The time is now for investors to get their AI survival plan in place, with bets on bonds and small caps among the smartest moves to make, say Citigroup strategists.
“We think U.S. rates will work as a hedge against a bursting AI bubble or against an AI-driven labor market dislocation,” said a Citi team led by Dirk Willer, global head of macro strategy and asset allocation.
He conceded that bonds didn’t work in 2022, as they fell along with stocks as sticky inflation triggered a string of Federal Reserve rate hikes. For 2026, however, Citi economists expect a “benign environment for risky assets,” driven by good-enough global growth, low stable inflation, three more Fed rate cuts and plenty of liquidity.
But they’ve shaken up their asset allocation, noting pronounced sector and geographic rotation due to AI disruption worries. For example, the S&P 500 Software Industry Index has sank 20% this year, while the S&P 500 Energy Sector Index is up 22%. While that bubble is probably not ready to pop yet, Willer and his team say “better diversification is essential.”
The U.S. stock portion of their recommended global portfolio is now half in small-cap stocks, while half of their tech exposure has been downgraded to neutral. They are sticking to a big bet on communications and also boosting cyclicals exposure.
Small-cap stocks work for Citi’s Goldilocks-type economy that they see ahead, given those equities are biased toward cyclical industries such as financials, industrials and consumer discretionary. Those stocks have also been lifted by data showing improvement in U.S. manufacturing — the Russell 2000 is up over 7% so far in 2026, versus a 0.2% gain for the S&P 500.
As for bonds, Citi has shifted to overweight on long-term inflation protected bonds, which tend to work if the Fed is cutting rates, but also to shield against a pair of big market worries simmering right now. The bursting of the AI bubble, triggering a negative wealth effect and more Fed cuts, is one, while the second is AI disruption severely hitting the labor market, which would also mean Fed easing. While the timing of those is unclear, Citi sees them becoming more of base cases over time.
“But the point is that U.S. rates will work well again, in our view, to hedge equity risks, after failing to do so in the high inflation equity selloff in 2022, because AI will be a deflationary force,” said Willer and his team.
They see the AI disruption story now also partially priced in, given the selloffs seen this month, but are unclear over what will calm worries about massive AI spending by big tech. “For the market to buy back into the hyperscalers will require a clearer path to monetization, preferably into the context of healthy margins,” they said.
They have a strong bet on Japan — the Nikkei 225 index is up around 12% this year — but have halved U.K. equity exposure and are less keen on China, with those markets up 7% and flat, respectively. Citi has also shifted to a neutral stance on commodities, taking profits in base metals. “While macro fundamentals are still very base-metal friendly, prices have run up a lot, to a level where our commodity strategists don’t’ see major upside anymore for copper, given metal specific fundamentals,” they said.
Copper futures have climbed 26% over a year, with platinum up over 114% and palladium up 76%.
Comments