Tim Graf (TG): This is Street Signals, a weekly conversation about markets and macro brought to you by State Street Global Markets. I'm your host Tim Graf, European Head of Macro Strategy.

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And with that, here's what's on our minds this week.

TG: It wasn't supposed to go like this. The consensus was that US stocks, which make up something like 60 percent of global equity market capitalization, would have another great year, led by further gains in tech stocks, which make up about 40 percent of that US market cap. But of course, things have gone horribly wrong the last few months for tech, for US stocks and in fact for the performance of most of the trades that were associated with the election of Donald Trump.

This week, to talk about why that is and how to now think about this large, underperforming corner of the stock market for the coming months, I'm pleased to bring back Cayla Seder, a senior strategist from our team in the US who focuses primarily on equity markets.

TG: Howdy.

Cayla Seder (CS): How are you?

TG: Good. How's it going?

CS: Oh, it's good.

TG: Oh, it's good. Is it as sunny there as it is here?

CS: It is, actually. It's a little chilly, but...

TG: Yeah, yeah, that's fine. We'll take that. That's what it is here. It's not 18 hours of darkness, which I'll take.

CS: Yeah.

TG: So to kick things off with just a few numbers, very high level, there were expectations this was going to be a good year for US equities. But so far, year to date, S&P 500 is down about 1 percent and about 5 percent from its peak. Tech and Communication Services, the Magnificent 7, which is what we're going to talk about mostly, is down 6 percent year to date and 9 percent from its peak. So we are almost in correction territory. And finally, US stocks have underperformed Europe by about 10 percent. And there are, of course, European reasons for this too, particularly on the defense side of things.

I wanted to just lay that out there. I wanted to see if you could start and set the scene with a very broad overview of what our behavioral metrics say, these institutional investor measures of flow and positioning. And let's, I guess, let's cast back to the end of last year, since I did everything year to date.

What did positioning look like then? And we'll then get to what does it look like now and what flows have been doing. So if maybe you could start with, what did it look like then?

CS: So I would say the theme heading into the end of last year was concentration risk was pretty high. You had very few overweights. The most overweight sector was tech, followed by communications. You had something of an overweight in financials, but by and large, neutral or underweight every other sector. So you had a lot of concentration risk heading into this year.

From a regional perspective, the sole overweight was US and really underweight most of the rest of the world. Within the sector level positions, can you drill down a little bit and talk about specific industries, industry groups? Where were those overweights concentrated? And maybe were there any elements within large cap tech that institutions really weren't interested in?

So there's a couple of ways to slice that. I would say when we look at industry groups, the heaviest overweights were in tech hardware and semis. So, for example, when we look at global semis, on January 1, positioning was around the 86th percentile. And just for context, when we talk about percentiles, that's a five-year look back period Pretty heavy overweights, especially in that tech hardware space. Software was slightly less. So, for example, in the US, software positioning was in the 65th percentile.

They have decreased their exposure across all three, but not that much from the perspective that, when we look at positioning today, for example, semi-positioning is in the 72nd percentile. Tech hardware went from 88 to 83. Software is right around the 60th percentile.

So, we don't see this huge exodus, but I think what this shows is that investors want to diversify a little bit. They don't want to move away entirely from high-quality parts of the market, and we can talk a little bit more around what that looks like. But they're trying to be pragmatic, I think, and there's a lot more uncertainty out there, and though I think the way you deal with uncertainty is to diversify a little bit.

TG: Yeah. Well, can we talk then about flows? You've mentioned some of the reduction in positions, and I know that, especially on the hardware side of things, some of this began almost six, eight weeks ago. And I'm just curious what things look like now, maybe the last week or even the last month.

Where would you say the selling is most heavily concentrated? And you talked about diversification. I definitely want to cover that. I wanted to hear about where money is going as well.

CS: Where we see money trending now is, we actually have started to see an increase in demand for US tech hardware. So we're seeing net buying now, and we had been seeing net selling. And most of the selling in terms of like when we look at our flows, the strongest outflows have been in semis actually. But that selling has started to reverse. We're not seeing net buying yet, but it looks like we've seen the maximum selling. And so we're starting to see some of that selling slow.

