The electrifying rally fueled by artificial intelligence may be losing steam, and investors are seeking refuge. Capital Economics, a firm that accurately predicted a slowdown in the AI trade earlier this year, is now advising a strategic retreat into traditional defensive sectors.
James Reilly, a senior markets economist at Capital Economics, had warned in September that the "AI equity boom is nearing an end." Now, the firm suggests that sectors like real estate and consumer staples offer the best sanctuary as the momentum in AI stocks falters.
In a stark forecast, Capital Economics anticipates that the S&P 500 could tumble to 6,500 by the end of 2027, a potential 16% decline, if the AI bubble deflates gradually or bursts. However, before this potential reckoning, the firm sees a possibility of a "final rally in the stock market, led by tech stocks, this year." Investors are advised to consider defensive sectors as a haven "over the next 12 months."
The firm also highlights U.S. Treasurys as a crucial counterbalance to an AI bust. Capital Economics expects Treasury yields to decline, which would lead to higher bond prices. Historically, when the PHLX Semiconductor Sector Index (SOX) has dropped 35% or more, the 10-year Treasury yield has fallen eight times since 1995. Real estate could benefit from falling yields, as it has historically performed better during SOX selloffs accompanied by declining yields, compared to sectors like energy and financials.
Despite potential benefits, Capital Economics cautions that even real estate would experience a decline, albeit less severe than the broader market, in the event of an AI bust. For an even more robust defense, the firm points to consumer staples, citing its strong performance after the tech stock peak in the early 2000s.
The recent pressure on AI-related stocks stems from investor concerns about megacap tech giants like Meta Platforms, Microsoft, Amazon, and Alphabet pouring billions into AI infrastructure without generating adequate returns. Elevated capital expenditures are impacting these companies' cash flows and profits. Recent earnings reports from Alphabet and Meta have shown negative free cash flow, with Meta also increasing its full-year capital expenditure commitments.
Unlike previous tech downturns, Capital Economics believes that energy and financials are unlikely to provide a stable footing this time. These sectors have performed better recently than in past tech selloffs, not due to inherent resilience against AI-driven market shifts, but because of recent supply shocks, particularly in energy commodities, which have inflated energy prices and, consequently, Treasury yields.
