News & Insights

It has been a jarring few weeks for investors. The U.S. and Israeli strikes on Iran that began on February 28th have reshaped the outlook for energy prices, inflation, and monetary policy in ways that were hardly on anyone’s radar at the start of the year. Brent crude has surged above $100 per barrel, up more than 40% from levels below $70 before the war, as traffic through the Strait of Hormuz has slowed to a trickle. Gasoline prices climbed nearly a dollar per gallon in a matter of days. The ripple effects are showing up everywhere: in airline costs, shipping rates, fertilizer markets, and consumer confidence. Against this backdrop, the S&P 500 has been under pressure, giving back more than 5% from its highs and currently trading below 6,600.

The economic data, even before the war, were painting a complicated picture. Nonfarm payrolls fell by 92,000 in February, a sharp reversal from January’s modest gains and well below expectations. The unemployment rate ticked up to 4.4%. Inflation, as measured by the February consumer price index, had been trending in the right direction at 2.4% versus the prior year, but the oil shock now threatens to unwind that progress. The Federal Reserve’s favorite inflation measure, Core PCE, remains stuck around 2.8%, above its 2% target while the energy price surge will only make further progress more difficult. Consumer spending was already showing signs of fatigue, retail stocks fell more than 5% in February, and higher fuel and food costs will further squeeze household budgets, particularly for families at lower income levels who spend a disproportionate share of their earnings on essentials.

The U.S. economy continues to hum along despite all the headlines about “affordability,” tariffs, immigration, and actual or potential military actions across the globe. Fourth quarter Gross Domestic Product rose at a 1.6% annualized rate but would have been up 2.5% excluding the drag from lower government spending. The quarterly figures are comparable to the level of full-year growth.

Underlying economic indicators have been less consistent. December retail sales were surprisingly flat after a robust November. For all of 2025, 3.7% growth in retail sales seems satisfactory until one realizes that growth is in the low 1% range once inflation is factored in. We remain in a bifurcated economy where the high-end consumer continues to spend, buoyed by strong financial markets and home prices. Lower income consumers have never recovered from the cumulative impact of several years of higher prices and subdued wage growth. Middle income consumers, even some in the upper middle range, have started to feel pinched as well.

The year has started nicely for both stock and bond investors. In the early part of January, stocks rallied, largely from a broadening of market participation, while interest rates declined slightly. The economic backdrop for 2026 looks favorable, as moderation in both the employment market and inflation might give the Federal Reserve room to continue lowering rates. On the fiscal policy front, tax cuts and increases in government spending represent a tailwind to growth.

As we start 2026, GDP growth appears to be accelerating. The latest estimate from the Federal Reserve Bank of Atlanta’s GDPNow forecast for fourth quarter 2025 growth is 5.1%. Besides relatively strong consumer spending, AI data center infrastructure is having a noticeable impact on growth. A January 12th study by the Federal Reserve Bank of St. Louis examined three Bureau of Economic Analysis data series – software, R&D, and information processing equipment – along with Census Bureau data on data center construction. The study estimates that AI categories contributed 0.97 percentage points to real GDP growth in the first three quarters of 2025. Recent announcements of additional AI data centers should further contribute to GDP growth.

The Year in Review: Resilience Amidst Fog

The financial markets demonstrated remarkable resilience in 2025, climbing a wall of worry constructed of tariff shocks, geopolitical tensions, and a historic government shutdown. While the S&P 500 index touched record highs in December, investors appear poised to enter January with caution rather than the euphoria often associated with such strong gains. Ironically, this sentiment may bode well for stock returns in 2026. 

While the indices are near their peaks, the narrative driving them has become more complex. The soft landing that seemed elusive earlier in the year has arguably been achieved, but it has been accompanied by a data fog caused by the 43-day government shutdown that ended in November, leaving investors and policymakers to navigate with limited visibility.

From its April tariff-related trough to its recent peak, the S&P 500 gained more than 35%, though in recent weeks the market has faced greater resistance. The market’s move higher was powered by optimism surrounding AI, strong earnings growth, and a move to more accommodative policy by the Fed as it reduced interest rates. The more recent price action has been the result of growing concern that AI isn’t yet generating enough revenue or profits to justify the spending on infrastructure, the market’s perception that the Fed will be less aggressive with rate cuts by forgoing a rate reduction in December, and increasing scrutiny on potentially stretched valuations.

These pressures resulted in the benchmark closing below its 50-day average for the first time in nearly five months, breaking its second-longest stretch above this line in over 25 years. Bitcoin, a reasonable gauge of overall investor sentiment, has sold off sharply, briefly dropping below $90,000 after hitting a record high of over $126,000 in October. In one sign of the current environment, a columnist for The Wall Street Journal openly advocated for a “good, long bear market” to cure “dangerous complacency.” Setting aside the ill-considered desire for a long bear market, a doom-seeking piece chastising investors for imprudence captures the increasingly bifurcated sentiment of investors.

