Citi: Risk aversion resembles a French fiscal shock, while AI hedging increases
Recent cross-asset performance most closely resembles concerns over French public finances, but worries about AI financing are growing. Citi has added a USD/JPY volatility hedge and gone long UK and Spanish government bonds relative to French bonds; despite elevated credit stress, sector concentration keeps it preferring equities over credit.
Original source：Citi ResearchFirst published on Unhidea：Original source date：
Key takeaway
Citi remains positive on AI and equities over the medium term while adding protection against AI volatility and French fiscal divergence. Concentrated pressure in credit market sectors is grounds for caution, not a broadly bearish stance.
What is driving this bout of risk aversion?
Cross-asset performance over the past week most closely resembles the risk-off episode triggered by French fiscal concerns, but its cross-sectional correlation with each of the three historical samples—France, oil and AI—is below 50%. Citi therefore concludes that multiple shocks are overlapping and that no single theme explains much on its own.
Compared with the period from late September to early October, when French and oil-price concerns dominated, AI worries are becoming more important. Citi already has protection against rising oil prices and French risk; this adjustment focuses on adding an AI risk hedge.
Why use USD/JPY volatility to hedge AI risk?
Citi's transmission thesis is that a setback in the AI trade would push markets to lower their expectations for US interest rates and strengthen the yen; when USD/JPY falls, its volatility may also rise. Buying volatility can therefore provide protection against this kind of shock.
Relative to the volatility of 1-year US dollar interest rates starting 1 year from now, 1-year USD/JPY volatility looks low. Citi bought a 1-year volatility swap at 9.20, with a target of 11.20, a watch level of 8.20 and an allocation of 250 thousand US dollars.
The trade depends on a combination of yen strength and rising volatility. Citi lists a recovery in risk appetite or a hawkish shift by the Federal Reserve as the main adverse scenarios.
Why choose UK and Spanish government bonds over France's?
Citi added a currency-hedged relative-value position that is long 10-year UK and Spanish government bonds and short French government bonds. It bets on divergence in the three countries' fiscal outlooks, rather than a broad rise in European government bonds.
Citi expects no major surprises in the UK budget, with the fiscal headroom buffer remaining at 14 billion to 16 billion pounds. Spain has a stronger primary fiscal balance and growth foundation; Citi expects a more prudent fiscal stance if the general election at the end of November produces a coalition led by the People's Party.
French cost-of-living protests make budget consolidation more difficult. Although the relative-value trade has already moved a long way, Citi sees few near-term catalysts for a reversal and has nevertheless added it to the portfolio, with a total return target of 4% and a watch level of negative 2%.
Why hasn't deterioration in lower-rated credit made Citi broadly bearish on equities?
US investment-grade credit spreads have widened by about 15 basis points from their low for the year, but remain low by historical standards. CCC spreads, however, have risen to the 83 percentile of their distribution since 1994, with stress clearly concentrated at the weaker end of the credit-quality spectrum.
Citi identified 17 episodes of sharp CCC spread widening since 2000. Most continued to deteriorate over the following 21 days and were accompanied by weakness in higher-rated credit. Subsequent equity performance varied, however, with the median roughly flat; the higher starting level today also increases the likelihood of short-term equity volatility.
The current widening in CCC spreads has come mainly from telecoms and media: the sector accounts for only about 15% of the index but has contributed about 70% of the widening this year, with AI not the main driver. Citi therefore believes it overstates overall systemic risk and retains its long equities versus credit trade; if stress spreads to higher-quality credit, it will become more cautious.
Should investors follow or fade the post-US midterm election move?
Citi's backtest found that, unlike the stronger trend continuation after presidential elections, moves in the S&P 500 and the US dollar index on the day after midterm elections are more like contrarian signals, with the effect peaking after about 10 trading days. This supports its contrarian approach to a short-term post-election pullback.
US Treasuries are an exception: prices typically rise or remain flat after midterm elections, the yield curve tends to flatten, and the move subsequently continues. Citi suggests a possible explanation: when the governing party loses seats, government becomes more divided and new deficit spending may decrease.
