Capital Markets Outlook 1Q 2026: Keep an AI on the Prize

Key Takeaways

• Economic growth has been resilient but is expected to moderate, and the US economy features underlying frictions and a labor market that’s flashing yellow.
• Higher-beta and momentum stocks fueled 2025’s equity-market gains, but we think investors’ focus should be on businesses that are durable and lasting.
• A steep yield curve and the potential for falling rates set up a good environment for US bonds, but the US isn’t the only region of the world with potential.
• Municipal yields remain high, and the yield curve is steep. A barbell maturity structure seems best suited to maximize income and return potential—along with credit exposure.

Parts of the Economic “Holy Trinity” Are Flashing Yellow

Growth has been resilient in the face of elevated policy uncertainty and is expected to moderate. In this “K-shaped” economy, those earning the most—and exposed to rising asset markets—are continuing to spend, so an equity downturn could hurt the economy. Lower-income earners are struggling; as long as the labor market doesn’t stall, consumer spending should stay positive.

The labor market is flashing yellow and is now the Fed’s main focus. Labor cooling was welcomed after pandemic over-hiring, but the cooling has continued. With the buffer in the labor market gone, it’s vulnerable to stalling. Inflation’s decline, disrupted by tariffs, should resume if conditions remain favorable, but the Fed will tolerate slightly higher inflation to protect the labor market.

Focusing on Stocks with Durable Businesses and Staying Power

The S&P 500 is well above its long-term average, and the 10 biggest stocks remain a large portion of the index amid concerns about AI hyperscalers’ massive capital spending. Improved earnings outlooks enabled other segments like small-caps to benefit from the rally. Higher-beta and momentum stocks fueled 2025’s gains, but we think the focus should be on durable businesses with staying power.

Lower correlations and possibly lower rates imply a better active-management backdrop, and we see equity potential in diverse segments. One that has potential is large-cap quality core, which offers investors optionality and diverse choices in a world where passive indices are concentrated. Value stocks present attractive price points, with an easing Fed and slow growth arguing for a gradual rotation into high cash-flow generators.

Long-term thematic trends offer avenues for investors to pursue, and the opportunity set intersects with traditional growth and value. Low-volatility stocks feature very attractive relative valuations and have shown the ability to play offense and defense (Display). Beyond the US, earnings volatility is lower, and many stocks are trading at a discount.