After global capital markets soared around artificial intelligence, the recent pullback in the semiconductor sector has left the market struggling in a fierce tug-of-war between strong demand for capital and tight liquidity. CICC Research said in its latest report that while the current megacycle is not over, the combination of high congestion, rising leverage and unmitigated liquidity means global markets are entering a “half-time break.” The company warned that correctional pressures are likely to continue into the third quarter, but after the break, a security and investment-led tech rally is poised to extend to AI applications, industrials and resources sectors in the second half of the year.
Intensifying contradictions within the United States: Unclear monetary policy and increasing corporate lending pressure
The central risk currently facing U.S. markets lies in the imbalance between heightened monetary policy uncertainty and corporate financing needs. Kevin Warsh has maintained a low profile since being named Federal Reserve Chairman, positioning himself as a reformer and disrupting the “expectation management-market pricing-expectation fulfillment” dynamic that has been established between markets and the Fed since 2008, according to market reports. Markets lack consensus on new monetary policy rules and tend to prepare for the “worst-case scenario” before concrete reforms are concluded. In particular, even though long-term inflation expectations have remained relatively stable due to fluctuations in nominal inflation caused by oil price shocks, market-implied expectations for interest rate hikes have skyrocketed since March of this year, completely reversing expectations for interest rate cuts that had been building since July last year.
Meanwhile, funding pressures have increased significantly. Although the Fed continues to expand its balance sheet, overall liquidity has remained relatively tight since tapering its RMP bond purchases in late April. Due to tax timing and other factors, the crowding-out effect of fiscal management on liquidity has become increasingly noticeable since June. The U.S. Treasury is expected to issue a net $671 billion in debt, including $367 billion in medium- and long-term debt, in the third quarter, a significant increase in both total volume and duration from the second quarter, according to data from the CICC memo. To mitigate risks related to next year’s debt ceiling restrictions, the Treasury General Account (TGA) is likely to remain high and continue to drain market liquidity.
On the corporate side, the mid-to-upstream AI sector relies heavily on corporate bond financing. The research note estimates that net corporate bond issuance could exceed $460 billion in the third quarter. Over the past year, net corporate debt financing in the information technology and industrial manufacturing sectors has increased rapidly. We expect this momentum to continue, given that cloud service providers’ free cash flow is rapidly declining. Surprisingly, while credit default swaps (CDS), which reflect default concerns among tech companies, have increased recently, investment-grade credit spreads for tech companies remain at historically low levels. CICC believes that the market may not have fully priced in debt financing pressures. If corporate bond spreads widen significantly, stocks will face significant headwinds. Additionally, the downstream AI sector relies primarily on private credit, with bank lending to non-bank entities expected to increase by an additional $79 billion in the third quarter. Credit standards tightened again in the second quarter, increasing pressure on private credit.
This funding pressure has clearly had a negative impact on market prices. Since late May, the 10-year TIPS yield has been rising while the breakeven inflation rate has been falling. This interest rate combination is bullish for the US dollar, but clearly bearish for stocks and resources. Overall, funding pressures in the US corporate bond market are at historically high levels.
External shock: Sword of Damocles in yen carry trading and high leverage risk in Korean semiconductors
Beyond U.S. domestic pressures, structural risks in the Japanese and Korean markets could also be a factor amplifying global volatility.
The yen has been depreciating recently, with the dollar/yen pair exceeding 160 yen, entering territory not seen in about 40 years. The Bank of Japan has entered an interest rate hike cycle, and the difference in interest rates between Japan and the U.S. has narrowed from 210 basis points at the beginning of the year to about 170 basis points, but it will be difficult to stop the yen from weakening. This is largely due to divergent expectations of monetary policy, with hawkish signals from the Fed dominating the recent yen depreciation.
However, the weaker yen has further encouraged yen carry trades. According to the data, the size of assets in internal accounts at Japan’s foreign banks, which are proxies for carry trade activity, is at a historically high level of nearly 160 trillion yen, and net short positions in yen futures and options held by funds are also rising at historic levels. CICC’s FX team notes that the current environment closely resembles the period before the carry trade was unwound in August 2024. If the Bank of Japan tightens its guidance or tight U.S. liquidity causes global AI trading to cool down, a reversal in currency expectations could trigger a large-scale unwinding of carry trades, pushing down U.S. stock valuations through intermarket deleveraging. Historical data shows that global stocks are generally under pressure during periods of strong yen, with annualized returns for U.S. stocks on average 23.5% lower than during cycles of weak yen.
In the Korean market, the rebound in the semiconductor sector has been noticeable since late June, with SK Hynix and Samsung falling more than 28% and 22%, respectively, from their previous highs, and the Philadelphia Semiconductor Index in the United States also fell accordingly. Further concerns for the market are the wide divergence in capital flows and high leverage. According to June data, South Korean retail investors had net purchases worth 40 trillion won (approximately $28 billion), while foreign investors had net sales worth 47 trillion won (approximately $32.9 billion). CICC’s flag, which leverages the level of the Korean stock market, is currently rising, with margin loans totaling approximately 38 trillion won (approximately $26.6 billion) and leveraged ETF assets reaching $33 billion. Structural vulnerabilities arising from high concentration, deep divergence, and rising leverage in South Korea’s stock market now pose a risk of global contagion. In particular, since April of this year, the simultaneity of the correlation between capital flows and returns between the Korean and US technology sectors has increased significantly. If the Korean market were to trigger a forced sale of retail margin positions or leveraged ETFs, this could easily be transmitted to the US semiconductor sector, creating a negative feedback loop.
Outlook for the second half of the year: K-shaped economic gap deepens, gains extend to AI applications and resources
Short-term risks cannot be ignored, but from a strategic perspective, the structural factors underpinning this cycle have not changed. CICC believes that the global K-shaped economy is here to stay. Meanwhile, the AI-related investment cycle continues to support real growth and earnings momentum in the US. On the other hand, high-frequency job offer data remains at a low level, and demand for recruitment from small and medium-sized enterprises is weak. This means that there is no basis for a “wage inflation” spiral. Real disposable income is even negative compared to the previous year.
Based on our assessment that the lower limb of the K-shaped economy will remain weak for an extended period of time, we believe that the tightening of liquidity due to expectations for interest rate hikes will not last in the long term. If a real rate hike cycle begins, it will not only seriously damage AI chain finance, but also accelerate the decline in consumption and real estate. It’s worth noting that Mr. Warsh’s approach in establishing the Inflation Framework Task Force appears to be pragmatic and flexible, with the goal of giving the Fed greater latitude in navigating the K-shaped economy and the AI wave. Alternative indicators suggest that consumption- and wage-side inflation may be much weaker than official data suggests. As the working group provides more detailed information, market uncertainty should gradually dissipate.
If expectations for unilateral tightening ease, real interest rates peak and begin to fall, and dollar funding pressure eases, the market will take a breather. CICC highlights that after the half-time break, the bull market is poised to expand within the upper echelons of the security and investment-driven K-shaped economy. Beyond AI hardware, sectors such as AI applications, industries, and resources are set to start the second half of the year.
