Social and Regulatory Risks of AI

Magellan Asset Management

February 2024

Artificial intelligence (AI) is no longer an abstract concept; it is quickly evolving as an integrated part of our daily lives. From virtual assistants and transportation to eCommerce and even healthcare, AI is continuing to expand its application. As investors, understanding the risks and opportunities associated with this new technology is vitally important.

Since the release of OpenAI's ChatGPT in November 2022, investors have recognised the large impact generative AI¹ could have on businesses' productivity, growth, and innovation.
In a previous article, we outlined the AI investment opportunities that we see across chip, software and cloud providers. While we have a high conviction in the structural growth tailwinds of AI, as mentioned, we must also understand the risks associated with this expansive technology. Below we focus on some of the ESG risks associated with AI and the regulatory landscape, which is evolving rapidly.

What are the ESG risks of AI?

Despite the incredible benefits that AI can bring to businesses, it comes with significant social risks - privacy concerns, bias, discrimination, misinformation, ethical considerations, job displacement, safety and autonomy to name a few.
We're already seeing rising cases of AI-related controversies, litigation and government intervention.

Source: https://aiindex.stanford.edu/report/

However, these risks should be viewed across short-, medium- and long-term horizons for a more detailed understanding of the potential impacts.
Short-term risks (within the next few years): These could include risks of misinformation, bias and inaccuracies, copyright infringement, and data breaches, security, and sovereignty. For example:

• AI has the potential to misdiagnose health issues.
• A technology platform may inadvertently distribute misinformation that could be discriminatory or fraudulent.
• AI data training sets may breach copyright, for example: The New York Times filed a lawsuit against OpenAI and Microsoft in December 2023, claiming "widescale copying" by their AI systems constitutes copyright infringement.² Whether its allegations have merit remain to be seen.

Medium-term risks (Next 5 - 10 years): These could include risks of potential job loss, social manipulation, human rights violations and company or economic disruptions. For example:

• Automated recruitment systems may have a discriminatory bias against specific groups of people based on the data they are fed and trained on.

Long-term risks (10 years and beyond): These could include environmental or existential risks. For example:

• The increasing use of AI could lead to significantly higher energy demands, driven by the growing utilisation of computing resources.

To mitigate these risks, we have seen an increase in regulation across many jurisdictions. It's important that both developers and users of AI technology are factoring these regulatory expectations into their intended use cases, to minimise these potential ESG risks and the potential impacts on cash flows as well as regulatory fines.

What impacts could regulatory risks have on companies?

AI regulation, if not managed well, could have a negative impact on cash flows for businesses. This may come in the form of higher costs, including potential fines and litigation or increased operating costs to meet regulatory requirements. Regulation could also lead to lower revenues, with constraints on new product developments as an example.

Decreases to cash flows

What will AI regulation look like?

AI regulation has long been discussed but lags developments in technology. Early regulation targeted the short- and medium-term risks - to protect basic data rights, fundamental rights, and democratic freedoms in certain regions. An example of this was seen in New York where AI technology was created and in use for résumé screening long before the AI hiring law (under which employers who use AI in hiring must inform candidates) was implemented in New York.

Each jurisdiction is approaching AI regulation differently, ranging from self-regulation and voluntary standards to strict rules with penalties for breaches.

European Union (EU):
In April 2021, the EU proposed a risk-based framework, the EU AI Act. The use cases of AI are categorised and restricted according to whether they pose an unacceptable, high or low risk to human safety and fundamental rights. The AI Act is progressing through the process of becoming law and will sit alongside the Digital Markets Act, the Digital Services Act, the Data Governance Act and the Data Act.

United Kingdom (UK):
The UK views AI as general-purpose technology. They have proposed a principles-based regulation approach. Industry-based regulators have flexibility in how they define their own regulations with the principles as guidance.

United States (US):
Prior to the recent executive order issued by President Biden in October 2023, the US encouraged companies to follow a set of "voluntary commitments". The new executive order grants the government greater powers to supervise how AI models are built and tested.

Australia:
Australian ministers have commented that a new advisory body would work with government, industry and academic experts to legislate AI safeguards.³

What's next for AI and regulation?

