AI mania turns industrials into chip stocks

OPTIMISM surrounding the potential for industrial companies to profit from the artificial intelligence (AI) boom has fuelled record-setting momentum in the sector.

Now worries are mounting that the group’s link to AI may be getting too tight.

A gauge of 45-day correlation between the S&P 500 Industrials Sector, home to stocks like Deere & Co and Fastenal Co, and the Philadelphia Stock Exchange Semiconductor Index is sitting at 0.75, near the highest level since June.

A reading of 1 means the securities move in lockstep.

Many industrial companies provide the essential physical infrastructure needed to build and operate data centres, making them a second-derivative play for AI.

That makes the sector, already sensitive to swings in the broader economic cycle, also susceptible to risks of AI demand slowing.

“If AI is the single engine that’s driving both the stock market and the economy, any types of sputtering will end up being a bigger issue for everything,” said Michael O’Rourke, chief market strategist at JonesTrading Institutional Services.

“Any weakness that emerges among a key player here should have ramifications throughout everything.”

The near-tandem moves were on display on Monday, when chipmakers like Qualcomm Inc and Micron Technology Inc helped lift the S&P 500 Index and industrial firms like power-equipment provider Vertiv Holdings Co were among the top performers in the benchmark.

The dynamic also sets up a test for both tech and industrial stocks when heavyweight Nvidia Corp reports results next week.

Right now, there are 15 non-tech companies with a combined market capitalisation of US$2 trillion that are “moving as a derivative of AI capex,” Neil Dutta, head of economic research at Renaissance Macro Research LLC, wrote in a May 7 note to clients.

“If the AI cycle ever cools off, the wealth-effect drag on consumption is not going to be confined to the Magnificent 7,” Dutta added.

Industrials including Vertiv, Eaton Corp, Caterpillar Inc and even engine maker Cummins Inc are high on the list.

The stocks are more than 60% correlated to the VanEck Semiconductor ETF, data compiled by Renaissance Macro show.

“These are not tech stocks. They trade like semis because their order books have become AI capex order books,” Dutta said, noting that Caterpillar is selling backup generators to data centres, while Vertiv provides cooling and power management equipment.

Indeed, the AI spending boom has reshaped the way that some of the sector’s most-storied names trade.

Caterpillar, famous for its yellow backhoes and bulldozers, has surged more than 170% in the past 12 months.

Sales to data centres have fuelled a 250% rally in Vertiv and a 150% advance in GE Vernova Inc over the past year.

“These are the picks and shovels and infrastructure behind the AI buildout,” said Emily Roland, co-chief investment strategist at Manulife John Hancock.

She said that while the sector has gotten expensive, the “magnitude of the earnings beats” in industrials is outpacing other groups.

At the outset of the earnings season, Roland noted that analysts had expected to see average earnings growth of 3%, whereas the sector has shown 20%.

Yet the risk is that any material slowdown in AI spending or a simple reversal in momentum in AI stocks will likely spill over into industrials, fuelling swings in the sector that’s trading at a valuation premium to the broader S&P 500 that’s been exceeded just briefly this century.

Shares of Vertiv and GE Vernova fell 5.4% and 2.8%, respectively, in late April after a report that OpenAI had missed internal targets for revenue and new users.

Philip Straehl, chief investment officer at Morningstar Wealth, wrote on May 7 that the US equity market “has increasingly become a concentrated bet on AI” as earnings growth is tied to AI infrastructure spending.

He warned, however, that AI spending is at this point “just a forecast” and some of those spending plans could be trimmed.

“History offers many examples – from railroads to fibre-optic networks – where companies built capacity based on optimistic projections around future adoption,” Straehl said, adding that in those cases, the main beneficiaries were consumers, not investors.

To be sure, industrial stocks are trading in-line with some of their historic norms.

After a spike in February helped the S&P 500 Industrials Sector outperform the broader S&P 500 by two standard deviations, the group is now directly in the middle of an expected 100-day breather, data DataTrek Research shows.

Still, the firm does see concentrated outperformance in the stocks participating in the AI buildout.

“Industrials have recently enjoyed a renaissance in investor interest as a derivative AI trade, but that has left many leadership names with tech-like valuations but still capital-intensive, manufacturing oriented business models.”

The group has also gotten expensive: For the first time since 2021, industrials in the S&P 500 are trading at a higher forward price-to-earnings multiple than technology companies.

Those lofty valuations further set the group up for a potentially rough landing because the services they are offering are more commoditised than in the tech space, O’Rourke said.

“The industrial names have a larger risk,” he said. — Bloomberg