The one place where we do see selling accelerating, so a movement from net buying to selling is in software. So what that means if we take a step back, because there's kind of a couple of mixed signals there, I would say the big picture is that money is moving into tech. This is being driven by tech hardware and less selling of semis.
It's being counteracted, though, by more selling of software.

TG: Okay. What about the overall approach to equities? We have these asset class indicators that look at things from a very high level. You know, the US, you mentioned the concentration risk. And the US is, you know, in global equities, concentration risk writ very, very large.

Has there been any movement away from equities as an asset class over the last two months, really, in the year to date period?

CS: We're pretty close to flat. However, and I think that's kind of surprising, because over the past two weeks, you've seen a lot of news around, okay, A, is it time for fixed income now? And then B, you know, you've seen a lot of nervousness.

As you mentioned at the start of our conversation, US equities have not had a good year. When we think about what's happening from the asset allocation perspective, over the past few weeks, we have seen a movement out of equities and into cash, actually. We still see cash growing. If you're thinking about your choices here, equities, fixed income or cash, there's a couple of things I think that are important to keep in mind.

The front end of the yield curve is still inverted. So I'm talking like bills versus two years. That keeps cash attractive for now. It's going to be a challenge to see allocation move from equities to fixed income until you see the front end of the yield curve dis-invert. Over the past two weeks, you have started to see some pressure. Year to date, though, that pressure doesn't look that extreme.

TG: Yeah, that's super interesting, as you say. It doesn't necessarily line up with the price action or the performance of equities versus bonds. But I think we'll get to kind of maybe why that is towards the end when we think about the future and what we make of it all. I want to now shift to fundamentals. We've, of course, just come through earnings season.

And look, I'm not an equity person. So anytime I see good news, in my view, is good news, at least. The market sells off and when I see bad news, things rally. So I'm not a good judge of this, but it seems like things were okay, at least on the fundamental side of things.

I mean, what did you make of earnings season in general for the US, but in particular and specifically for these tech names?

CS: The big picture generally is that there is a lot of trepidation around tech, and there's questions around whether or not earnings will continue to be able to deliver, especially if valuations are expensive.

I was, when we think about more specifics, so although we don't do stock specific recommendations, I do look at earnings of these companies. And so when we look at, for example, NVIDIA, I thought NVIDIA's earnings were quite strong, right? There was concerns around revenues. Do we see signs that revenue growth is healthy? Do we see signs that demand is going to continue? My read from the earnings was yes. Demand continues to be strong. Revenues beat forecasts, expectations for Q1 were higher than expected. That was a really good sign.

The disappointment, however, came from profitability. How profitable, especially post, you know, we had the deep seek news, how profitable are some of these semis companies? And that's where some of the sell-off came, I think, because gross margin forecasts were lower than expected. However, I think it's really important to put these into context. So when we look at gross margin forecasts for Nvidia, it was something like 70.5 percent versus 71.5, 72.

And yeah, you're laughing because those are solid numbers. And what that tells me is that this general concern about profitability is a bit overblown.

What also worries people, though, is valuations. Is tech too expensive? Are multiples too high? And when we look at valuations today versus, let's say, the.com bubble, because I've gotten a couple of questions, do you think we're in a bubble? And the first place I usually go is valuations and fundamentals.

So one thing that's different today versus the.com bubble is that the deviation of valuations today across sectors is much smaller than it was in the early 2000s. Tech might feel expensive, but everything else is still expensive. There aren't many other great choices.

To me, what that says is some of this rotation, there's a limit to how far that rotation can go.

TG: The parallel to the.com era is really interesting. And that was Tim Graf formative years in terms of learning about markets. And that was a very, very narrative heavy market. And markets, as our research talks about a lot, markets are always narrative driven. But that was a ‘tech is going to change the world, and everything will be put on the internet’.

And to a degree, that was true. Certainly, you know, the winners or the survivors from that were Amazon, as the prime example, Google, now Alphabet, the key examples of those who had huge corrections, but ultimately survived.

And we now have AI. NVIDIA is the poster child of that. So thinking about the AI narrative, or the theme that has driven NVIDIA, as well as many of these other companies that are within the industry groups you've talked about.

Is this simply in your view a shift in the narrative, or for lack of a better way of putting it, a shift in risk appetite around this theme? Or is it really the fundamentals and the questions and the valuation concerns you ask? What do you think is the bigger factor there?