As we have highlighted, one of the challenges of AI regulation is that the current approach is fragmented across different jurisdictions, making it more complex for companies creating or using AI to remain compliant. A way to overcome this would be the adoption of global AI standards to create consistency in how companies ensure responsible AI practices. We will continue to monitor the evolving AI regulation as well as the use of existing legislation for AI use cases such as the copyright infringement court case with The New York Times.⁴

What does this mean for investors?

Investors need to carefully consider the ESG risks associated with AI when making investment decisions. These risks, ranging from reputational damage to regulatory non-compliance and workforce impact, may influence the long-term growth and performance of companies. To help mitigate these risks, investors should have a detailed understanding of the companies they are investing in when it comes to their commitment to responsible AI practices. Rigorous due diligence is essential, involving thorough research and analysis of how companies approach and address social risks associated with AI. Companies that prioritise ethical considerations, engage with stakeholders and navigate regulatory landscapes effectively provide investors with greater confidence their investments are aligned with responsible business practices and are better positioned to withstand potential environmental, social and regulatory challenges associated with AI technologies.

At Magellan, social risks associated with AI form part of our company risk assessment and investment thesis. Our investment team undertakes thorough research and company engagement, and continues to monitor risks and how these risks may offset the opportunities.

Leading cloud and AI vendor Microsoft, a key exposure in our global equity portfolio, has already integrated initiatives to minimise the risk of regulation including implementing a principled approach to AI development, transparent reporting about its responsible AI learnings, an AI assurance program to bridge customer requirements with regulatory compliance, and internal governance teams integrated as part of leadership.
Expectations of companies developing AI can be summarised as:

What should AI developers be working towards to minimise risk?

• Active industry / community engagement on AI development
• Transparent reporting on developments and learnings
• Promote fairness and inclusivity in development of AI models and datasets
• Have adequate disclosures
• Internal governance teams to monitor AI risks (human oversight)
• Policies and processes to prevent AI risks like bias
• Implement AI explainability models to allow for external auditing

While some of the AI opportunities are being priced into stocks, there are still opportunities to be found, especially where companies can exploit the disruptive potential of AI. 

Funds operated by this manager:

Magellan Global Fund (Hedged), Magellan Global Fund (Open Class Units) ASX:MGOC, Magellan High Conviction Fund, Magellan Infrastructure Fund, Magellan Infrastructure Fund (Unhedged), MFG Core Infrastructure Fund

1 Generative AI refers to algorithms that can be used to create new content based on the data they were trained on. This can include audio, images, code, text and more. 
2 Boom in A.I. Prompts a Test of Copyright Law - The New York Times (nytimes.com) 
3 https://www.smh.com.au/politics/federal/new-laws-to-curb-danger-of-high-risk-artificial-intelligence-20240111- p5ewnu.htm
4 Boom in A.I. Prompts a Test of Copyright Law - The New York Times (nytiWmes.com)

Important Information: 

This material has been delivered to you by Magellan Asset Management Limited ABN 31 120 593 946 AFS Licence No. 304 301 ('Magellan') and has been prepared for general information purposes only and must not be construed as investment advice or as an investment recommendation.  This material does not take into account your investment objectives, financial situation or particular needs. This material does not constitute an offer or inducement to engage in an investment activity nor does it form part of any offer documentation, offer or invitation to purchase, sell or subscribe for interests in any type of investment product or service. You should obtain and consider the relevant Product Disclosure Statement ('PDS') and Target Market Determination ('TMD') and consider obtaining professional investment advice tailored to your specific circumstances before making a decision about whether to acquire, or continue to hold, the relevant financial product. A copy of the relevant PDS and TMD relating to a Magellan financial product may be obtained by calling +61 2 9235 4888 or by visiting www.magellangroup.com.au.

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Hedge Clippings | 08 March 2024

This week saw a slew of  Australian economic data released, including Housing, Labour and Employment numbers, and National Accounts.

