Avoid this group of chip stocks as the US election approaches: Citi

The broader U.S. equity market saw a sell-off on Wednesday, dragging the Nasdaq 2.8% and the S&P 500 down 2.8% and 1.4%, respectively.

The sell-off was led by a sharp pullback in the semiconductor sector, which experienced a decline of 10%. According to Citi analysts, the group fell due to three main reasons.

These include chipmaker ASML (AS:ASML)'s disappointing Q3 guidance, former President Trump's remarks that Taiwan “should pay” the US for its protection, and Bloomberg's report that the Biden administration is considering severe trade restrictions, including the foreign-direct product rule, to curb business in China by companies like Tokyo Electron and ASML.

"We believe the US government is likely considering this action as China sales from foreign peers outgrew US equipment makers last year all else being equal,” Citi analysts commented.

The sustainability of China’s equipment spending, which accounts for about 35% of wafer fabrication equipment (WFE) this year, remains a significant issue for the semis, Citi added. Analysts expect the sector to remain volatile leading up to the US elections.

While the major indices ended Wednesday trading in the red, the small-cap Russell 2000, which surged 11.5% over the past five sessions, ended its longest winning streak in over four years. This surge was fueled by renewed interest in undervalued stocks and sectors within the equities market.

Investor anxiety was evident as the CBOE Market Volatility Index briefly reached its highest level in six weeks.

For months, smaller company shares have lagged while investors focused on large tech stocks that have driven indexes for most of 2024. Despite the recent surge, the Russell 2000 has only increased by 10.5% this year, compared to a 17% gain in the S&P 500 and nearly 18% in the Nasdaq 100.

The outlook shifted last week after a softer-than-expected inflation report raised expectations that the Federal Reserve will cut rates in the coming months, potentially benefiting smaller companies burdened by high borrowing costs.