The defensive stocks to play the potential AI-led correction

Last week, I shared where some of Australia's leading global equities managers were looking for US stocks that could outperform the Mag 7.

Much of that analysis was based on the assumption that global stock markets continue to rally. But what if that's not the case? 

Say instead we get the correction that many have expected since stocks bounced back so strongly from Trump's Liberation Day in April. 

Where on the S&P 500 should investors be looking for the stocks that can offer downside protection if things go pear-shaped due to an AI-led correction?

To answer that question, we've again asked Frank Thormann, portfolio manager for global equities at Schroders Australia; Magellan Global Opportunities Strategy portfolio manager Alan Pullen; and Fidelity portfolio manager Maroun Younes.

Frank Thormann - Schroders

"It will be those companies which are more insulated from AI disruption that offer downside protection," says Frank Thormann, Schroders portfolio manager for global equities.

He suggests one consumer name that is showing strong global growth and unlikely to see any impact from AI - Monster Beverages (NYSE: MNST).

"Monster Beverages sell energy drinks, hardly a business facing huge disruption, from AI at least. They are growing in multiple markets around the world and while we don’t have a hugely different view versus the market over the next few quarters, we have growth over the next few years that the market is missing."

He also sees opportunities in established companies that are quietly bouncing back while AI dominates the conversation. 

"There are also incumbents being written off as losers from wider disruption that, in our view, are mounting comebacks," he says. 

"Oracle (NYSE: ORCL) were deemed to be in structural decline as disruptors in enterprise software were born as the rise of SaaS companies transformed how business software is consumed and delivered."

"Oracle quietly reshaped its business, rebuilding its database and application stack for the cloud and made significant infrastructure investments. In some segments, Oracle is now growing faster than SaaS companies that once threatened to leave them behind."

Alan Pullen - Magellan

There are three key sectors that investors should pay attention to in an AI-led downturn, says Magellan Global Opportunities Strategy portfolio manager Alan Pullen. 

"From our analysis, we view that quality consumer staples, healthcare and utilities will provide the best downside protection in an AI-led correction." 

In consumer staples and healthcare, it's companies that are either market leaders or essential where Magellan sees the opportunity.

"In the consumer staples space, it's names like Procter & Gamble (NYSE: PG), Coca-Cola (NYSE: KO) and Yum! Brands (NYSE: YUM) that are best-in-class operators, and their earnings are highly resilient in a downturn," said Pullen.

"In the healthcare space, UnitedHealth (NASDAQ: UNH), and Medtronic (NYSE: MDT) are great examples of companies that offer essential services, and face limited cyclical headwinds."

It's a slightly different story in utilities, where AI currently has a much more active role in driving demand. 

"In utilities, we need to be a little more nuanced given the link between AI and energy demand. Companies like Eversource (NYSE: ES) have little exposure to data centre energy demand, and hence we view they will be resilient in an AI-driven market correction."

Maroun Younes - Fidelity

Fidelity portfolio manager Maroun Younes also sees the best downside protection offered at a sector level. 

"The usual defensive sectors will offer relative refuge," said Younes. "Healthcare and consumer staples stand out." 

“Both sectors tend to maintain stable revenues and earnings, and could benefit from capital rotation as investors shift away from AI-exposed names — supporting share prices.”

Like Pullen, Younes is keen to stress that utilities are somewhere investors need to tread more carefully. While it has often performed as a defensive sector, the relationship between AI and utilities muddies the water. 

"Historically, utilities offered downside protection due to stable demand and their sensitivity to interest rate cuts,” he said.

“But today, investors need to be selective. Some utilities have seen share prices driven up by AI-related demand, and those names could face sharp corrections if the AI trade unwinds.”

Younes also warns that any market correction, AI-led or otherwise, could have the ability to drag the rest of the market down with it, which is something else investors need to keep in mind.

"Depending on its severity, a correction could drag down the broader equity market, much like what we saw during the Dot-com bust.”