Housing first - According to the ABS, January's total housing finance fell 3.9% in January, coming after a fall of 4.1% in December 2023. Even though that's still 8.5% higher than a year ago, owner-occupied housing fell 4.6% and was only 3.4% higher than January 2023.

Today's Labour figures for the December quarter showed actual hours worked dropped by 0.3% - the second quarterly drop in a row. This was the first time since March 2014 that two consecutive quarterly falls had occurred, excluding the COVID era. Job vacancies also fell by 5.6% for the quarter, the fifth consecutive quarterly fall, although again COVID related issues have played havoc with trend numbers.

Both of these followed on from the release of the National Accounts on Wednesday. While overall the economy grew by 0.2% in the December quarter, the rate of GDP growth declined for the fourth straight quarter.

It seems the multiple rate hikes to date from the RBA are having the desired effect, so the question now is how soon before they might start to cut rates? Probably not at the next meeting, unless the board changes their tune the week after next, or fall in line with US Federal Reserve Chairman Jerome Powell's comments that the Fed was close to being able to reduce rates. The RBA's minutes of the February meeting were customarily cautious, noting that there had been "further progress towards their objectives, but that more progress was required, and the outlook remained uncertain". One known unknown, or uncertainty that the RBA noted that they were going to have to grapple with was the effect that the revised Stage 3 tax cuts, due from July 1, will have on spending.

Moving overseas, Trump's legal issues continue to mount even as his GOP nomination is confirmed. AP News even has a dedicated web page to track his various court cases. Like him or loathe him, and there's seemingly plenty in both camps, the fact that he's still in November's US presidential election race is extraordinary. US TV show host Jimmy Fallon summed it up well in this TikTok clip which even if you're a fan of the Donald, is pretty clever.

In Australia, even a (relatively speaking) minor mis-step, such as Barnaby having one too many drinks and having to lie down on the footpath while he phoned his wife, would spell curtains for higher office. Equally extraordinary is the reality that Joe Biden, if elected, will be 86 by the time his second term ends, while Trump himself will be 82.

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Hedge Clippings | 01 March 2024

This week's inflation figures were encouraging, but unlikely to prompt the RBA to change their approach at their next board meeting. Annual inflation stayed steady at 3.4% in the 12 months to January, well down from the peak of 8.2% in December 2022, while the number for underlying inflation, excluding volatile items, dropped fractionally to 4.1%, also well down from its December 2022 peak of 7.2%.

We have long held the view that getting inflation down the "last part" to the RBA's target of 2.5% will be the most difficult, and the RBA has been consistent in its guidance that they won't be rushed into cutting rates too soon - at least not until they are convinced the battle has been well and truly won. So while there will be calls from some quarters for a cut sooner rather than later, the RBA is more likely to reverse that, (i.e. later rather than sooner) particularly as the Wage Price Index (WPI) for the December quarter came in at 4.2% - indicating that wages rose faster than inflation. Until the RBA sees the unemployment rate, currently 4.1%, nudge higher they're not going to feel comfortable cutting rates and sending a signal that the inflationary problem is over - even if the actual inflationary cycle has turned.

Normally we'd be waiting until the RBA's meeting next Tuesday, but under the board's new structure the normal first Tuesday of the month meeting is now postponed to 18-19th of March, by which time the ABS will have released a slew of data to keep economists busy, with next week seeing National Accounts (including GDP) on Wednesday, and of particular interest to Hedge Clippings, the statistics on the Managed Funds sector due on Thursday.

Elsewhere next week our attention will be piqued by Super Tuesday in the USA, when 16 states vote for their preferred Republican and Democratic candidates. Both Joe Biden and Donald Trump would appear to be a shoe-in for their respective party's nominations, with Nikki Haley hanging in there in the hope of a Steven Bradbury like finish if Trump can't overcome his multiple issues with various court cases, and Joe Biden just hoping to hang in there, full stop, or as they say in the USA, period! Both Biden's and Trump's greatest hope for a clear - if not clean - result in November, would seem to be the other's failings.

