Bond Market Turmoil Sparks Concern for AI Sector's Momentum

Tech and AI Stocks Continue to Rally, But Rising Yields Cast a Shadow

Investors remain fervently optimistic about the hot rally in tech and AI stocks, with 80% of 32 investment managers across the US, Asia, and Europe, including those at Wells Fargo Investment Institute, Amundi SA, and BMO Global Asset Management, expecting equities to outperform other asset classes such as commodities or bonds over the next three to six months.

The top investment choice for about half of these buy-side professionals is the megacap tech and artificial intelligence stocks at the heart of a seven-week, record-setting surge in the S&P 500 Index. This rally is fueled by the return of AI as a key investment thesis and powerful earnings growth, despite concerns about companies overspending.

Read also: SpaceX Seeks Record $75 Billion IPO, Potentially Positioning Elon Musk as the World's First Trillionaire

The tech-heavy indexes, such as the Nasdaq 100 and the SOX, have hit repeated records in a sharp rebound from their Iran-war lows. However, a closer look beneath the index-level moves reveals that the rally is extremely concentrated and displays signs of overheating. Just four stocks are responsible for more than half of the S&P 500's gains this year, and the SOX currently trades at more than 25 times forward earnings, well above its average of 19 over the past decade.

Positioning has turned far more crowded, and technical signals are flashing overbought levels, making the setup a lot more fragile. Most investors interviewed pointed to the yield on 30-year Treasuries holding sustainably above 5% as the "danger zone" for stocks.

Rising yields are a major concern, and apprehension is creeping higher as the impasse in the Strait of Hormuz persists, increasing the risk of elevated oil prices feeding into inflation and harming the economy. On Friday, a global rout in government bonds sent longer-dated Treasury yields to nearly their 2023 peak.

Long-term interest rates "sit at the crossroads of the cost of capital for AI capex and private credit," affecting the financing of government deficits and potentially having an "adverse impact" on consumer wealth. Stagflation and hawkish central banks were cited by many investors as key risks the market is failing to price properly.

Read also: Treasury Yields Experience Largest Increase in Two Weeks Following Release of Labor Market Data

While investors are optimistic about equities, worries over stagflation and rate hikes were topped only by the fear that over-optimism about corporate earnings will come back to bite investors. Confidence around growing profits has been a cornerstone of this rally, helped along by an exceptionally strong reporting season.

In the US, earnings per share for S&P 500 members have climbed more than 27% in the first quarter from a year earlier, more than double analyst expectations. It's the strongest growth rate since 2004, outside of recoveries from major shocks. European results have also surpassed projections, albeit with a more modest 7.5% annual improvement.

"If earnings were to hit an air pocket, a lot more investors would consider selling equities, since it's the bedrock of their investment thesis," said Sameer Samana, head of global equities and real assets at Wells Fargo Investment Institute.

The rally took a breather on Friday, but not before the S&P 500 and the Nasdaq 100 both charted fresh all-time highs during the week. It's the type of performance that sustains faith among stock bulls about where the best returns in coming months lie.