Capital Market Outlook

Summary

• The U.S. economy in 2026 has defied consensus expectations of moderating growth, Fed rate cuts, modest earnings, contained energy prices, and Republican control of Washington.
• Five major shocks defined the year: a diesel energy shock, a shift from expected rate cuts to rate hikes, an earnings boom, unexpectedly hot economic growth, and a shifting political landscape.
• Diesel prices rose from $3.55 per gallon at the start of the year to roughly $6.52 per gallon due to reduced refining capacity from wars in the Middle East and Ukraine.
• The Federal Reserve raised rates once in 2026, reversing expectations of two to three quarter-point cuts, as inflation pressures and strong growth persisted.
• S&P 500 earnings estimates increased from $290 per share in January to $340 per share by September 21, driven by robust domestic demand, AI capital spending, and productivity gains.
• Real U.S. GDP growth was 2.1% in Q1 and 1.5% in Q2, with real final domestic demand running at a 4.2% annual rate in Q2 and Q3 growth tracking at 5.1%.
• Polling odds shifted to a 90% chance of Democrats taking the House and a 60% chance of them taking the Senate in the upcoming midterm elections.
• U.S. Equities have outpaced historical midterm patterns, with the S&P 500 up 13% year-to-date and a maximum drawdown of only 9% compared to a historical average of 20%.
• The S&P 500 posted its best Q2 in a midterm year since 1938, surging 14.9% compared to an average decline of 1.6%.
• Inflation measures remained elevated, with headline CPI at 3.4% in August and core CPI at 2.4% year-over-year.
• The U.S. budget deficit stands at 5.4% of GDP, and public sector debt surpassed $40 trillion in August.
• The 2-year Treasury yield is approximately 4.88% and the 10-year Treasury yield is about 5.11%, indicating expectations of further Fed hikes and healthy growth.
• The bond market signals expectations for 3 to 4 more rate hikes over the next 18 months, with long-end yields drifting higher due to strong economic activity.
• Portfolio recommendations favor diversified equity exposure across growth, value, small- and mid-caps, non-U.S. equities, and thematic strategies including AI and reindustrialization.
• Strategic portfolio adjustments include favoring longer-dated municipal bonds and high-quality bonds given attractive nominal and real yields.
• Alternative investment opportunities are identified in industrial metals, energy, real/tangible assets, hedge funds, private markets, and global strategies.
• Historical data indicates the S&P 500 rose 100% of the time in the six and 12 months following elections, averaging 13% and 14% returns respectively.
• Q4 has historically gained 5.6% on average since 1930, with October ending higher 67% of the time.
• Asset class weightings suggest an overweight view on emerging markets and a neutral to overweight stance on U.S. large-cap equities.
• Economic forecasts project real U.S. GDP growth of 2.1% for 2026 and 2.2% for 2027, with inflation expected to moderate to 2.6% in 2027.
• The Fed funds rate is projected to end 2026 at 4.38% and remain at that level in 2027.