U.S. equity markets have reached new record highs since March. Credit spreads have retraced to pre-conflict levels. Market-implied volatility has collapsed across asset classes after the jump during the early days of the Middle East conflict. On the surface, this looks like a market at peace with itself. But surfaces can be deceiving.
The Risk-On Case: A Resilient Economy Boosted by AI
The bull case is supported by a U.S. economy that continues to demonstrate remarkable resilience despite huge macro and policy uncertainties. The AI capex boom is accelerating — not just in hyperscaler spending, but in the breadth of the underlying AI ecosystem. First-quarter 2026 earnings have come in very strong and, perhaps most telling, the rally is showing signs of broadening beyond the AI mega-caps that have dominated the equity market for the past couple of years. The AI capex boom and the increase in stock market wealth are boosting demand, while contributing to price pressures.
President Trump has been very effective in managing market communication and expectations for a deal around the negotiations with Iran. By cutting off the left tail of the distribution of possible outcomes, this has mechanically compressed volatility and lifted the mean. Markets have priced in this pattern of behavior, becoming less sensitive to bad news.
And then there are technical factors. The equity rally has been supported by retail investors’ enthusiastic embrace of risk. Institutional investors who were underweight equities and sitting on cash are now chasing performance. As volatility falls, systematic and vol-targeting strategies mechanically add risk exposure. The rally feeds on itself — for now.
President Trump has been very effective in managing market communication and expectations for a deal around the negotiations with Iran. By cutting off the left tail of the distribution of possible outcomes, this has mechanically compressed volatility and lifted the mean. Markets have priced in this pattern of behavior, becoming less sensitive to bad news.
And then there are technical factors. The equity rally has been supported by retail investors’ enthusiastic embrace of risk. Institutional investors who were underweight equities and sitting on cash are now chasing performance. As volatility falls, systematic and vol-targeting strategies mechanically add risk exposure. The rally feeds on itself — for now.
Emerging Cracks Beneath the Surface
Look beneath the surface and the picture is somewhat more mixed. Retail investors have become an increasingly dominant force in equity markets. A growing share of options flow — particularly in short-dated contracts, including zero-day-to-expiry (0DTE) options which can offer quick gains — is reportedly linked to retail participants, often trading via apps designed to feel like games and frequently employing leverage. The buy-the-dip mentality has become almost reflexive. That reflexivity works beautifully in a rising market. It can amplify dislocations when the market turns.
The most consequential risk is the inflation-monetary policy nexus. Prediction markets assign very low odds to a reopening of the Strait of Hormuz by the end of June. Investors are pricing Brent at roughly $85 per barrel through year-end. With the inflation outlook darkening, investors have now fully repriced Fed expectations: not only are cuts off the table, but a 25-basis-point hike is now anticipated — nearly 100 basis points higher than where the policy path was priced in early March. This poses a challenge to incoming Federal Reserve Chairman Kevin Warsh, who was initially expected to keep rates low.
And markets anticipate the 10-year Treasury yield to reach about 5.30% five years from now, some 80 basis points above current levels. This is a materially different interest-rate backdrop than the one that has supported the rally in risk assets.
And markets anticipate the 10-year Treasury yield to reach about 5.30% five years from now, some 80 basis points above current levels. This is a materially different interest-rate backdrop than the one that has supported the rally in risk assets.
Importantly, this is not another cyclical inflation shock. The geopolitical environment has changed, and the inflationary pressures building in the system are structural due to accelerating financial and economic fragmentation together with the costs of building supply chain resilience.
The Deeper AI Macro Bet — and the Question Worth Asking
What financial markets are pricing is a very large, very concentrated macro bet on AI adoption and the productivity gains it will generate. The S&P 500 carries significant exposure to hyperscalers and the broader AI ecosystem. That concentration is amplified by a circularity of revenues and earnings as well as by exposure to the funding structures of AI capex and data centers.
Imminent mega-IPOs — SpaceX, Anthropic, and OpenAI — will test capital markets’ capacity to absorb deals of extraordinary scale. If investors rotate out of existing holdings to access these offerings, concentration risk will rise further.
It will also test the seemingly inexhaustible appetite for risk by retail investors. Today, retail investors, especially younger generations, trade directly from their phone, often via commission-free apps with game-like features and easy access to leverage. Many also participate in social media investing communities on platforms such as Discord, Reddit, and X, where investment ideas can spread rapidly. Their portfolio set now extends to prediction markets, crypto and other digital assets, meme stocks, leveraged ETFs, short-dated options, and other esoteric instruments.
The return on risk assets in the years ahead will ultimately boil down to how the tug of war between geoeconomics and AI will play out, and whether the timing of AI productivity gains implicitly embedded in earnings growth expectations and asset prices will be validated by the actual pace of adoption by firms and consumers.
History has a consistent message about technology-driven financial booms: markets tend to run well ahead of the underlying reality of technology adoption and productivity realization. The AI story may be different this time in scale and speed. But the pattern of markets pricing perfection, but colliding eventually with a messier, slower, more uneven reality is one of the most durable regularities in financial history.
Imminent mega-IPOs — SpaceX, Anthropic, and OpenAI — will test capital markets’ capacity to absorb deals of extraordinary scale. If investors rotate out of existing holdings to access these offerings, concentration risk will rise further.
It will also test the seemingly inexhaustible appetite for risk by retail investors. Today, retail investors, especially younger generations, trade directly from their phone, often via commission-free apps with game-like features and easy access to leverage. Many also participate in social media investing communities on platforms such as Discord, Reddit, and X, where investment ideas can spread rapidly. Their portfolio set now extends to prediction markets, crypto and other digital assets, meme stocks, leveraged ETFs, short-dated options, and other esoteric instruments.
The return on risk assets in the years ahead will ultimately boil down to how the tug of war between geoeconomics and AI will play out, and whether the timing of AI productivity gains implicitly embedded in earnings growth expectations and asset prices will be validated by the actual pace of adoption by firms and consumers.
History has a consistent message about technology-driven financial booms: markets tend to run well ahead of the underlying reality of technology adoption and productivity realization. The AI story may be different this time in scale and speed. But the pattern of markets pricing perfection, but colliding eventually with a messier, slower, more uneven reality is one of the most durable regularities in financial history.
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