Economic and Market Environment

The Economy

• The economy was surprisingly strong, again defying recession predictions.
• Inflation increased, mainly due to tariffs.
• Weakening employment trends kept the Federal Reserve (Fed) on an easing path.
• Both short-term and long-term interest rates declined, resulting in the best bond market returns in several years
• "Uncertainty” and “affordability” were terms that occupied the minds of consumers and investors during the year.
• Stocks provided solid returns across the board, but the largest gains were concentrated in a few dominant companies and Artificial Intelligence (AI) related firms. This prompted talk of an AI bubble.

Preview 2026

• The Fed’s latest projections are optimistic for 2026:
  
  
  • Stronger Gross Domestic Product (GDP) growth – 2.3%
  • Lower unemployment – 4.4%
  • Lower inflation – 2.4% PC
  • Lower short-term interest rates – 3.5%
• If these projections materialize, it should be favorable for investors. However:
  
  
  • Lower long-term interest rates may be limited by concerns over growing government debt.
  • Stocks will be challenged by lofty valuations. Continued earnings growth and profit margin expansion will be required for further gains.
  • “Uncertainty” may be less in 2026. “Affordability” likely not.

• The K-shaped economy illustrates the wide divergence between high-end and low-end consumers.
• It also highlights growing income and wealth inequality.
• A healthier and more balanced economy could be symbolized by the letter O, illustrating a favorable circular dynamic that benefits all economic participants.

• The real hope for Artificial Intelligence (AI) is that it can increase productivity enough to meaningfully increase GDP.
• Declining labor force growth (population and immigration) is a secular headwind to GDP growth that needs to be overcome.
• The benefits from greater productivity and faster growth, among others, could be:
  
  
  • Rising standards of living
  • Government debt stabilization
  • Higher corporate profits
• These benefits may be achieved with widespread AI utilization across the economy. This will take time but offers optimism about the future of the economy.

• The very strong returns from stocks over the last three years have been very rewarding. However, it leaves us with historically high valuations.
• The S&P 500 now trades at about 22x earnings. Other valuation measures are also extended. To expect further valuation expansion is probably unreasonable. Therefore, the burden of proof falls to earnings growth.
• In the absence of strong sales growth, corporate margins have continued to move higher. They too reside at historically high levels.
• Again, AI may be the secret sauce. Significant productivity gains could lead to even higher profit margins.
• High valuations may reflect optimism about the potential long-term benefits of widespread AI adoption.

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