A key risk for 2026 is the disconnect between stretched market valuations (e.g., tight credit spreads in the 1st percentile) and a macroeconomic environment that doesn't feel late-cycle. This tension suggests that even if growth drives equities higher, it could be accompanied by increased volatility or widening credit spreads.
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One of the key risks to the 2026 outlook is a 'demand upside' scenario where growth accelerates unexpectedly. This would keep inflation hot and likely force the Fed to pause or even reverse its planned rate cuts, creating a significant shock for financial markets that have priced in a more accommodative policy.
While top-line GDP figures appear strong, the US labor market has been in recession since mid-2024. The key question for 2026 is whether the economy can resolve this underlying weakness without it surfacing and triggering a broader downturn, a risk that intensifies if the stock market stumbles.
A surge in corporate spending on AI, capex, and M&A can boost stock prices. However, this same activity often requires issuing large amounts of new debt, increasing supply and causing credit spreads to widen, leading to underperformance versus equities.
History shows that markets with a CAPE ratio above 30 combined with high-yield credit spreads below 3% precede periods of poor returns. This rare and dangerous combination was previously seen in 2000, 2007, and 2019, suggesting extreme caution is warranted for U.S. equities.
Unlike equities, credit markets face a growing risk from the AI boom. As companies increasingly use debt instead of cash to finance AI and data center expansion, the rising supply of corporate bonds could pressure credit spreads to widen, even in a strong economy, echoing dynamics from the late 1990s tech bubble.
Despite tight spreads signaling caution, the current market is not yet cracking. Parallels to 1997-98 and 2005—periods with similar capex, M&A, and interest rates—suggest a stimulative backdrop and a major tech investment cycle (AI) will fuel more corporate aggression before the cycle ultimately ends.
2026 will be a year of two halves. The first half continues a "Goldilocks" phase with risks skewed towards economic cooling, favoring bonds. The second half will see a transition where the primary risk becomes overheating and resurgent inflation, signaling a portfolio rotation into commodities.
Instead of an imminent collapse, the credit market is likely poised for a final surge in risk-taking. A combination of AI enthusiasm, Fed easing, and fiscal spending will probably drive markets higher and fuel more corporate debt issuance. This growth in leverage will sow the seeds for the eventual downturn.
With credit spreads already tight, their potential upside is limited while their downside is significant in a recession scare, offering poor convexity. Goldman Sachs advises that a better late-cycle strategy is to move up the risk curve via equities, which offer more upside potential, rather than through credit investments.
When asset valuations are elevated across all major markets, traditional fundamental analysis becomes less predictive of short-term price movements. Investors should instead focus on macro drivers of liquidity, such as foreign exchange rates, cross-border flows, and interest rates.
