US midterms loom over jittery investors

Investors are rolling into a perilous period, and even the diehard optimists are willing to accept the market mood has taken a turn for the worse as next week’s US midterm elections open up risks on two key fronts: AI and geopolitics.

In truth, beyond the hype and hope of the AI trade, this has been a drab second half of the year in markets after a bright start fizzled out. Global stocks are up a paltry 2 per cent since the start of July, mostly because the US market has been busy going nowhere. Bits of Big Tech are still working out fine, and investors are optimistic about the possibility of Anthropic’s public market debut this autumn, despite its warnings about possibly destroying all human life. (And look, it’s important to really put it all out there in your regulatory filings about risk factors — you can’t knock them for that. When we’re all eating bark and dodging the robot lasers, we won’t be able to say they didn’t warn us.)

But higher interest rates — the precise opposite of what investors had anticipated at the start of this year — have weighed heavily on more cyclical sectors. The benchmark S&P 500 index is up by 12 per cent this year — again with the start of the year having done pretty much all of the heavy lifting — but if you strip out tech, that performance is cut in half.

Now cracks are forming in the AI trade too. The early warning came from Korea’s famously memory chip-heavy stock market, with the Kospi index down some 40 per cent since its June peak.

This month, nagging doubts about the sustainability of lavish borrowing to fund the construction of vast data centres spooked the debt markets. Analysts and investors bicker about what really happened there — is the worry that companies will fail to make money quickly enough to pay the debt back, or is it an old-school oopsie where massive borrowing meets a surprising rise in borrowing costs? Probably a bit of both. But it doesn’t really matter. The point is, the easy money has been made on this trade already, and now it is getting harder to avoid treading on rakes.

Google’s parent company Alphabet did just that this week. In its quarterly earnings, it told investors it was still ripping its way through cash to fund its AI build-out. But it also said its “AI mode” searches were cannibalising its key advertising business. This technology is supposed to enhance margins for the companies that use it. If Alphabet can’t figure out how to do that, what hope is there for the rest of us?

The news wiped a massive $500bn off the value of its stocks — the second-biggest decline in history, after Nvidia’s $593bn drubbing in January 2025.

Suddenly the big spenders on AI can’t win. If they keep throwing money at data centres and the like, they look like they’re taking on too much debt. If they reel it in, it is taken as a sign that the boom is behind us. The whole theme is getting a grilling and wealth advisers are shouting even more loudly than usual to clients about the importance of spreading their bets.

Into that environment, with wobbly tech debt and drive-by assaults on big-name tech stocks, we must now mix in the US midterm elections on Tuesday.

This is usually good for US markets. Deutsche Bank has calculated that 21 of the last 23 midterm years have brought positive returns in the fourth quarter, with an average of 7 per cent in the S&P 500. That makes sense — investors usually hunker down before a vote, just in case of a curve ball, and then ratchet up bets again afterwards. That pattern is perfectly plausible again now.

But the clear risk is of a Democratic majority of such size, in both houses (a big ask, to be sure), that the party could push through a much tougher regulatory agenda on AI, which has so far enjoyed a freewheeling attitude in Congress and the White House.

Investors also tell me that a humbling midterm election result for the Republican Party would corner Donald Trump and open up all kinds of geopolitical risks. Those include yet more violence in the Middle East, with the obvious human cost and potential upward pressure on oil prices. But behind closed doors, big investors in Europe say they are war-gaming all kinds of horrible scenarios, up to and including the slim but devastating chance that the US administration could seek to confiscate their US assets.

Caution certainly seems warranted for the coming weeks. The reliably upbeat multi-asset team at HSBC, which has been super bullish on stocks and seen no need for the safety of government bonds since March, has now had a change of heart, citing a possible Democratic sweep in the election, what with its implications on AI, and the simmering war in Iran. “Given the constant narrative bingo, we just can’t have the same level of conviction any longer,” the team said. Just for now, ahead of what they still think will be a positive 2027, they have swung to a neutral stance on stocks and a positive stance on government bonds that act as a shock absorber in periods of stress.

A chill is setting in. Wrap up warm.

katie.martin@ft.com