeek, investors demanding to see AI investment being monetised and the supply-chain threats from protectionism under the Trump administration. These factors mean that continued outperformance of US tech cannot be taken as given. Market returns have already become more broad-based in 2025, with industries outside the tech sector showing strong earnings growth and regions like Europe outperforming America. While our long-term expected returns point to continued strong performance for US equities, there are risks around elevated valuations, especially among big tech companies.

Valuation and concentration risks mean that equity diversification remains important, in our view. Small caps are one way to broaden exposure with stock valuations cheap, both in absolute terms and relative to large caps. Policy tailwinds like deregulation and lower interest rates may also offer further support to small caps. Maintaining exposure to AI is a necessity, especially as its impact is felt more widely, but an approach that considers valuations is prudent.

ILIM’s Bottom Line

AI is likely to continue driving markets in the coming years, particularly as we see a broadening out of the theme beyond the Magnificent Seven. In our view the current strong economic environment justifies equities trading above long-term valuation multiples, but concentration risk has increased over the past number of years and needs consideration. In this environment, we believe that investors should take a more judicious approach when allocating to publicly listed equities and maintain a broad exposure. Diversification remains an important tool for ensuring strong investment outcomes, with our long-term expected returns forecasting healthy gains across global equities.

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