High-quality, long-duration bonds should provide a substantial buffer in the event of a tech and AI-driven crisis.
As we lay out in Monetary and fiscal fuel is powering expansion, unprecedented ‘peacetime’ stimulus is supporting both the economy and risk assets. Investors face two key risks should all this excess create problems: a major shift in artificial intelligence (AI) sentiment, and the resurgence of inflation. In this chapter, we examine the strategies available to investors who wish to mitigate against these risks.
What if it is a bubble?
As discussed in Navigate tech concentration carefully, we simply don’t know at this stage what the end demand for AI will be and whether the large-cap tech companies will be able to sustain the supernormal profits that the market expects. Investors who are concerned that these highly valued companies may not meet long-term growth expectations have two main hedging options.
High-quality, long-duration bonds should provide a substantial buffer in the event of a tech and AI-driven crisis, which would be deeply disinflationary. If demand for AI infrastructure is overestimated and the return on this investment disappoints, we could see overcapacity, falling prices, shrinking margins, and lower investment, echoing the early 2000s. Stock prices would fall, driving negative wealth effects, and consumer spending would contract. Private markets would also be affected, as 36% of private equity and 25% of private credit are exposed to tech.
Such a scenario could push the US economy towards recession, prompting the Federal Reserve (Fed) to cut rates sharply. During the dotcom bubble and the global financial crisis, long-dated US Treasuries delivered returns of 29% and 17% respectively (see Exhibit 30). In the bursting of the tech bubble, high-quality, long-duration corporate bonds also offered protection.
Non-US investors should also consider currency movements. The US dollar typically strengthens during market stress but given the leading role of US firms in the AI story, its safe-haven status is not assured in this scenario. Depending on hedging costs, long-duration local government bonds could be an alternative to US Treasuries, though the return potential from falling yields in the eurozone and the UK is likely lower than in the US.
Investors should also think about the concentration risks within global equities. The tech and communication services sectors now account for 37% of the MSCI All Country World Index.
Simply diversifying outside of tech and tech-related sectors is insufficient. An AI slowdown would have broad economic implications, and valuation risks are widespread. Cyclical sectors offered protection during the dotcom era. However, since 2022, cyclical sector valuations (excluding technology sectors) have expanded from 13x to 22x 12-month forward earnings, leaving these sectors vulnerable if an oversupply of AI infrastructure slows growth.
Defensive sectors, after a period of underperformance, now sit on undemanding valuations. Their earnings are also less tied to tech infrastructure build out and economic activity more generally, making these sectors better insulated from any tech downturn (see Exhibit 31). Portfolios with a high share of defensive stocks should therefore prove relatively resilient if AI exuberance fades.
Largesse induced inflation
The second key risk is inflation. Loose fiscal policy is pressuring bond markets with rising supply and deteriorating sovereign creditworthiness. Government consumption can fuel inflation if it coincides with strong private demand or supply shortages. Such inflation could take the form of an acute shock or instead a chronic creep, with different assets best positioned in each scenario.
Acute inflation: Lessons from 2022
As previously discussed, we are wary of the potential for fiscal largesse to trigger a resurgence of inflation. Tax rebates from the One Big Beautiful Bill, and possible further stimulus ahead of the midterms, could stimulate demand-driven price pressures in the US economy. Also, while the current trajectory for trade policy appears more benign, the full inflationary impact of tariffs is yet to be felt, and there remains the risk of further supply-side disruptions from new US tariffs or partner retaliation.
In this scenario, the Fed could be forced to halt its cutting cycle and potentially hike rates to maintain credibility. Rising bond yields would force broad asset repricing, hurting public markets.
Real assets such as timber and core infrastructure would offer the best protection during an acute inflation shock (see Exhibit 32). Traditional inflation diversifiers, such as real estate and inflation-linked bonds, struggle as income adjustments lag behind capital losses, while the commodity-heavy FTSE 100 would likely outperform other equity markets.
Chronic inflation: Erosion of real returns
Inflation could prove less of a short, sharp shock and more of a creeping problem, as each year closes out with yet another modest target miss. Governments were very successful in the 1950s and 1960s at inflating away their debt via a series of small inflation surprises: nominal interest rates below nominal GDP growth slowly shifted the burden of debt away from taxpayers and towards bondholders, whose returns were eaten away by inflation.
With chronic inflation, the risk is therefore a gradual erosion of real returns rather than rapid repricing. Historically, in periods of chronic, creeping inflation real estate outperformed stocks, while inflation-linked bonds outperformed their nominal counterparts (see Exhibit 33). Without sharp upfront capital losses, the inflation adjustments inherent in these two assets’ income streams can help protect real returns.
Gold is another asset to consider. In chronic inflation scenarios, its store-of-value properties make it an important portfolio diversifier. It also serves as a hedge against concerns around US institutional credibility, or fiat currency risks. If US institutional credibility was called into question, this would likely support demand for gold as international reserve managers diversified away from the dollar.
However, gold’s performance as a diversifier against acute inflation shocks is mixed. Average returns are boosted by strong performance in the late 1970s when investors were already hyper-focused on inflation, but returns were negative when inflation spiked in 1990 and 2022 as inflation surprised markets. This mixed performance raises the risk that investors looking to gold for protection against an inflation shock could be disappointed.
Conclusion
Our base case is that monetary and fiscal fuel continues to power an economic expansion. But there is a risk that policy ‘excess’ leads to either an asset bubble, or inflation. Investors should think carefully about building up protection against these outcomes.
To protect against a fall in tech stocks, investors should consider high-quality, long-duration bonds and defensive equity sectors. To protect against inflation risk, investors should allocate adequately towards alternative assets, which should support a portfolio whether inflation is acute or chronic.