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Looking through the headline noise

Ox Capital (Fidante Partners)

February 2024

Reality vs. sentiment

We are seeing a clear dislocation between reality and stock market sentiment. Contrary to news headlines of a lacklustre macro-economic environment and outlook, quality companies continue to execute and grow earnings. The overall economy is resilient and showing pockets of strength. Headwinds to the property market are manageable and well understood.  Our base case is the Chinese economy will grow this year (4.5% to low 5% range) and we continue to expect the Chinese authorities to provide support for the economy to restore confidence. After sharp pullbacks in Chinese equities, the authorities are intervening, introducing various measures to support the stock market.  It's important to look through the noise. 

Return of the flow. Daily volumes of on shore ETFs have spiked. This is important, as the National Team (China's Sovereign Fund) has proactively intervened with direct purchase of equities/ETFs to support the market. The Sovereign fund also vows to further increase ETF holdings to support the market as needed. This reminds us of when the Hong Kong government stepped in during the Asian Crisis to support the market and uphold stability.

Recurring headlines are somewhat old news. Despite recent headlines, the Chinese property downturn is in fact quite advanced. This is a well-known fact as sales are down over 40% since peak. Developer loans exposure to the baking system is low (less than 6%). Distressed developers have defaulted, while contagion to the trust industry is low and very manageable.  The news of property developer Evergrande's inevitable collapse was well known despite recent articles highlighting its demise. Again, it's important to look through the noise. The government extending support for local developers (both private and state owned) through banks with measures to improve developers' liquidity will further improve confidence. Moreover, China's real estate investment relative to GDP remains one of the lowest relative to other major economies while sales are approaching sustainable levels after years of declines.

Finally, the government continues to show willingness to provide support by easing policy further. The PSL (China's version of QE) grew in December and January to fund urban village redevelopment and social housing. In addition, the PBoC recently lowered the deposit reserve ratio requirements of financial institutions by 0.5%, in-line with prior guidance of further monetary policy easing. As such, the reduction in reserve requirements will provide liquidity, benefiting the real estate market and economy overall, supporting consumer confidence even further.  We do acknowledge however, the stimulus measures all up (including urban redevelopment, lower mortgage rates, ect..) will take time to fully restore confidence and strengthen the economic outlook.  

China is not Japan's "Lost Decade": There have been a recent uptick in headlines and concerns that China's outlook is similar to Japan in the 1990s when there was a period of economic stagnation and a significant slow-down in economic activity and the asset bubble eventually collapsed.  Notable differences:

• China's GDP per capita (12K) is much lower than that of Japan in the 1990s
• China's property bubble is not as large as Japan's during that period
• The ratio of real estate to GDP has declined and much lower than Japan was in the 90s
• Limited gains in stock prices over the past decade for Chinese indices

Right now, valuations for Chinese equities are at depressed levels, and at a time when government authorities are dedicated to restoring confidence and reinvigorating the economy. Quality businesses will continue to grow and become champion businesses in coming years. Now is the time to invest and take advantage of the very attractive valuations. As we have stated previously, it is important to consider the multiple catalysts and act now given 1) valuations are extremely cheap, 2) property market is stabilising, 3) China QE "PSL" is supporting the economy (and restoring confidence) at this juncture, 4) Chinese capital replacing international flows in Hong Kong equities market, 5) National Team providing stability, and 6) geopolitical stabilisation.

Funds operated by this manager:

Ox Capital Dynamic Emerging Markets Fund

Just Eat the Marshmallow: Why Wait When Value Is

Already on the Table?

Redwheel

January 2024

Funds operated by this manager:

Sources:

[1] Mischel W, Ebbesen EB, Zeiss AR. Cognitive and attentional mechanisms in delay of gratification. J Pers Soc Psychol. 1972 Feb;21(2):204-18. doi: 10.1037/h0032198. PMID: 5010404. (https://pubmed.ncbi.nlm.nih.gov/5010404/)

[2]We can think of a few culprits, who shall remain nameless; one rhymes with Badobe

[3] I would be one of those people

[4] In this case, 2.5% annualised per share earnings growth, a 2.0% perpetual growth rate, and a 15.0% discount rate

Key Information
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor's investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of Redwheel. This article does not constitute investment advice and the information shown is for illustrative purposes only.