Markets have been drifting lower, and with AI-linked equities trading at stretched multiples, investors are increasingly questioning the durability of the current cycle. Most people will point to inflated valuations of NVDIA or AI companies, but that’s not where we see the biggest cracks. Here’s our thoughts. (This is not investment advice.)
Executive Summary
Equities have softened in recent weeks as AI-linked valuations remain stretched and macro conditions lose momentum. Our base case still expects a brief rebound supported by falling real yields, lighter positioning, and seasonal flows. However, the window for strength looks narrow.
We expect conditions to turn more difficult from January into Q1 2026, as tightening liquidity, renewed rate uncertainty, and rising credit stress begin to bite. These factors are likely to pressure risk assets again even if the market enjoys a short-term bounce beforehand.
Sentiment: Volatility Is Rising
Source: VIX Index
The VIX has climbed from 18 to the mid-20s within the past five days, reflecting a sharp rise in hedging demand and growing concern around stretched valuations, earnings durability, and macro uncertainty. While not yet at crisis levels, this move signals a shift from complacency toward caution.
The elevated implied volatility typically caps upside rallies and makes markets more sensitive to negative catalysts as a reason to drop. This raises the probability of short, violent downswings even if fundamentals haven’t changed. As VIX levels remain elevated, investors are likely to demand higher risk premiums, raising doubts about the market’s ability to sustain momentum and reinforcing the likelihood that volatility will persist.
Rates: Real Yields Not Providing Tailwinds
Source: 10 Year Real Treasury Rates
Real 10-year Treasury yields drifted lower through the year, with easing financial conditions and enabling equities to rebound, however, that support may now be fading. As yields stabilize around 1.85%, it could suggest the easing cycle losing further momentum.
In our view, January presents several risks that could pressure markets. Higher Treasury issuance may push yields upward, while stickier inflation dynamics threaten to keep real rates elevated. At the same time, thinner year‑end liquidity often amplifies market moves, making conditions more volatile. If real yields turn higher under these pressures, valuation‑sensitive segments such as mega‑cap technology and AI‑linked equities are particularly exposed to fast reversals. Real yields directly influence discount rates, making expensive sectors the first to correct.
Market Cracks: Private Credit
Recently, Blue Owl Capital, a private credit firm, announced plans to merge its private fund into its publicly traded arm after refusing to honor $1.8 billion in withdrawal requests. This decision highlights potential liquidity concerns and the firm’s inability to manage redemptions internally. By channeling investors into the public markets, Blue Owl is effectively relying on stock market trading to provide liquidity, though investors face losses of nearly 20% due to discounts to net asset value. The forced merger underscores the firm’s dependence on external liquidity and signals that it cannot sustain redemptions within its private structure. As a result, investor confidence has declined significantly. (Source)
Additionally, hedge fund titans such as Citadel, Bridgewater, Point72 are all doubling down on private credit just as signs of stress begin to surface. Recent reports highlight growing reliance on payment‑in‑kind structures, maturity extensions, and covenant‑lite deals to mask borrower fragility. While headline performance appears stable, these practices point to rising liquidity risk beneath the surface. (Source)
The timing of everything is alarming, Blue Owl freezing withdrawals and broader concerns over redemption pressure, the influx of hedge fund capital may be chasing yield into an increasingly fragile corner of the market. The stress in private credit tends to spill over into public markets as refinancing becomes more expensive and default risk rises.
Market Cracks: Consumer Finance
Capital One’s latest credit data points to escalating pressure across consumer finance. Domestic credit-card net charge-offs rose to 4.77% in October, an increase of 42 basis points in a single month, while delinquencies reached 4.99%, now materially above pre-pandemic averages. Stress is broadening beyond cards with the auto loan book showing charge-offs of 1.67%, with only marginal easing in early-stage delinquencies.
These figures show that household balance sheets are weakening under heavier debt loads, elevated inflation, and tighter borrowing conditions. Capital One faces increasing loss exposure as a result, and the trend signals that the consumer credit cycle is entering a more vulnerable phase with potential spillovers into broader financial conditions. If consumer stress accelerates, we foresee it directly threatening Q1 earnings and forward guidance.
Portfolio Implications (My view)
1. Maintain a slightly defensive stance in credit. Risk and liquidity stress are starting to build across private and consumer segments.
2. Watch real yields closely. If they stabilise or move higher, trim exposure to stretched-growth and AI-linked equities. These sectors are highly sensitive to rising discount rates and tend to reverse sharply.
3. Monitor private credit and consumer finance because early stress here often spills into public markets through tighter lending standards, funding pressure, and widening spreads.
Conclusion
Across sentiment, rates, and credit markets, the same pattern is emerging cracks are forming beneath the surface. Rising volatility shows that investors are demanding more compensation for risk. Real yields have stopped falling, removing a key pillar that previously supported stretched equity valuations.
At the same time, the private credit market is flashing early-cycle stress signals, funds unable to meet redemptions, reliance on public-market liquidity, and a surge in payment-in-kind and covenant-lite structures. As borrowing becomes more expensive and risk premiums stay elevated, weaker companies struggle to refinance, raising the probability of credit accidents. What begins as private-market stress often migrates into public markets through tighter lending standards, higher funding costs, and downward pressure on valuations.
Taken together, these developments point to a market entering a more fragile phase. A short-term rebound is possible, but the foundation of this year’s rally is weakening. Unless conditions ease meaningfully, the combination of elevated risk premiums, deteriorating credit quality, and fading liquidity increases the likelihood that some companies particularly heavily leveraged or overvalued segments will fail to meet the market’s higher risk threshold. This is how cracks quietly deepen before they become visible in asset prices.
