Why selectivity matters in the next phase of the AI trade

Not participating in the AI rally has been one of this year’s biggest investment risks.

Record infrastructure spending,¹ strong earnings growth, and expanding demand across the supply chain have propelled AI-linked stocks to new highs, even as commodity shocks and inflation risks have unsettled the macro backdrop.

But after such a powerful advance and a recent pullback, many investors are wrestling with two competing questions: “Should I get out?” and “Am I missing out?”

The more useful question is which companies can convert AI demand into durable value.

The AI trade remains compelling, but the next phase is likely to reward selectivity over broad exposure—and a global lens over a narrow focus on today’s winners.

What has changed in the AI trade?

As the AI buildout has accelerated, investors have crowded into many of the same winners. That has raised the risk that valuations and positioning move ahead of fundamentals, leaving even strong companies vulnerable when results don’t meet lofty expectations.

Second-quarter earnings made this trade-off more visible. Some hyperscalers showed strong cloud demand and clear evidence of AI monetization. For others, robust revenue growth came with sharply higher costs and capital spending. Markets have responded by rewarding proof of returns rather than AI investment alone.

Infrastructure suppliers have not been immune to the market’s growing focus on execution. Semiconductor results have remained strong, yet South Korean memory stocks sold off sharply in July when robust earnings fell shy of analyst expectations—with a leverage unwind amplifying the move.

Questions about the sustainability of infrastructure-related earnings persist. However, continued enterprise adoption of AI models, demand-supply imbalances along the supply chain, and growing enthusiasm over AI agents—which could boost demand for central processing units (CPUs)—suggest that the AI infrastructure cycle has room to run.

Investment implication: The importance of risk management is coming into focus. Investors may benefit from harvesting gains, controlling position sizes, rotating exposure across bottlenecks, and avoiding concentration in any one part of the AI supply chain.

Can market leadership broaden beyond the largest AI winners?

Market breadth improved in the second quarter as smaller stocks outperformed and AI-related gains reached second-order beneficiaries.

The question now is whether that broadening can continue.

U.S. small- and mid-cap stocks offer a differentiated way to participate in the AI cycle, providing exposure to a resilient U.S. economy and companies that should benefit from AI-related capex. Stock selection remains critical, however, as higher short-term borrowing costs can weigh more heavily on smaller companies and challenge weaker balance sheets.

Many smaller companies provide the specialized components or “golden screws” of the AI ecosystem, including advanced photonics, networking, power, and thermal management. These companies could see meaningful earnings revisions if demand continues to broaden. Others stand to gain from fiscal stimulus, reshoring, and efforts to bolster the U.S. industrial base—a theme that dovetails with the AI buildout.

Developed markets outside the U.S. also remain part of the broadening discussion. The energy shock initially weakened the case for these markets, interrupting a period of outperformance for non-U.S. equities. Given uncertainty around a more lasting resolution to the Middle East conflict, energy and inflation risks are likely to resurface periodically.

Even so, Europe continues to be supported by a mildly expansionary fiscal stance and higher public investment, including defense spending. The opportunity remains selective, centered in areas such as industrials, physical infrastructure, energy-security beneficiaries, and banks.

Investment implication: A broader AI trade does not merit indiscriminate exposure. The current environment should favor companies with pricing power, balance sheet strength, and credible links to AI infrastructure demand, industrial reinvestment, or supply chain resilience.

What role do emerging markets play in this environment?

Two of the biggest secular stories globally have been commodities and AI infrastructure. Emerging markets (EM) are crucial to both.

Across Asia’s technology markets, companies involved in memory, foundry capacity, optics, power components, and semiconductor equipment are receiving cash flow from hyperscalers and frontier model developers. Many are less crowded and less expensive than comparable U.S. names while still benefiting from the same structural demand.

The central role of emerging markets in commodities, critical minerals, and AI supply chains should remain an advantage as global economies fragment, rearm, and rebuild industrial capacity. Yet foreign outflows and South Korea’s recent stock market plunge underscore that valuations and positioning still matter.

Investment implication: Emerging markets can serve as both AI supply chain and real asset allocations. Selectivity remains key, however, as technical conditions, lofty expectations, and country-specific risks can significantly affect outcomes.

What macro risks could disrupt the AI investment cycle?

The AI cycle is unfolding against a less stable macro backdrop.

Renewed military clashes between the U.S. and Iran in late July reminded markets that the memorandum of understanding was a bridge to negotiations, not a lasting resolution. Market narratives can whipsaw in this environment.

Even if diplomacy remains in the economic interest of all parties, structural uncertainty is likely to persist and generate periodic volatility. Longer term, the conflict has reinforced new geopolitical realities.

In addition to an evolving geopolitical landscape, investors are also adjusting to a new era for monetary policymaking.

As the Federal Reserve signals greater flexibility, less forward guidance, and a different communication style under new chair Kevin Warsh, a wider range of outcomes is likely.

These shifts, combined with growing divergence among global central banks, could usher in more frequent cross-asset volatility and more abundant relative value opportunities. Investors aligned with the structural changes reshaping the global economy should be better placed to identify opportunities while managing risk.

Final thoughts

Alongside a more volatile macro backdrop, key risks span both technical and fundamental factors, including positioning, financing constraints, and regulatory headwinds to frontier AI models.

Instead of relying on broad exposure to the AI theme, investors may benefit from focusing on companies with credible monetization strategies, disciplined capital spending, and exposure to durable supply chain bottlenecks.

The bull market’s foundations remain intact, but the next phase is likely to be more demanding.