News & Insights

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.

Markets cheered on May 12th when the Trump Administration agreed to suspend most of the 145% tariff that it imposed on Chinese goods back on April 2nd, substituting a new 10% global base-line tariff plus a separate 20% levy tied to China’s role in the fentanyl trade, a total rate of 30%. In exchange, China will reduce its retaliatory tariff to 10% from 125%. The deal is good for 90 days as negotiations continue. The S&P 500 gained 3.3% on the news and turned positive for the year. 

Even before the China tariff reprieve, investors were bidding up the market as companies were generally reporting strong first quarter results. According to FactSet, with 90% of S&P 500 companies reporting, first quarter earnings are on pace to grow 13.4%, the second-straight quarter of double-digit earnings growth. 78% have reported actual EPS above the mean EPS estimate, above the five-year average of 77% and 10-year average of 75%. For the remaining three quarters of 2025 analysts expect earnings to grow 5.2%, 7.4%, and 6.7%, respectively, with a full year prediction of 9.3%. This is a reduction from previous full year estimates that had contemplated double-digit earnings growth.

The Trump administration's sudden imposition of aggressive reciprocal tariffs on April 2nd triggered significant selling pressure, causing the S&P 500 to fall by a staggering 10.5% over two days. This tariff-driven panic has secured its place among Wall Street's most notable events.

Following the initial shockwave, markets have shown signs of stabilization and recovered some losses, partly supported by subsequent announcements, including a 90-day pause on certain tariffs. The exclusion of major electronics from the steep 145% tariff levied on China helped alleviate immediate concerns about drastic price increases, contributing to a relief rally. Nevertheless, persistent trade tensions and the possibility of future escalations continue to foster caution among investors.

We warned about froth in equities last month, and the S&P 500 responded with a sharp correction. The index experienced a steady slide from its peak of 6,163 on February 19th, closing in correction territory down 10.3%, on March 13th. The more volatile NASDAQ 100 slid 13.5% during the same period. A subsequent bounce left both indexes trading in territory they originally reached six to nine months ago. After starting the year up about 4%, 2025’s market now has a foot in the hole.

It is no surprise that the biggest contributors to the market’s multi-year gains, the so-called Magnificent 7, also paced it on the way down. The March 17 cover of Barron’s Magazine illustrated their pullbacks from respective 52-week highs. Six of seven showed declines in a range of 19%-23%. Tesla showed a 50% decline, returning to its pre-election range. The graphic was printed on a solid red background under the heading “Mag 7 on Sale”. Barrons Cover Curse believers might debate whether the red background portends a green bounce or whether the reference to stocks “on sale” foreshadows another leg down. Either is certainly possible. The S&P 500’s trailing P/E ratio remains in the mid-20s, at the high end of its all-time range. A return to the 20-year average of about 16 would equate to nearly a 40% drawdown from here, give or take earnings growth for the constituent companies. On the other hand, while corrections are historically common and occur about once every two years, bear market drawdowns of 20% or more occur only half as frequently. Treating every correction as a budding bear market is equally likely to be right or wrong.

After two great years in the equity market, 2025 got off to another strong start with the S&P 500 making record highs driven by earnings growth and non-Magnificent 7 stocks. Valuations are stretched, and there are other signs of froth in the market, arguing for caution. The economy is on solid footing with moderate employment gains and continued economic growth. However, inflation remains higher than the Federal Reserve’s 2% target and the Fed anticipates only a half percentage-point reduction in the Federal Funds rate this year. Long-term rates remain about where we entered the year. Their direction from here will be a function of inflation and government borrowing requirements as the new administration implements its tariff and fiscal policies.

Year to date the S&P 500 is up 4.2%. But in a change, the Magnificent 7, about a third of the index, has lagged while the other 493 stocks have powered the gain. Excitement for Artificial Intelligence continues to drive the market and its impact was visibly seen on January 27th when DeepSeek, a Chinese AI firm, reported using older Nvidia chips to train AI models at a fraction of the cost of current methods. Nvidia, the leading AI chipmaker and stock powering the AI revolution, dropped 17% on the news. Since the announcement Nvidia has recovered most of this drop as investors were soothed by the increasing capital expenditure plans from other Magnificent 7 members Microsoft, Alphabet, Amazon, and Meta Platforms. However, except for Meta these “Cloud Titans” have seen their shares struggle as investors stomach these massive spending plans while worrying that revenue from AI won’t fully justify them.

Market volatility has picked up in early 2025, a continuation of December’s fluctuations. This shouldn’t come as a surprise as several factors are each promoting increased volatility. The greatest impact results from investor concern over interest rates. The Federal Reserve controls short-term interest rates by setting the Fed Funds rate, the interest banks charge each other when lending or borrowing excess reserves. The Fed has cut this rate three times since September 18, kicking off its easing cycle with an eye-catching 50 basis point reduction prompted by a weak employment market in the late summer and early fall. The market, however, determines interest rates for everything else. While the Fed Funds rate is down a cumulative 100 basis points since the September Fed meeting, yields on the 10-year Treasury Note have risen 80 basis points during that time from 4.00% to a recent high of 4.80%.

Despite the drag from 11 rate hikes from March 2022 to July 2023, the U.S. economy has continued to grow solidly overall with a few pockets of weakness emerging, particularly in manufacturing. Employment growth has remained positive with modest job growth from April through October giving way to stronger numbers in November and December.

