Diversifying with Bonds

Bonds can diversify portfolios against an AI-driven equity and economic downturn even if they lag while the bubble continues to inflate.

• The ten largest companies in the S&P 500, all exposed to AI to some degree, represent 41% of the index and are expected to generate about $270 billion in Q3 earnings.
• In a continued AI investment boom, hyperscalers spend more than $200 billion per quarter on infrastructure, increasing bond issuance and pushing yields higher while AI-sensitive equities rise.
• If productivity gains emerge, AI infrastructure spending normalizes, margins improve for users of the technology, and bonds may stabilize as lower inflation pressures yields, while equities continue to benefit.
• If the bubble deflates over coming months, quarters, or years, slower infrastructure spending and earnings growth could weaken AI stocks, slow the economy, and support bonds.
• The U.S. 10-year yield is around 5.25%, including a 2.9% real yield, although yields could still rise and produce short-term losses.

Takeaway: Investors who remain exposed to the AI rally should add bonds as insurance against a deflationary scenario, accepting that the hedge may underperform during the first two scenarios and may not work on every weekly or monthly horizon.