AI bubble and bond chaos among the biggest risks as investors hit peak optimism
Fund managers are so bullish they’ve abandoned cash safety nets, yet almost 40 per cent still believe AI stocks are in bubble territory and that’s creating a perfect storm for financial chaos.
Global investors are feeling bullish. Perhaps too bullish.
Fund managers are displaying a level of optimism not seen since the height of the post-pandemic boom in July 2021, slashing cash holdings to record lows and loading up on stocks with an enthusiasm that should set off alarm bells.
Bank of America’s survey of 119 global money managers shows cash levels have plunged to a record low 3.3 per cent, down from 3.7 per cent a month earlier. That is well below the 4 per cent threshold that historically triggers a sell signal: the nine previous times since 1998 that cash levels fell below 3.6 per cent, global stocks dropped an average of 2 per cent in the following month.
More worrying, the bank’s closely watched Bull & Bear Indicator has surged to 7.9, perilously close to the 8.0 level that flashes a sell signal. Investor sentiment, based on cash levels, equity allocation and growth expectations, sits at its highest point since July 2021.
Chief investment strategist Michael Hartnett has identified five key “tail risks” that could derail markets this year.
The AI bubble
The biggest worry keeping fund managers awake at night is an AI equity bubble, cited by 38 per cent of respondents as the number one tail risk. That figure is down from 45 per cent in November, suggesting some concerns have eased. But the fear remains palpable. More than half of investors still believe AI stocks are in bubble territory.
The Magnificent Seven tech stocks have dominated market returns for years, driven by euphoria around artificial intelligence. These companies are spending eye-watering sums on AI infrastructure, with capital expenditure reaching levels that make investors nervous.
Tellingly, investors say companies are “overinvesting” for the first time in 20 years – 14 per cent of respondents think so. That sentiment is aimed squarely at the tech companies pouring hundreds of billions into AI data centres.
Much of the concern centres on Oracle and its debt-fuelled spending spree to build computing capacity for OpenAI, the maker of ChatGPT. The company’s fate has become perilously tied to a single customer in a way that is unprecedented for a company of its size.
Even Meta Platforms, the most aggressive of the megacap tech companies in its AI investments, is expected to spend only about 36 per cent of this year’s revenue on capex.
The financial strain is showing.
Of course, most investors do not think this is a bubble about to burst.
Citi predicts a normal adjustment rather than evidence of fundamental weakness. The US bank’s conversations with enterprise chief information officers and chief technology officers suggest AI adoption is actually accelerating as use cases move from pilot projects to full production.
“We continue to believe that the market is underestimating the scale of the opportunity in AI,” Citi analysts said in a recent note. “Consensus estimates for nearly every part of the ecosystem remain too low.”
Companies are deploying tens of thousands of AI agents in large-scale operations, and this acceleration could persist through 2026.
Still, the worry remains that spending is racing ahead of returns, creating a dangerous gap between promise and reality. If the AI investment boom stalls or major tech companies start scaling back their capital spending plans, the market impact would be severe.
The Magnificent Seven remain the most crowded trade in global markets for the second consecutive month, according to 54 per cent of managers surveyed by BofA.
When everyone is on the same side of the boat, the risk of a sudden lurch is amplified.
Bond market chaos
The second biggest tail risk, flagged by 17 per cent of managers, is a “disorderly” rise in bond yields. It might sound technical, but it matters enormously. When government bond yields surge too quickly, it’s a recipe for chaos across financial markets. Higher yields mean higher borrowing costs for companies and governments, lower stock valuations, and potential stress in the financial system.
The concern is particularly acute given the mountain of government debt accumulated during the pandemic and large budget deficits in major economies, including the United States.
Investors are clearly nervous about this risk. A net 38 per cent of fund managers expect long-term interest rates to be higher in 12 months’ time, the highest level of bond yield anxiety since April 2022.
Markets have largely assumed that inflation is under control and central banks will keep cutting interest rates. But if bond investors lose confidence in government finances or inflation proves stickier than expected, yields could spike sharply.
Such a move would hit everything from property markets to equity valuations. It would also expose any hidden leverage or risky positions in the financial system. The recent rerating of risk premiums across the AI ecosystem, evident in elevated borrowing costs and equity multiple compression, shows how quickly sentiment can shift.
Market positioning makes this risk more acute. Fund managers have slashed bond allocations to a net 29 per cent underweight, the most since October 2022. When positioning is this extreme and everyone is leaning the same way, any reversal can be violent.
Inflation’s return
Closely related is the third tail risk: a second wave of inflation, worrying 16 per cent of fund managers.
Central banks have spent two years fighting to bring inflation down from 40-year highs. The battle appeared won, with price pressures easing and rate cuts beginning. But now investors are nervous about a potential resurgence.
Several factors could reignite inflation. Geopolitical tensions might disrupt energy supplies. Labour markets could stay tight. Government spending remains elevated, particularly with fiscal stimulus plans in both the US and China. Trade tensions and tariffs could push up prices.
When asked about the most bearish development for 2026, 45 per cent of fund managers pointed to inflation and Federal Reserve rate hikes. The fear is that instead of the expected rate cuts, central banks might be forced to raise rates again, crushing the soft landing scenario that markets are currently pricing in.
Fifty-seven per cent of investors expect a soft landing for the global economy, while 37 per cent see no landing at all. Only 3 per cent expect a hard landing, the lowest reading in 2½ years.
That overwhelming optimism could prove painfully misplaced if inflation roars back. Growth expectations have surged to their most optimistic level since August 2021, with profit expectations also at their highest since then. Markets are priced for perfection.
Credit crunch
The fourth tail risk is a US consumer credit crunch, but only according to 8 per cent of managers. American consumers have powered global growth for years. But there are signs of strain; credit card debt is at record levels. Delinquencies are rising. Pandemic-era savings have been largely depleted.
If consumers suddenly pull back on spending because they are overleveraged or economic conditions deteriorate, the impact would ripple through the global economy. Consumer spending accounts for about 70 per cent of US economic activity.
Adding to these concerns, private credit has emerged as a major worry. Fund managers identified private equity and private credit as the most likely source of a systemic credit event, with 40 per cent pointing to this largely opaque and rapidly growing corner of finance as the biggest threat to financial stability.
Notably, 14 per cent now see private credit as the biggest tail risk overall, a new category joining the survey that reflects growing unease about leverage and risk-taking in the shadows of the financial system.
Trade war escalation
While this ranks lowest among the five risks (only 6 per cent of respondents), it reflects ongoing concerns about protectionism and tariffs disrupting global commerce. Trade tensions between major economies could flare up unexpectedly, damaging supply chains and economic growth.
Trade risks are manageable for now. But geopolitical tensions remain elevated, and policy shifts could quickly change the calculus.
What to do when market signals flash red
What makes these tail risks particularly concerning is the context in which they sit. Fund managers are running meagre cash levels and when investors are this fully invested, there is little dry powder to buy the dip if something goes wrong. Positioning is stretched to extremes.
Investors have piled into technology stocks, with allocations rising to a net 21 per cent overweight, the highest since July 2024.
Commodities allocation has surged to a net 18 per cent overweight, the highest since September 2022. Meanwhile, bonds are being dumped at the fastest pace since October 2022.
The message is stark: bullish positioning remains the biggest headwind for risk assets. With investors so fully committed and cash levels at record lows, markets have no cushion.
Investors should pay attention to these five tail risks, even if most market participants are currently ignoring them. History shows that tail risks have a nasty habit of becoming reality just when everyone assumes they will not.
Whether anyone is paying attention is another matter entirely.
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