The U.S. government shut down for the first time in seven years on October 1st. Politicians hope voters will blame the other party. Voters may barely notice at all. Outside the federal government, the shutdown has little practical impact on most people’s day-to-day lives. The last shutdown, which occurred during President Trump’s first term, was the longest in history at 35 days yet barely registers today as a storyline from that era.

Official economic data is not being released during the shutdown. ADP’s private employment report showed a small reduction in jobs in September, with annual pay per job up a robust 4.5%. ADP chief economist Nela Richardson underscored a disconnect between declining private payrolls and ostensibly strong second quarter real GDP growth of 3.8%, as reported on September 25th.

Markets have staged a strong recovery from the April lows, with the S&P 500 up more than 30% and hovering around all-time highs. Though there has been a recent broadening out in anticipation of interest rate cuts at the Fed’s September meeting, the market has been largely driven by narrow leadership tied to the AI theme. Oracle’s most recent quarterly earnings announcement simply underscored this, as the company highlighted key contract wins related to its role as a provider of AI computing capacity that are projected to send revenue in its cloud-computing business up 700% over the next three years. Shares surged more than 35% and Oracle added approximately $250 billion to its market capitalization. AI remains very much at the forefront of investors’ minds.

AI may be the dominant theme, but markets have also responded to increased expectations for rate cuts following soft labor reports in July and August. Smaller capitalization companies, which generally are more indebted and therefore stand to benefit from lower rates, have begun to perk up. Since the beginning of August, the Russell 2000 has outpaced the S&P 500, but the small cap benchmark remains well behind the traditional benchmark for the year.

The S&P 500 reached an intraday high of 6,457 on July 28th, nearly triple its lowest point of 2020. The NASDAQ continued setting new highs into August and has now nearly quadrupled from its relatively recent lows. The One Big Beautiful Bill Act has been a tailwind, extending 2017’s tax cuts and providing visibility for income tax rates, state and local tax deductions, and estate taxes.

Another tailwind is earnings growth. With Q2 earnings season about complete, FactSet’s John Butters reports that 81% of companies have reported positive earnings and revenue surprises, with average earnings growing nearly 12%. Q3 estimates call for 7% earnings growth on average. Strong performance has helped justify high valuations. The S&P’s forward P/E ratio based on analyst estimates has reached 22.1, 10% above both its 5-year and 10-year average.

The first half of 2025 has presented investors with a paradox. Equity markets have demonstrated remarkable resilience, staging a powerful recovery from the lows of early spring, while the fundamental economic and policy backdrop has become increasingly clouded by uncertainty. This divergence between market sentiment and economic reality has created a complex and challenging environment. Follow­ing a sharp, tariff-induced correction in the spring that saw the S&P 500 fall 20%, markets executed a rapid rebound, surging 30% to all-time highs. This rally has been fueled by a persistent risk-on sentiment, with speculative appetite visible in the strong performance of recent Initial Public Offerings (IPOs) and the climb of Bitcoin back to all-time highs.

Market strength has pushed equity valuations into elevated territory. The forward 12-month P/E ratio for the S&P 500 now stands at 22.2, well above its 5-year average of 19.9 and 10-year average of 18.4. Such a premium implies a highly optimistic outlook, one that assumes corporate earnings growth will re-accelerate and policy risks will be resolved without major economic damage. This optimism, however, stands in direct conflict with a deteriorating fundamental picture, as analysts have been actively cutting their earnings forecasts. According to FactSet, while earnings growth was strong in Q1, the outlook for Q2 has deteriorated significantly. The estimated earnings growth rate for the quarter has been slashed from 9.4% to just 5.0%.

On the back of easing trade tensions, markets have staged an unusually rapid recovery from a tariff-induced near bear market about two months ago. The S&P 500 rebounded more than 20% from its April low and is hovering near all-time highs. The leadership of the Magnificent Seven faltered earlier in the year, as the group entered a bear market, but the recent rally has seen the celebrated collection of companies reassert its leadership.

Despite a host of uncertainties, market participants have remained in a risk-on mode with a buy-the-dip impulse prevailing. In a sign of the current bullish market sentiment, recent IPOs have performed particularly well out of the gate. Bloomberg reports stocks of companies going public are jumping the most in their first day of trading in three and a half years. Some examples include stablecoin issuer Circle, which leaped more than 165% on the day of its $1.2 billion IPO, Chime Financial, which closed up nearly 40%, and space and defense firm Voyager Technologies, which surged more than 80%. Positioning reports suggest large money managers remain underweight equities, which could prompt a chase later in the year to close the performance gap if the current trend persists. Bitcoin, often viewed as a proxy for investor risk appetite, is also around all-time highs at more than $105,000, up about 40% from the April lows.