This article first appeared in Forum, The Edge Malaysia Weekly on May 25, 2026 - May 31, 2026

Following the American attack on Iran, global economic fundamentals may have been deteriorating by the day, but equity markets do not seem to have noticed. Stock valuations are at or near record territory not just in the US but also in South Korea, Taiwan, Japan and several others. The biggest disconnect between stocks and underlying fundamentals may be in the US, where the artificial intelligence (AI) boom is fuelling a small highly concentrated group of stocks into stratospheric valuation levels.

There are two factors at work here. First is the rising market concentration. Whether it’s the Magnificent 7 or the AI 11, the focus on tech giants has amplified market concentration. A Morgan Stanley report shows that a mere 10 stocks account for 33% of overall US market value and 37.5% of the MSCI USA Index. The concentration is even worse in Taiwan where TSMC alone accounts for 40% of the stock index and in South Korea where Samsung accounts for 20%.

Apart from concentration, there is a second factor at work, which is the formation of a feedback loop. As investors channel their money into Mutual funds, Index funds and exchange-traded funds, given their index weights, much of the new money gets allocated into these top 10 stocks, thereby increasing their values even further, regardless of whether their fundamentals justify it. As a result, most of the AI stocks have experienced a parabolic increase in value. Of late, AI-related semiconductor manufacturers and even memory and storage players have also had sharp upticks in valuation. Clearly, a snowball effect is at work.

The consequence is that these two factors combined may be creating a doom loop, in which market concentration lifts most, if not all, constituent stocks of the index on the way up — as appears to be happening now — but could trigger a disorderly rout if the top weighted stocks experience a drawdown.

If the last US stock boom and bust was caused by a housing bubble, this time it would appear to be the AI bubble. The flawed narrative back then was that residential home prices could not come down, this time, it’s that AI is going to change the world and our lives so much that traditional valuation models don’t apply. In other words, as has been the justification for every previous bubble, this time it’s different. While there is no doubt that AI has the potential to bring huge benefits over the long run, the immense amounts of needed investments being touted and the pricing to perfection of the underlying stocks appear to be seriously detached from the rapidly deteriorating economic fundamentals.

For the US, where the disconnect seems most apparent, the many economic, political and geopolitical problems arising from the war with Iran appear to be coalescing into multiple vulnerabilities. The financial sector, already plagued with stretched asset valuations, has to contend with leverage concentrated in specific sectors and funded by shadow banks. As the Financial Standards Board (FSB) has noted, the AI boom appears to have been funded by private credit institutions working with lesser known rating agencies to source funds from rating reliant investors like pension funds and insurers.

Note that a very similar tripartite arrangement was in play between private home loan providers, insurers and credit raters leading into the US subprime crisis of 2007/08. More than the credit risk being concentrated within narrow sectors, private creditors are not subjected to the disclosure and regulatory oversight of banks. This opaqueness implies difficulty in valuation and their institutional set-up enables them to sidestep the discipline of mark-to-market requirements.

Already, several private creditors have experienced liquidity mismatches with some imposing limits on redemption. Apart from a potential firm or sector-specific shock turning into broader market stress, the bigger fear cited by the FSB is that the liquidity mismatches could interact with heightened market volatility to create a double whammy threat to financial markets and institutions — falling asset valuation and the inability to liquidate.

As for the Trump administration, in an environment where policy is never certain and can turn on a dime, two of the key early initiatives, tariffs and Department of Government Efficiency (DOGE) have turned out to be blanks. There is no DOGE dividend, nor does there appear to have been a tariff dividend. If anything, the court-imposed tariff refunds impose further fiscal pressures and widen the funding gap on a government that has cut taxes and committed to increased tax refunds.

If tariff imposition had been the initial catalyst for reviving inflation, the war and the resulting disruption in supply chains and rising oil prices have further stoked domestic inflation. Despite the chestthumping about the US being the world’s largest oil producer and how it stands to benefit from higher oil prices, the fact that US consumers pay prices directly linked to global oil markets implies a direct passthrough of all the ills of rising oil: higher inflation and reduced affordability.

To make matters worse, the US has to face these heightened volatility and inflationary pressures while being burdened with historically high debt. With gross national debt now approaching US$39 trillion (RM154 trillion), net interest payments which were about 2% of gross domestic product in 2020 have more than doubled to 4.2% of GDP in 2025, and are set to rise further. What becomes truly alarming is the combined effect of rising debt and inflation on interest rates and debt servicing requirements. Rising nominal interest rates and required yields have the potential to simultaneously prick both the US bond and stock markets.

If the US has multiple vulnerabilities, the global environment is not much better. Some 80% of the world’s nations are oil importers, many, being low-income nations, simply lack the fiscal space or foreign reserves to cushion the oil price shocks. Further, many of these countries had since Covid-19 gorged up on debt just to sustain themselves.

The International Monetary Fund (IMF) estimates that for many developing countries, interest payments consume 21% of their tax income on average. Thus, the global addiction to debt has meant that fiscal flexibility has been steadily shrinking across many countries. The developed world too is just as badly affected by the Iran war-induced shocks and volatility. The potential for disorderly unwinding of bond markets applies just as much, if not more, to the UK and Japan as it does for the US.

The IMF, which now sees the war to have a longer negative impact than initially thought, has cut global growth estimates and raised the alarm on rising inflation especially of food and necessities. Outright shortages arising from disruptions to the supply chain are cited as added risks. Yet, financial markets seem to be blissfully ignoring these realities and disconnected from fundamentals.

History shows that the further out the divergence between financial markets and the real sector, the sharper and more disorderly the correction would be. Like most things, markets too, are mean reverting.

Given the multiple vulnerabilities, all it would take is for one or two pain points to cave in for broader markets to unravel. As it stands, two key factors could determine whether financial markets can avoid sharp corrections and unwind steadily to converge with economic fundamentals.

The first would be a full and proper resolution of the war, enabling oil prices to fall from current levels. Second, as the major stock markets now appear tethered to AI, AI’s ability to deliver on its expectations is critical. These two factors, notwithstanding, nominal interest rates, will be the Achilles heel. Rudi Dornbusch, the renowned economist had famously said, “Crises take much longer to happen than you think, and then happen faster than you thought they could.”

Dr Obiyathulla Ismath Bacha is professor of finance at INCEIF University

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