The Maturing Stage of the AI and Momentum Unwind
Various AI groups have had a challenging spell of performance, with sharp declines across Korea, semiconductors and individual memory stocks as market leadership broadens.
- In the past few weeks various AI groups had a challenging spell of performance. From last month’s high, Korea is down 25%, SOX 20%, stocks such as Samsung, Micron and others anywhere between 20 and 50%. Mag-7 price relative is stabilizing of late, but it is still lagging the market on the year. AI at risk baskets continue underperforming by 20%+ ytd. We are proponents of rotation, and of broadening in 2H - see our market update report from mid June, we maintain medium term concerns over the monetization of extreme hyperscalers’ capex surge, and stay fundamentally bearish on Software, Business services and Media - AI cannibalization groups - see our Year Ahead. Rotations and momentum factor unwinds have in their initial stages tended to lead to increased overall market volatility.
- Having said that, we do not expect prolonged market weakness on the back of these rotations. It is encouraging that despite 20%+ drawdowns among many heavyweights, as per above, MXWO is so far holding within 1-2% of its all-time highs. Momentum factor has already lost a chunk of ytd performance, with technical positioning becoming less problematic. We think that various AI groups should not be falling in absolute terms for long, given likely continued strong earnings uplift, and increasing valuation support. In particular, Semiconductors should soon start to find a bid.
- The top chart shows an increasing gap that is opening between Semis price relative and earnings relative. Our view is that fundamentals will likely remain constructive, as meaningful supply additions are not due before 2028, so it would be too early at present to price in an inflection. As RSIs on Semis are fast approaching oversold territory, momentum factor excess has been to a good extent unwound, and if hyperscalers capex guidance remains strong, then we think that investors should step back into the space over summer.
- Separately, inflation rates have started to peak out in latest prints, as we looked for. This in turn could lead to lower bond yields, less pressure on central banks to be hawkish, and even to lower USD, all facilitating the broadening in market leadership. Inflation remains sensitive to Brent direction and to the Iran developments. We have been arguing consistently since 2H of March to use geopolitics driven dips to add into, and continue to do so. Volatility likely remains, but we do not see de-anchoring in inflation expectations, inflation forwards are staying well behaved, and differences to 2022 remain stark, in particular with respect to labour market dynamics, wage growth and sentiment.
- Finally, the early Q2 results are coming in strong. It might not feel like it, given some notable fades, mostly in Tech space, but aggregate stock price reactions to beats are positive so far, in both the US and in Europe - bottom chart. The hurdle rate was rising into results, which is unusual - see our Q2 preview - but we thought the reporting season would end up reassuring for the overall market. In our preview from last week, we highlighted Semis and Banks in particular as likely to deliver strong results, which should provide a floor for Semis, and is already pushing Banks higher.
- Regionally, we note that Eurozone EPS revisions have been accelerating for 15 weeks now, and have in fact fully closed the gap with the US, for the first time since Jan ’25. Unless the Iran conflict keeps re-escalating in 2H, we believe Eurozone earnings are likely to remain on an uptrend.
The maturing stage of the AI and momentum unwind
Various AI-linked equities have seen a sharp pull-back over the past few weeks. Kospi index, driven primarily by major memory players, is down 25% since the recent highs. The dramatic moves in the index triggered the sidecar, a program trading curb that pauses certain automated trades when futures move beyond preset thresholds. Other memory stocks like Micron are also down by 30%.
The correction in Tech stocks was likely driven by a number of reasons. News that Meta may be looking to sell access to its compute resources and models was seen as an indication of the company's intent to monetize its infrastructure and preserve flexibility around utilization. This led to concerns about over-build risk, questioning future hyperscaler capital spending and the timing of when additional demand for AI chips and memory might materialize. In addition, reports that Apple has been weighing the possibility of buying memory from Chinese vendors added to fears around the possible threat to the pricing power and margins of established Korean players should Chinese capacity ramp up.
SOX is also down 20% since the highs.
Mag-7 price relative has been stabilizing, but it is still lagging the market on the year.
AI at risk baskets continue to lose 20%+ relative ytd. We remain fundamentally bearish on AI cannibalisation groups, including Software, Business Services and Media.
Worries about an increasing focus on token efficiency has also likely weighed on these names, as well as newsflow around Chinese AI labs like Moonshot closing the Technology gap with the US.
While some shift in fundamentals was also in play, the bulk of the drawdown was likely driven by technicals. Until last week, the surge in chip stocks had pushed positioning indicators to the highest level since ‘99-’00.
SOX RSI is approaching the “Oversold” threshold.
In addition, the rapid growth in leveraged ETFs, particularly with the launch of single-stock leveraged ETFs, has contributed to the dramatic rise in volatility in Korean equities.
Cyclical sectors are outperforming Defensives, ahead by 5% ytd in Europe, and 7% in US. We believe this will continue through 2H, underpinned by healthy earnings delivery and a constructive macro backdrop.
Within the Cyclical group, Consumer sectors were the one space to lag meaningfully, but have shown signs of participating in the rally more recently. A number of consumer sub-sectors have been trading off their lows over the past few months.
It is encouraging that, despite major drawdowns among many heavyweights, the MXWO index is still near all-time highs.
Momentum factor, which saw a strong run until June of this year, has now unwound a large part of its ytd gains.
At the same time, technical positioning has become less stretched.
The Mag7 group is now trading at 1 standard deviation cheap on the relative P/E metric.
