Capital Economics believes the recent surge in foreign investment into U.S. equities could be another indication that the current stock market rally is becoming overstretched, pointing to previous periods when similar buying patterns preceded major market downturns.
Chief Economic Adviser John Higgins said strong overseas demand for U.S. stocks has historically coincided with powerful advances in the S&P 500 that were later followed by significant corrections.
Foreign Ownership of U.S. Equities Has Climbed Sharply
Capital Economics noted that the United States’ long-running current account deficit naturally leads foreign investors to accumulate U.S. financial assets, with the country’s net external liabilities exceeding $21 trillion at the end of the first quarter.
However, the firm highlighted a significant change in the composition of those holdings.
Around two decades ago, foreign portfolio investment was concentrated primarily in U.S. debt securities. Today, equities account for the majority of those investments.
According to Higgins, foreign investors now own more than 21% of the U.S. equity market, compared with just over 6% in 1997.
Previous Buying Surges Were Followed by Market Reversals
Capital Economics said historical trends suggest that periods of heavy foreign buying have often coincided with stock market rallies that later reversed.
The firm stated that “substantial increases in foreigners’ net purchases of US equities have coincided with sizeable rallies in the S&P 500 that have subsequently reversed,” citing the dotcom bubble, the Global Financial Crisis and the 2022 market decline as notable examples.
It also observed that the latest increase in overseas purchases alongside the current rally “has been much larger than the increases in foreigners’ net purchases of US equities during the rallies of those earlier episodes.”
AI Optimism Could Reverse
According to Capital Economics, the current wave of foreign buying has been fuelled largely by enthusiasm surrounding artificial intelligence.
The firm warned that this AI-driven investment trend “is likely to reverse if and when the bubble in AI bursts,” a scenario that could leave U.S. equities underperforming international markets.
Dollar Outlook Depends on Central Banks
Capital Economics said the implications for the U.S. dollar are less certain.
The firm believes that the currency’s performance in the event of a reversal in AI-related investment “would probably depend heavily on how much, if at all, the Fed eased monetary policy compared to other central banks.”
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