The Year In Review: A Reflection on Markets and the Economy

Equity investors have much to celebrate this year as indices continue to rise to all-time highs. The Federal Reserve cut interest rates in September for the first time since 2020, boosting investor optimism and supporting the strong rally in stock prices. In a reversal of recent trends, small-cap companies represented by the Russell 2000 index surged post-election, outperforming large-cap companies. Optimism for policies favorable to U.S. companies may have contributed to some of the outperformance as smaller companies tend to have more exposure to domestic markets.

Stocks were already trading near all-time highs prior to the election, after which markets took another leg higher. Overall, equities have been supported this year as the economy has held up better than many expected following the Federal Reserve’s interest rate increases to combat inflation. A combination of inflation tracking back towards the Fed’s 2% target and concerns about a softer labor market set the table for the Fed to kick off an easing cycle in September with a larger 0.5% cut, its first rate reduction in four years. Beginning the path toward less restrictive policy while consensus expectations reflect projected earnings growth of nearly 10% in 2024 and approximately 15% in 2025 make a relatively attractive backdrop for equities, helping to explain some of the bullish sentiment exhibited by investors.

The Fed continued down the path toward easier policy with a 0.25% cut in November with expectations for another 0.25% reduction in December. Market expectations are for an additional 0.50% of easing in 2025, which should help support equities. Additional rate cuts meaningfully beyond that over the coming year would likely be in response to unwelcome economic or geopolitical developments.

Judging solely by the U.S. stock market, economic conditions could hardly be any better. Year to date, the S&P 500 is up more than 22%. Investors may be taking their cues from economic data suggesting a desirable “Goldilocks economy,” one that is neither too cold nor too hot. Economists forecast U.S. Gross Domestic Product to be up about 2.5% for 2024. Inflation has been gradually ebbing.

Underlying statistics paint a murkier picture. Manufacturing has been in a recession for most of the past two years, and new factory orders continued to decline in August. The Institute for Supply Management’s Purchasing Managers Index showed continued contraction into September. The weakness is largely due to high interest rates that reduce demand for big-ticket consumer and industrial goods like cars, appliances, and factory machinery. The Federal Reserve’s goal in hiking interest rates in recent years was to slow down the economy by making large items more expensive to finance. Demand for services, about 80 percent of the economy, continues to rise steadily.

While the S&P 500 remains near all-time highs, markets have been choppy as sentiment has vacillated between belief in the Federal Reserve’s ability to achieve a soft landing versus concerns regarding a more significant slowdown. Progress on inflation set the table for the Fed’s half-point rate cut at its September meeting, as Chair Powell had noted that the balance of risks to the Fed’s two mandates, price stability and stable employment, have changed. Inflation has come down, trending toward the Fed’s 2% target, while the labor market has slowed. Given the increase in downside risks to employment, at the Jackson Hole gathering Powell stated the Fed “does not seek or welcome further cooling in labor market conditions,” clearly articulating the Fed has shifted its focus, opening the door to a rate cutting cycle.

The September rate cut was the first reduction since 2020, marking the end of the policy tightening the Fed embarked upon beginning in March 2022 to combat inflation. Rate hikes resulted in the target range for the federal-funds rate hitting 5.25%-5.5%, a two-decade high, and remaining there for 14 months prior to the recent cut. This hiking cycle had the desired impact as the Fed’s preferred measure of inflation, the core personal-consumption expenditures index (PCE) came down to 2.6% in July, the most recently available data, compared with a peak of more than 5.5% in 2022. Based on consumer and producer price data already released for August, economists expect the headline PCE for August will be approximately 2.3% with the Fed’s own preferred inflation measure, the core PCE, advancing 2.7%. While we are not yet at 2% inflation, the general trend has been in line with what the Fed would like to see, and policy remains restrictive, albeit less so than before the recent cut.

For much of 2023 and into 2024, markets experienced a low level of volatility in the face of the fastest interest rate tightening cycle in U.S. history. However, since reaching a peak on July 16 the S&P 500 recorded both its best and worst days since 2022 during the week of August 5-9. The reasons for higher volatility are a softer economy, Artificial Intelligence (AI) skepticism, global uncertainty, and a contentious election cycle.

Since 2022, the Federal Reserve has been able to focus on inflation as the employment market has enjoyed a strong recovery from the pandemic. The news here recently has been good. After inflation slightly increased during the first quarter, the CPI has now slowed for four straight months. July’s reading of 2.9% year over year marks the first time since March 2021 that the index has been below 3%. Progress on the core CPI, a measure that excludes the often-volatile food and energy components, is also encouraging, coming in at 3.2%. Other indicators confirm inflation’s downward path. The Fed’s preferred inflation index—the Personal Consumption Expendi­tures, or PCE—has fallen from a high of 7.1% two years ago to 2.5% in June. The Producer Price Increase, or PPI, rose 2.2% year over year in July and has cycled around 2% since early 2023.

After spending much of the year lagging behind the Magnificent 7, a broader array of stocks joined the party and pushed the market to all-time highs. The reason appears to be investors’ growing belief that the Fed will start cutting interest rates in September in response to falling inflation and a softer employment market. Interest rate cuts would improve the prospects of non-technology stocks by spurring economic activity and increasing the appeal of those paying dividends. 

Investors take cues from the Fed’s data dependency when setting interest rates to fulfill its dual mandate:  full employment and stable prices. The Fed started the year expecting three rate cuts in 2024, but inflation’s rise and a solid employment market in the first quarter led the Fed in early June to revise its expectations to just a single quarter-point cut.