Why there could be more upside in store for AI

With technology now making up a near-record share of the global equity market, some investors are understandably nervous about a bubble - particularly given the emergence of Chinese AI lab DeepSeek. But with fundamentals still supportive of ‘big tech’ in the long run, we argue now could be the time to look through short-term noise and tap into the AI transformation.

Over the last two calendar years, we’ve seen the Magnificent 7 technology stocks (Apple, Microsoft, Tesla, Google, Amazon, Meta and NVIDIA) act as the engine room for the US equity rally, returning more than 150% versus around 30% for the rest of the S&P 500 Index.³

In 2024, we also saw Australian investors turn to the technology thematic in droves, with the iShares S&P 500 ETF (IVV) and the iShares Global 100 ETF (IOO) – our two exposures with the largest weightings to tech – recording approximately $2.05 billion and $300 million of inflows respectively.⁴ Both IVV and IOO were within our top 5 ETFs on an inflow basis for the 2024 calendar year, with IVV the most popular product overall.

While the sector’s dominance has been tested this year by DeepSeek’s new AI model and US-China trade talks, the rapid growth of major tech companies means technology and communications now make up almost 35% of the MSCI World Index - the highest share since the dot-com crash in the early 2000s.⁵ Indeed, if we presume the “usual” business cycle conditions that defined the Great Moderation era – the period of high growth and low interest rates that preceded the COVID pandemic – it may seem as if these sectors are overvalued.

However, we would argue artificial intelligence – which is driving this unprecedented growth in tech – is a long-term mega-force disrupting the global economy, to the extent that it’s breaking historical trends in real time. For instance, we estimate global spending on AI infrastructure – such as data centres, chips and the power systems required to fuel AI technology – could top US$700 billion, or 2% of US GDP, by 2030.⁶

The potential productivity gains as AI matures are also astronomical: a 10% saving in labour costs as the technology begins to replace many human professional tasks would be worth US$120T in global GDP.⁷

In this environment, we see cyclical patterns in stock valuations and market concentration becoming less relevant, meaning the companies at the centre of this tech revolution may not return to their previous weightings within equity benchmarks.

Despite a huge couple of years for tech and US equities more broadly - the first time the S&P 500 Index has generated 20% returns for two consecutive calendar years since the late 1990s – Australian advisers still appear bullish on the outlook for the sector in 2025. According to data from our first quarterly pulse survey conducted in Q4 2024, a majority of advisers nominate tech as the sector they expect to generate the strongest returns this year.

This may be because the economic fundamentals of the tech sector indicate we are still some way off a bubble. Taking a look at 12-month forward price to earnings ratios for the sector (see below chart), we can see that these are higher than the broader equities market, but significantly lower than the extremely stretched valuations that heralded the crash of the early 2000s.

The question of over-investment by the big tech firms has also been raised, particularly given the recent release of DeepSeek’s seemingly more efficient AI model, which has seen NVIDIA⁸ in particular give back some gains from a price perspective.

We think investors need to take a long-term view on spending given AI’s potential to unlock new revenue streams – broad adoption of the technology is still to come, and we have barely scratched the surface of all the AI use cases. Recent developments with DeepSeek could push AI adoption sooner and ensure AI remains a key focus in US-China strategic competition, including any resulting US trade barriers.

In the short term, we don’t see the sector being overextended on a cash flow basis. Taking a look at the current free cash flow levels of the Magnificent 7 versus their market cap, we can see that they are again a long way off the lofty levels of the late 1990s. Strong results from the most recent earnings season have also underlined that big tech can support heavy AI cap-ex.

Market cap to free cash flow ratio, 1992-2023

Index exposures offering a high weighting to tech can be a suitable option for investors wanting to tap into the long-term growth opportunities offered by AI, while also building in broader diversification⁹ to other sectors. Opportunities to invest in technology through Australian equities are limited, with the sector making up just 3% of the ASX 200,¹⁰ so building out a broad global equity exposure with a tilt towards technology may make sense for investors with an existing portfolio of Australian shares.

The S&P 500 Index, with an over 30% weighting to technology, also offers significant exposure to cyclical sectors such as financials which have recently outperformed, and defensive sectors like healthcare which are set to benefit from long-term demographic change. Accessing the index, which has a long-term track record of over 14% annual returns, also gives investors broad exposure to around 80% of total US market capitalisation.¹¹

Turbo-charge your tech exposure
iShares ETFs with the largest weights to US tech

Source: BlackRock holdings data as of 21 January 2025

For investors wanting to further increase their exposure to the AI transformation, the S&P Global 100 Index offers an over 40% weighting to the tech sector. Companies in this index are selected for their global significance, deriving at least 30% of their revenue from outside their own geographic region and with a minimum market cap of US$5 billion.¹²

Generating an average annual return of more than 13% over 10 years, and with significant non-tech holdings including JPMorgan and Eli Lilly, the S&P Global 100 gives investors access to some of the largest economic ‘mega forces’ including the ageing population and the future of finance.¹³

Both these indices can make a powerful complement to Australian or other global equities exposures, allowing investors to take advantage of the technology sector’s long-term growth story, while limiting concentration risk in the event of a short-term sell-off. Of course, the exact trajectory of the AI transformation is not yet certain, meaning there may be bumps along the way, so investors should always consider tech exposure as just one part of a broader, diversified portfolio. However, we think the investment arms race underway in the technology space makes this thematic a compelling part of portfolios in the years ahead.