A continued selloff in the AI trade is forcing investors to move from tech names to the relative safety of government bonds and defensive stock sectors
Defensive plays are picking up steam.
A sharp selloff in shares of companies closely tied to the AI trade is driving investors toward safety, sparking a rotation into defensive stocks and fueling a surprise rally in hard-hit Treasury notes and bonds.
Treasury yields were slumping across the curve early Thursday as bonds headed for their biggest one-day rally in at least a year. Bond yields move inversely to bond prices, falling as prices rise, and vice versa.
The yield on the 10-year Treasury bond BX:TMUBMUSD10Y was off 14 basis points, to 5.064%, on pace for its largest one-day decline in over a year, while the 30-year rate BX:TMUBMUSD30Y was also sliding 13 basis points, at 5.394%, on track for its biggest drop since November 2024, according to Dow Jones Market Data.
Bonds continued to rally even after another inflation report showed price pressures picked up last month by an even greater degree than economists had expected. The data boosted the perceived odds of another Federal Reserve interest-rate hike later this month, but bond investors didn't seem to care.
Instead, worries that a slowdown in the AI-investment boom could weigh on economic growth appeared to overshadow the latest inflation data, according to Mike Thompson, co-portfolio manager at Little Harbor Advisors.
"With the AI trade coming acutely under pressure, if your read-through is that slowing AI spending leads to reduced capital expenditure, you can paint a macroeconomic picture where GDP slows dramatically. That allows Treasurys to rally even against a hot CPI print," Thompson said.
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Skepticism about returns on investment on the massive spending on AI by some of the world's largest tech companies is sparking another "tech wreck," as stocks associated with the AI build-out were coming under pressure. Semiconductor stocks and AI power plays have been hit particularly hard. Reports about stalled revenue growth at Anthropic have also stoked concerns about the health of the broader AI ecosystem.
In addition to buying up Treasurys, investors also appeared to be shifting money into defensive stocks, like those belonging to the consumer staples XX:SP500.30 and healthcare XX:SP500.35 sectors. Both sectors have been among the best performers on the S&P 500 on Wednesday and Thursday.
Thompson pointed out that some bellwether healthcare names, like Eli Lilly, were trading near their highest levels in a year, a promising sign that healthcare stocks could continue to climb.
Meanwhile, the violence of this week's rally in Treasurys could be due in part to hedge funds and other investors' betting against bonds - something that had become a hot trade as of late.
Data released by the Commodity Futures Trading Commission recently showed that bets against Treasury futures had reached extreme levels relative to history. With sentiment so bearish, the magnitude of this recent snapback rally makes more sense, Thompson told MarketWatch.
How to play it
Back in July, when a powerful semiconductor-led momentum trade endured a major crash, investors rotating into other sectors away from the AI trade limited the damage at the index level.
For investors worried that the pain at the index level might be even more intense this time around, there is still one powerful silver lining: Defensive options bets still look relatively cheap. The Cboe Volatility Index VIX, better known as the VIX or Wall Street's "fear gauge," remained well below its long-term average on Thursday. It stood slightly above 17 in recent trade, compared with a long-term average closer to 20.
Investors can buy calls on the VIX, or put options on the S&P 500, Thompson said. Both would likely pay off if the S&P 500 takes a sudden sharp turn lower.
"Spot VIX sitting around 17.5 doesn't seem particularly high given the level of market turbulence, which means options protection isn't crazy expensive right now," he added.
U.S. stocks traded mostly in the red Thursday morning. Strength in defensive stocks helped boost the Dow Jones Industrial Average DJIA, which was trading in the green. Meanwhile, the S&P 500 SPX and tech-heavy Nasdaq Composite COMP were trading lower.
-Isabel Wang -Joseph Adinolfi
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