Mega forces: Can the AI trade and inflation shocks coexist?

The Asset Allocation Committee entered 2026 positioned for market broadening. We held tactical overweight allocations to international, U.S. small- and mid-cap (U.S. SMID-cap), and emerging market (EM) equities, as well as real asset equities such as energy and metals stocks. These exposures added value as equity performance broadened beyond U.S. large-caps.

In recent weeks, however, U.S. large-cap growth stocks have reasserted leadership, driven by blockbuster earnings.

We’re now simplifying our positioning after a good run. We are reducing our developed international equity overweight to neutral and adding to U.S. large-caps and EM equities. Under the hood, we are moving toward EM growth, bringing EM value versus growth to neutral.

Which other tactical positions are left? We remain overweight U.S. SMID-cap, and we continue to hedge against inflation risk through an overweight to real asset equities and a short duration stance in fixed income (a position that has also added value). In addition, we are long the “large-cap barbell”: overweight U.S. large-cap growth and value and underweight core.

Sizing up the shock

Markets are balancing two mega forces: AI and geopolitical inflation.

“At the moment the market seems quite happy for those two things to coexist,” a committee member said at our last meeting, adding, “I don’t think they can coexist over time.”

Energy feeds data centers, chip production, and financing costs. It hits corporate margins. An energy shock could affect AI at a time when many investors are treating it as the only game in town.

One member asked whether the market had become too complacent about the drawdown in oil inventories and the possibility of shortages. Another added that “the probability of an energy price-driven accident has gone up,” even as markets have seemed to reprice that risk lower.

The committee did not resolve the energy debate, but the context wasn’t lost on anyone. We’re witnessing the largest oil supply disruption and the second-largest fertilizer disruption in history. Economic data have been surprising to the upside, but a growth shock can’t be ruled out. We judged international developed market equities to be particularly vulnerable.

Weakening case for international equities

We previously favored developed international equities for their attractive valuations and the potential catalyst from fiscal support. However, supply disruptions have generated economic headwinds in these markets. Europe and Japan are exposed to energy, currency, and rate risks.

Meanwhile, the U.S. has a stronger secular earnings engine. “The real driver of earnings growth for the global economy right now is AI, which is centered on the U.S.,” said a committee member.

From a style perspective, the story for international markets is more nuanced. Barring recession, the heavier weighting of energy companies (oil and power) and financials in international indexes supports a value tilt in this part of our portfolio positioning.

As one committee member highlighted, “Higher rates have been a major tailwind for international financials, and the rising interest rate trajectory is causing return on equity expectations to be revised upward.”

Evolving role of emerging markets

EM is broader than the AI supply chain, but across asset classes it may now be the closest proxy for AI capex—the gravitational center of the market.

This changes the role of EM in our portfolio positioning. It used to serve mainly as a source of regional and currency diversification. Today, it is increasingly an AI hardware allocation, one in which Taiwan and South Korea play a central role.

The bottom line is that EM offers exposure to bottlenecks along the AI supply chain. It also carries sharper cyclicality. A committee member warned that EM “will be a higher beta version” of the AI trade and could struggle if AI capex falters. He also noted the tactical discomfort: “The semiconductor index has gone up 50% in a month."¹

That quote captures the tension in the room. The AI spending case is strong, but the entry point for EM equity is awkward.

Holding a large-cap barbell

We’re adding to U.S. large-cap equities while holding a barbell in that asset class: overweight value and growth, underweight core. The core of the market comprises expensive non-AI compounders that have been lifted by the broad rally.

Leveraging bottlenecks through small- and mid-caps

Why are we maintaining an overweight to U.S. SMID-cap while leaning into large-caps? As one committee member argued, U.S. SMID-cap stocks still carry AI optionality through “golden screw companies” that control scarce components of the data center supply chain. With the upcoming Russell 2000 rebalancing, some of the best AI names may migrate out of the index, but these appear to be fully priced winners. A fresh set of bottleneck companies may emerge.

“The first, second, and third suppliers are sold out,” the committee member said. “This sends demand to the fourth supplier, often still inside small-caps. That creates “continued upside torque” in U.S. SMID-cap and supports an overweight position.

Takeaways

The market has rewarded AI-driven growth while largely looking past inflation risks. Whether those forces can continue to coexist remains an open question.

Our positioning aims to balance that uncertainty.

We are leaning into the strongest earnings engine in the market while maintaining inflation hedges, staying long smaller stocks, and reducing overall active risk.