CS: It's increased uncertainty around whether or not we've reached the peak in AI. I don't think we have for three reasons.

One is, and we actually asked our clients this, right? A, have we reached the peak in AI? And if we haven't, when? And it was really interesting to see the results. 32 percent said, we've reached the peak. 18 percent said, no, no, no, it's going to happen in the second half of this year, but it's close. 23 percent said, it's going to be in 2026. And then 27 percent said, it's post 2026.

To me, that says we have a pretty divided client base. Someone's going to be wrong, someone's going to be right, but no one's really sure right now. If you think about Moore's Law and you believe in Moore's Law, the observation that the number of transistors on a microchip doubles every two years, whether or not that specifically is true isn't really my point. My point is that that belief that we continue to see development in this AI story, and I don't think there's much in the story that's going to change that trajectory.

The reason why that is, is my third reason why I don't think AI has peaked, and that's because we need AI to continue to grow. If you think economic growth is going to continue, it's really hard to say economic growth, GDP, will continue in the long term without AI. And one reason for that is demographics. We have a demographic issue in the US. We don't have a growing labor force without immigration.

One way to help that productivity gap without having a greater labor force is AI. We've seen an increased number of firms mention AI in their earnings calls. And it's not just tech companies. If we think about 2022, 153 companies in the S&P mentioned AI in their earnings calls. 71 percent of those mentions were tech companies. If we look at February 2025, so three years later, tech is only responsible for about 60 percent of those mentions. So what that tells me is, it's not just tech companies starting to talk about AI.

It's a lot of other kinds of companies, and they're planning to implement AI to help their businesses grow. Those are reasons why I don't think this AI story is over just yet.

TG: Do you have a good feel for when that spread of AI's benefits might start to affect the bottom line? And exactly to your point, non-tech companies finding a use for the productivity gains available from AI. How far down that road do you think we are? And how much further do we need to go?

CS: I don't see an end right now. With that, I think for investors, what matters is are these investments into AI too costly? And so that brings it back to the fundamental story. This is something that we were looking for in earnings season this year. Are some of these AI implementers that had been investing a lot of money, should we be concerned about profitability? Because they're spending too much on AI.

And one thing that we saw in earnings is that the answer was really no. We still saw revenue growth was accelerating above five-year averages and faster than the rest of the S&P. So here I'm talking software, tech hardware, parts of the market like that. So they still have growing demand. They still have margins that are significantly higher than the rest of the market.

And then if you're concerned about whether or not they're investing too much in AI and their capex spending is too high, look at free cash flows. Are free cash flows still growing despite these investments? And what we see is free cash flow is still growing. So they still have excess money that can be put to good work. And that coupled with return on equity and being concerned about, are these companies putting their equity to good use? Are they too levered? Things like that. When you look at these parts of the market, they still have high ROE levels.

What that tells us is that these investments into AI are not hurting underlying fundamentals. I think this AI story can continue because their fundamentals still support it.

TG: As we make our way toward an outlook here, we will get there. But just thinking big picture about price action, we joked before we started the recording that we weren't going to necessarily talk about politics.

But it's hard to avoid it, especially as we record this on Tuesday afternoon at 3 o'clock UK time, where we're getting all sorts of headlines about tariffs, and we had ISM numbers the other day, that I think every single detail within that survey was about weaker demand and higher prices because of political actions, specifically tariffs.

And so as a capstone question to kind of what has happened, what is the balance in your view between the reaction to those headlines and the approach of investors and their risk appetite versus some of the maybe more cloudy outlook concerns you highlighted in discussing the earnings season?

CS: I think when it comes to allocation, what we've learned from the data so far, which is generally weakening soft data, hard data is still okay. What does that mean for my portfolio? I tie it back a lot to rates. What is going to happen to rates? And what does that mean for the sectors that I have more exposure to or less exposure to?
Right now, we're in this environment where it looks like the Fed can be patient, and rates are likely to stay where they are, at least for a couple more months.

We've seen markets start to move up to possibly three cuts this year, but simultaneously, inflation is still proving to be sticky here in the US. It's probably hard to justify too much rotation away from tech because we're in an environment where interest rates are probably going to stay where they are.

We would probably need to see strong signs of rolling over in the labor market and in consumer spending, and we haven't really seen that just yet. It's hard to move away from tech because tech has proven its relatively interest-rate insensitive.

