Goldman Sachs head of hedge fund coverage suggests investors look at Japanese stocks as a play on AI as U.S. equities face hurdles.

The "clear and present danger" for U.S. stocks is rising 10-year Treasury yields, a threat that's likely to linger.

Tony Pasquariello, global head of hedge-fund coverage for Goldman Sachs, said he'd be placing bets on Japan stocks next.

Pasquariello pointed out that the country's equities have seen a "heck of a post COVID rally." The Japan Nikkei 225 index JP:NIK has gained 177%, and the broader TOPIX JP:TPX 138% since the start of 2020, versus a 135% gain for the S&P 500 SPX, according to FactSet Research.

"I still think there is this bottom-up shareholder reform story that's coming through brick by brick, day by day," he said on The Markets Goldman Sachs podcast that published on Friday.

"If you're a believer in the AI trade, if you're a believer in the re-industrialization and the remiliterization trade, the Japanese stock market offers a lot of these," the strategist said.

"It has AI stocks, it has advanced manufacturing, has defense contractors, and you have, long may it run, a very pro-cyclical. Government policy, federal policy right now. I think that trade is cleaner than it was three or four months ago," he added.

One of Japan's most explosive AI stocks has been memory maker Kioxia Holdings (JP:285A), up more than 1,100% over a year. Semiconductor testing group Advantest (JP:6857) is up 134% over one year, with wafer fabrication group Tokyo Electron (JP:8035) up 112%.

"So, if I had to pick one horse to ride for the next phase of the game, I'm going Japanese equities with a bias towards the domestic. So, more of a Topix-like trade than a Nikkei-like trade," he said. The Topix is a broader index including domestic stocks, while the Nikkei encompasses only the top 225 companies.

There aren't any Topix ETFs listed in the U.S., though the Franklin FTSE Japan ETF FLJP has a similar revenue exposure to Japan.

Pasquariello said as U.S. stock-market investors face the threat of higher long-term bond yields, they may want to consider shorting bonds - a bet that bond prices will fall and yields rise - as a "bedfellow for the equity risk." If yields continue to rise, stock portfolios can suffer, and a short bet on bonds could help offset some of that.

U.S. stock investors also face the likelihood that strong S&P 500 earnings growth can not be sustained moving forward, still generating double-digit growth, but perhaps less so, he said.

Estimated earnings growth for the third quarter for the index is 28.9%, which would represent the third straight quarter of growth above 25%, according to FactSet data.

"On our view, it will slow, but you're slowing from 25%, 30%, to more like 10% to 12%, so still generating double-digit growth, but a meaningful slowdown. Trying to calibrate how the market's going to treat that second derivative slowdown is one of the big open questions," he said.

"My guess is where that leads is just a lower gradient of returns from here, i.e., as earnings growth slows, the extent to which the market appreciates slows, but on net still positive," he said.

-Barbara Kollmeyer