Our Tech analysts maintain their bullish view on the sector, driven by (1) the crucial role semis play in the tech value chain, (2) increasing content tailwind opportunities in all applications, and (3) structural profitability/FCF improvements, all of which remain intact. Importantly, secular growth in semiconductor industry revenue is being amplified by strong tailwinds from accelerated growth in data center capex. They expect this wave of spending to be sustained beyond 2026, benefitting the entire Semis value chain.
Despite the faltering conviction in Memory names recently, we note that DRAM prices have stayed elevated. Our global Tech team point to structural DRAM/NAND supply-demand tightness now extending through 2028, aligning with Micron’s recently revised expectation of S/D tightness beyond 2027, as surging AI/server-driven demand and HBM prioritization keep conventional DRAM and NAND supply tight.
The team expects this supply/demand tightness to result in healthy DRAM and NAND revenue growth over the next 3 years.
Interestingly, an increasing gap is opening between Semis price relative and earnings relative, where Semis stocks have rolled over despite continued earnings resilience. With fundamentals staying strong, we think that investors should add to the space over the summer.
Inflation peaking facilitates the broadening trade
Inflation rates have started to peak out in the latest prints, as we had anticipated. US headline CPI on a 3-month seasonally adjusted annualised basis has moved from 8.2% in May to 2.8% in the June reading, while Eurozone sequential inflation has similarly decelerated.
This is helped by the mechanical consequence of Brent being down approximately 25% quarter-on-quarter, with the passthrough to headline CPI now becoming visible in the data.
If oil prices stay at current levels, the base effects from the Q1/Q2 energy shock will mechanically push headline CPI lower through the second half. This matters enormously for the broadening trade as it should help real disposable incomes, reduce the upward pressure on bond yields, and diminish the case for central banks to keep tightening.
We see big differences from the 2022 template. Wage growth is moving lower this time around, corporates are unlikely to exhibit sustained pricing power, and inflation expectations remain well-anchored.
Long-term inflation expectations have remained well-behaved throughout the conflict-driven energy shock.
US 5Y5Y inflation forwards have stayed within a 25bp range, never breaching 2.60%. This is a critical distinction from 2022, when inflation expectations showed signs of de-anchoring. We believe this gives central banks the flexibility to be less hawkish than what is currently priced, which in turn supports equity multiples and facilitates the rotation into lagging cyclical areas.
The peaking in inflation should in turn lead to lower bond yields, less pressure on central banks to be hawkish, and potentially to a lower USD. We note that the US 2-year yield has already started to edge lower from its recent highs, and believe the hawkish repricing that occurred in June may prove to be the high watermark for this cycle. Markets are still pricing approximately 90bp of Fed tightening since the conflict escalated, which we believe to be excessive and will be gradually unwound.
We have been arguing consistently since the second half of March to use geopolitics-driven dips to add into equity exposure, and we continue to do so. The Iran conflict remains volatile with renewed escalation in the last few days. Even so, we think markets are increasingly adept at treating geopolitical risk as transitory, particularly as there remain strong incentives on both sides to de-escalate. Volatility likely remains, but we do not see this as a reason to reduce overall equity exposure.
Each successive geopolitical shock has produced a smaller drawdown followed by a relatively quick recovery, consistent with the idea that the risk is transitory. We believe the latest episode will follow the same pattern.
Earnings to offer support
The early Q2 results are coming in strong, with supportive stock price reactions. Of the companies that have reported so far, the beat rate is running at approximately 97%, modestly above the long-term average of 76%.
Even in Europe, earnings beats are tracking well above the historical average.
Encouragingly, stock price reaction to earnings beats is strongly positive.
In our preview from last week, we highlighted Semis and Banks in particular as likely to deliver strong results, helping equities performance. The early prints confirm this view. TSMC's results showed continued order momentum and positive commentary on 2027 capacity plans, while Banks are reporting resilient net interest income and strong investment banking revenues. We expect this pattern to continue as the bulk of reporting occurs over the coming weeks.
This is true in Europe too.
The hurdle rate was rising all the way into the results, something which does not typically happen. Despite this elevated bar, our view was that that the reporting season would end up reassuring for the overall market, given the supportive macro backdrop and the breadth of fundamental improvement.
Eurozone EPS revisions have gathered notable momentum in recent weeks, with the revisions ratio now fully converging with the US. We view this as a significant development. That said, we see the current backdrop as increasingly supportive of a European earnings catch-up, underpinned by improved operating leverage as revenues recover, fiscal impulse flowing through to Industrials and Defence, and a softer EUR providing a tailwind for export-oriented corporates.
The breadth of the improvement is notable. Seven of the Level 1 sectors have seen positive revisions momentum over the past six weeks, with the improvement broad-based across Cyclicals and even extending to some Defensive areas. Energy and IT lead in absolute terms, but the acceleration is also evident in Materials, Industrials and Communication Services i.e. sectors tied to the fiscal impulse and global trade recovery.
We remain constructive on equities at the overall market level, and believe the current rotation is healthy rather than threatening. The combination of peaking inflation, strong earnings delivery, lighter positioning post-correction, and the broadening in market leadership all argue for further upside in 2H. Within this framework, we favour Cyclicals over Defensives, Eurozone over the US on a relative basis, and see Semiconductors as a compelling tactical opportunity following the recent correction. We continue to avoid the AI cannibalisation groups (Software, Business Services, Media) and Energy equities.