However, where do you want to add exposure from here? And I think there's a case to add exposure to more defensive parts of the market. So looking for places that have lower beta and higher ROE. And so within defensives, the two best sectors for that would be staples and healthcare.

Utilities have been a big part of this AI conversation. And we don't really like utilities right now for a couple of reasons. And this might sound a little counterintuitive, because I've spent the last 20 minutes talking about how great tech is. However, we do have a couple of concerns about utilities. I think there's this theory behind utilities that we're going to see so much more energy demand. And we're going to see data center usage grow, things like that. That has to be provided by a lot of utility companies.

Our concerns with utilities are that interest rates matter for utilities because their cost of borrowing is really high. So this build-out that AI will require is going to be really expensive. Also, they have relatively low levels of ROE. They're relatively lower quality defensives. And if you already have a lot of AI exposure, why would you add AI exposure to a lower quality part of the market that also has AI exposure? I think that's why places like staples and healthcare makes a bit more sense.

TG: Okay, so that's really interesting in thinking about the utilities case. Because one of the things that's really caught my eye in the media is the story about Microsoft canceling licenses on data centers.

Not to bring it all the way back to tech just yet, but does that concern you in any way that there's less of demand for data center capabilities that also maybe feeds in to a negative utility story?

CS: I don't think so, because I think this is a sign that companies are being more strategic about where they're getting their energy. So, for example, with Microsoft, in 2024, they announced that they were going to be working with a utility company, Constellation Energy, to reopen Three Mile Island. So, in Pennsylvania, nuclear power plant.

Originally, they had been shooting for a 2028 start date, and there are reports that that reopening is proceeding ahead of schedule. And to put some of that into context, it would provide around more than 800 megawatts of carbon-free energy. The report about Microsoft closing leases on some of their data centers was a couple of hundred megawatts of capacity. That more than compensates for it.

The second thing too, is that Microsoft still says that their estimates of AI and Cloud CapEx spending is on target for around US$80 billion this fiscal year. So that hasn't decreased even though there's reports of them closing or ending their leases with data centers. And we've actually seen more reports coming out that they have been investing in other parts of the US to open even more data centers. If we're concerned about demand for AI and demand for energy on the back of AI, the holistic picture is that, no, there's still plenty of demand.

TG: So thinking about the allocation to tech then now amidst what is, as I say, we're close to correction territory in the S&Ps index of IT and communication services.

Do you just wait it out a little bit longer, maybe think a bit tactically about getting back into your what is a positive case still for you for this sector? Or do you just see this as an opportunity for right now?

CS: I think there's an opportunity right now because we see selling slowing in our data. If we were seeing real money continuing to sell at the same pace or an accelerating pace, I think I would hold off. But because we're starting to see long-term investors become less bearish on the sector, I think this could be an opportunity.

TG: And thinking beyond that then as a final question, what gets these stocks back on track? What do you think is the most important fundamental, political, narrative, one of those three or something that I haven't said, driver for both a return of absolute performance as well as better relative performance for these stocks?

CS: I do think all roads still lead to the Fed. If we're in an environment where interest rates stay where they are, I think you're going to see relative performance start to improve. If we see growth deteriorate and we start to see some of that hard data show that there's recession concerns or even potentially stagflation concerns, it's going to be hard for equities as a whole to outperform.

We usually look at the world from a relative perspective. If you do see growth roll over, a lot of investors are going to unwind their positions, what they have the highest risk allocation to. If we see growth really roll over, it's going to be hard for tech to perform well. However, there's a limit to that. And I think that's going to be the first thing that comes back if we start to see signs of improvement in hard data.

TG: Very good. Well, we have to wait and see. You've highlighted where the opportunity is. It appears it is right now, but we got to look out for the growth concerns that are building around the US economy. I suppose that's for a future podcast. Cayla, on this one, thank you so much. It's been great to catch up and it's been great to do a real deep dive on this sector.

CS: Thanks, Tim.

TG: Thanks for listening to this week's edition of Street Signals from the research team at State Street Global Markets. This podcast and all of our research can be found at our web portal Insights. There, you'll be able to find all of our latest thinking on macroeconomics and markets, where we leverage our deep experience in research on investor behavior, inflation, risk, and media sentiment, all of which goes into building an award-winning strategy product.

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