Citigroup Warns AI Slowdown Could Undermine Market Rally

Citigroup has adopted a more cautious stance on the U.S. stock market, warning that a potential deceleration in artificial intelligence advancements could undermine the recent rally driven by tech sector optimism. The shift to a neutral rating on U.S. equity risk was outlined in a Sunday night note by Stuart Kaiser, head of U.S. equity trading strategy at the bank.

“We shift to neutral on U.S. equity risk,” Kaiser and his team wrote to clients. “A potential slowdown in AI model development could crimp EPS [earnings-per-share] revisions.”

The warning comes amid growing alarm from leaders in the AI industry, including OpenAI, Anthropic, and Google DeepMind, who have called for a pause or slowdown in AI progress due to safety concerns. These developments have already rattled markets, with shares of companies like Marvell and Hewlett Packard Enterprise falling, while cybersecurity firms such as CrowdStrike and Palo Alto Networks rose.

Beyond the AI uncertainty, Citigroup’s strategists identified several other headwinds facing equities. They pointed to the upcoming November midterm elections, where Republicans face the possibility of losing control of both chambers of Congress, as well as sharply higher bond yields and surging oil prices following Saudi Arabia’s shutdown of a major pipeline.

The bank noted that much of the S&P 500’s approximately 12% gain this year has been fueled by optimism surrounding AI investment themes. The strategists suggested that if the trickle-down earnings story comes into question, it would weaken a key pillar supporting the current equity rally.

To hedge against further weakness, Kaiser’s team recommended purchasing put options on the QQQ, an ETF tracking the Nasdaq-100, or the VanEck Semiconductor ETF. These instruments provide investors the right to sell the ETFs at a predetermined price by a specific date.

Citigroup strategists observed that the S&P 500’s 0.8% drop last week, its largest decline since late August, reflected stocks becoming vulnerable to macro risks without the protection of strong earnings. They described the current period as one with no earnings reports, a seasonally weak September, and a summer pullback that has raised the bar for renewed investor engagement.

Looking ahead, Citi expects the S&P 500 to remain range-bound, trading within 2% above or below August highs, which may keep many investors on the sidelines. A decline of 3% to 5% could attract dip buyers, but the strategists stated that markets would need to test all-time highs to trigger a fresh buying frenzy.

The bank also indicated that companies linked to power generation and data centers may be more susceptible to negative sentiment from election news than semiconductor and memory stocks. However, they added that AI safety concerns could dampen enthusiasm similarly to what was observed in early February.

Despite these risks, Citi believes markets could continue to rally even with limited Federal Reserve interest-rate hikes—projected at two or three—given strong earnings-per-share growth, solid labor markets, and largely stable inflation.

Elsewhere, Goldman Sachs strategists led by Ben Snider noted that while a Fed rate hike on Wednesday could lead to a rough patch, the market has already priced in substantial tightening. Historically, the S&P 500 has generated an average 12-month return of +9% following the start of hiking cycles, with positive returns in every instance except 2022.