US midterm results prompt AI trade shift from semiconductors to hyperscalers, says Citi Research

Question

A big move that we saw in the markets overnight, and now that smile has turned into a big laughter as well. You know, give me a sense on the two things. One, the what the price action is suggesting, after you know the results that came in yesterday, that there would be de-escalation in the Iran war, and the second part is that the AI trade may come off. On both those, what are your thoughts? Because the price action so suggests, but the reality may be a little different as well.

Answer:

Yeah, I think you’re spot on with that, and your summary of what’s transpired overnight was excellent. We were expecting a blue sweep. I would say that the Democrats took more seats in the Senate than consensus was expecting. So that was a surprise that we’ll come back to, but importantly, also in some of the state races, you also saw party shift over to Democrats, and this is important because this ties back to the local dynamics at work when you’re looking at this AI infrastructure build out. So let’s cover that first. If you are concerned that there’s going to be increased moratorium or scrutiny on AI buildouts, this whole infrastructure play, then that has lots and lots of implications. As you pointed out, it’s negative initially for the semiconductor space, but then it’s positive for anybody that already possesses AI compute, which is why you saw some of these hyperscalers run today. In addition, though, there’s been ongoing and nagging concern about the ability to finance a lot of this expected capex. So on the premise that you slow that pace of build out, what you’ve also seen benefit today are those parts of the market where that concern was prevalent. You’re seeing it in areas of the financials. You’re seeing it in, in areas of, let’s say, the, the asset management component of financials, and so all of this is telling us that what’s happened here is a sentiment shift that’s triggering a repositioning away from these hot spots. And that’s why you see the stronger action in the hyperscalers, areas of software, but weaker action in the semis.

Question

Just a quick word on suppliers to these hyperscalers. Where do they fit in? For example, here in India, we don’t have very many AI plays, but we’ve got suppliers, optic fibre guys, cable companies. We’ve got, I mean, their entire ecosystem, right? And stocks in this space have, has done phenomenally well. Looking at what has happened in the U.S., where hyperscalers have done well and the socks was lower. What’s the indication for the supplier ecosystem, according to you?

Answer:

This is sort of a sentiment move right now. What we know or think we know is that for a lot of those component suppliers into the AI build out, the market has already been pricing in 26 and 27 fundamental improvement. There’s been an ongoing debate in the US markets in terms of the persistence of that capex build-out into 28 and beyond. So what’s happened here as you pull forward this concern, now introducing a political component in addition to the financing component, you’re drawing these companies down. Ultimately, we would expect that a lot of the moratorium discussion on AI and data centres, it will find resolution. It might stretch out the build cycle, but it doesn’t completely eliminate it. So what you’re getting, as I keep coming back to, is a repositioning now. Ultimately, that set should set up for those companies as we let the dust settle on this current trade.

Question

The Philadelphia Semiconductor Index, that is for supplier ecosystem around the world. Is that the index to look at to take cues from?

Answer:

Yep. Pretty much. I think that’s where you’re going to capture most of it. You’re not going to see as much of it in the Nasdaq because the Nasdaq has a more balanced weight. So I think you keep your eye on the semiconductor component for now. That’s where we’re going to get the most evidence of this. And like I said, we’re still unwinding a lot of the bottlenecks. Play that you had unfold during the second quarter. So I come back to this notion that it had been a sticky plate. It has begun to unwind. The news flow on the elections, combined with this financing dynamic begin to cause some disruption in that. But ultimately, what we’re still looking at in terms of the AI setup is excess demand versus supply, compute supply, and so the supply-demand dynamics are still very constructive here. So we need some settling out, but ultimately, even if the pace of capex falls, we should end up in a fairly comfortable place. Yet there’s still some legs to the longer-term play.

Question

Given the fact that the yields have cooled off, global yields as well as the US 10-year yield in particular, 50 basis points is no mean feat, and the dollar index is a little bit softish. What is your view on emerging markets, particularly India, because we have got the additional trigger with regard to crude oil prices that have cooled off, and we are net importers. Your take?

Answer:

Let’s pivot now from the AI play to the, I call it the triumvirate. Oil prices leads inflation expectations leads interest rate concerns. So, if you’re of the view that the blue sweep is going to lead to a more conciliatory approach to Iran in resolving that conflict, that’s a big if, by the way. But if you’re of that view, then what you get is what we saw today: oil prices falling. You’ve taken out one of the expected Fed rate hikes. You know that was expected to unfold next year. That’s now come out of the market. You’ve seen 10-year yields come down. That also, by the way, is going to be influenced if you think there’s going to be lesser than previous supply of debt financing for the AI build out, so it’s all integrated. Now to get to EM specifically, there was one element that you left out in the earlier summary of what’s happening here, and that is with this blue sweep, not only do you trigger the oil price retreat around the Iran conflict, but you also look at the Trump policies regarding tariffs from 2025, which have been lingering, and they’ve been embedded in investor sentiment for over a year now. So I think what you also get with the blue sweep is an expectation that we see some lessening pressure from tariffs. The combination of lower oil prices, I would expect, benefits emerging markets. Taking some pressure off of the tariff discussion, I think, can do the same thing. So the combination of the two is why you’re seeing a broadening effect today, and it does open the door for rally opportunities in other parts of the world. I’d also say in the US. Apart from the large cap S&P 500, it also does set up for broadening down cap in the US mid as well.

Question

What’s your team telling you about whether oil will stay lower, which then goes back to essentially what happens with Iran, etc.? I mentioned earlier, Iran war is being blamed for it by no less than people like JD Vance. So markets are expecting that this is now solved quickly and maybe some resolution. What’s your view? Will this big move done now, and prices stay behaved?

Answer:

I think this is easier said than done. Resolving the Iranian conflict and finding that negotiation path where both sides feel they’re getting something is still elusive. And as I’ve been saying for several months now, if there’s one element of the equity markets has been really difficult to get conviction on, it’s been how to resolve the Iran conflict. Now that said, I think these steps begin to change the sentiment around this. But also, what we have been keeping in the back of our minds is that upon reopening of the Strait in a more fully approach and some lessening of some of the logistics expense. Our commodities team has been suggesting there’s significant downside in the price of oil. So even though we’ve seen the 10% or so correction today, in a full resolution and a full reopening, you would still have further downside to the oil price. I don’t know that it’s something that we can make a call on with high confidence. But it’s been in the back of our minds for several months now. It’s part of why, going into Q4, we went underweight the energy sector, as an example.

Question

The other big issue has been the Fed, right? A very confrontational sort of executive versus Fed. Those concerns also cool off, you think, which is positive markets?

Answer:

What happened today is that there had been an expectation in the markets for three additional Fed rate hikes between now and next fall. As of today, we’re pricing in two hikes. So, the market is implicitly assuming that if you do take some pressure off of oil prices, perhaps take some pressure off of the tariff discussion, that resolves via lesser inflation. And we know one thing about the Fed with Warsh as the chair is that they’ve been fairly hawkish on this inflation aspect. So if you lessen that, then do take a little bit of pressure off of the Fed, but I’d say at this point it’s really one step at a time on that. Again, this isn’t going to resolve overnight. The market is pricing in a changing paradigm, if you will. But the fundamental influence of all of this is still months ahead.