Strong Fundamentals Provide a Tailwind to the the Economy….and Stocks

Outlook: January 2026

Executive Summary
Strong fundamentals are serving as a tailwind to the economy and the bull market in stocks. Consumer net worth is at a record high, and retail sales remain strong. We expect the spending trends to continue as there will be a wave of tax refunds in the coming months from the One Big Beautiful Bill Act. At the same time, the Federal Reserve has shifted its focus from fighting inflation to ensuring sustained economic expansion. Their recent rate cuts are designed to provide a tailwind to growth and offset weakness in the employment markets. While recent employment data show weak job creation, economic output is relatively high, and our economy's productivity has increased significantly. Furthermore, we expect the high level of investment in technology to help maintain that trend.

The underpinnings of this expansion, noted above, have set the stage for strong corporate earnings growth, and the major stock market indices have reached record highs. Looking forward, we expect earnings to continue to grow at a solid pace, and as we progress into 2026, we maintain our positive outlook. 

We wish you all the best in the new year and encourage you to reach out if you want to discuss our outlook in more detail.

Economy

Recent economic data has painted a mixed picture of the outlook, but we maintain our positive view. We are closely watching labor market conditions amid the moderation in job creation. Still, the latest GDP report showed the economy expanded at a 4.3 percent rate in the third quarter. The GDP report was far better than consensus expectations and helped to demonstrate that several growth drivers characterize our economy. Significant investment in artificial intelligence is helping boost productivity; the increase in stock prices over the last few years has raised the net worth of U.S. households; and both fiscal and monetary stimulus are set to provide additional support in the coming months. 

Given concerns about the slowing pace of job creation, the Federal Reserve has shifted its focus from fighting inflation to sustaining the economic expansion. Accordingly, the central bank has lowered rates three times since mid-September. In addition, the Federal Open Market Committee recently published updated Statements of Economic Projections, which showed their forecasts for interest rates, economic growth, and inflation. These projections are notable because the committee members are forecasting more rate cuts than in their previous guidance from last summer. They are also forecasting higher inflation in 2026, a faster pace of economic growth, and a lower unemployment rate. Collectively, these data points suggest that the Federal Reserve is willing to tolerate higher inflation to achieve faster growth and support the labor market.

As we progress into 2026, we expect the momentum to be sustained. The pace of economic growth is solid, and the drivers of this expansion remain well entrenched. The expected level of investment in artificial intelligence continues to rise, tax relief from the One Big Beautiful Bill Act should result in a significant increase in tax refunds in the coming months, and the Federal Reserve’s recent rate cuts should start to work their way through the economy. Accordingly, consumer spending remains strong, and our outlook remains positive.

Inflation

The latest Consumer Price Index (CPI) report showed inflation at 2.7 percent. The inflation rate has held steady at that level for the last two months, and it remains well above the Federal Reserve’s 2.0 percent target. 

In the coming months, inflation is expected to remain close to its recent range, given the imposition of tariffs and the ongoing economic expansion. Tariffs are placing upward pressure on the prices of intermediate and finished goods, while the strong demand for services continues to boost prices in that segment of the economy. We expect these trends to continue and inflation to remain above the Federal Reserve’s target for the foreseeable future.

U.S. dollar

Last year, the U.S. dollar declined relative to other currencies. The weakness was driven by expectations of a moderation in U.S. growth, improvements in the economic outlook for many foreign economies, uncertainty surrounding U.S. trade policies, and the sustained increase in U.S. debt levels. 

Looking ahead, a continuation of the trends noted above is expected to keep the U.S. dollar volatile in the coming months, but within its recent trading range. On a long-term basis, the dollar is at risk of further depreciation if our government debt levels continue to increase at their current pace. 

Asset class

Cash/Money Market Instruments

Cash and money market instruments remain attractive for near-term liquidity, offering competitive yields and low volatility. The Federal Reserve recently trimmed the federal funds rate to 3.50–3.75 percent, but they signaled a cautious stance on future cuts. Given the central bank’s focus on supporting the labor market, investors are pricing in modest additional easing in 2026. However, if inflation and labor data soften, yields on cash equivalents may fall more than expected, reinforcing the role of cash as a short-term liquidity and safety tool rather than a long-term holding.

Intermediate Government/Credit Bonds

Intermediate-term bonds should benefit from the Federal Reserve's gradual easing and a resilient economy. Within this segment of the fixed income market, the addition of high-quality, intermediate-term corporate bonds can enhance your portfolio’s yield relative to Treasuries. Corporate bonds are also supported by strong fundamentals and continued investor demand, even as credit spreads remain relatively tight and issuance stays robust.

Tax-Exempt Municipal Bonds

Intermediate-term municipal bonds offer attractive tax-adjusted yields with generally stable credit quality, making them a compelling option for higher-income investors seeking conservative, income-oriented portfolio diversification. Credit quality should remain high given robust state reserves, though total returns will likely be driven more by steady coupon income than significant price appreciation. Intermediate-term bonds will benefit from strong reinvestment demand and a steeper yield curve.

U.S. Equity

The U.S. stock market increased significantly in 2025, but it was volatile. Between February and early April, the S&P 500 Index declined nearly twenty percent only to rebound to a record high. The development of artificial intelligence (AI) infrastructure and the hundreds of billions of dollars invested in this technology continue to be drivers of equity prices. Accordingly, technology stocks declined more than the S&P 500 Index during last spring’s sell-off, then led the rally as the market rebounded to new highs. 
 
Earnings growth has been another catalyst, and in 2025, profits rose about ten percent in the first three quarters of the year. That rate exceeds the long-term average, and the outlook remains solid. As we progress into 2026, earnings are expected to continue growing at a similar pace, fueled by ongoing investment in AI infrastructure, the continuation of the economic expansion, and an accommodative Federal Reserve. 

Earnings growth is critically important given relatively high equity valuations. As it stands, the S&P 500 Index is trading at 22x forward earnings, a level well above the long-term average. However, the P/E multiple is being skewed higher by the rising concentration of the largest technology companies in the index. The top ten companies in the S&P 500 Index, many of which are in the technology sector, now account for almost 40 percent of the total holdings. As a group, they are characterized by strong earnings growth, high margins, and not surprisingly, high valuations. Excluding these stocks from the Index brings the valuation much closer to the long-term average.

We maintain our positive outlook. However, given elevated valuations, we expect earnings growth to be the primary catalyst for markets, and for returns of the major benchmarks to be closer to their historical averages.

International Equity

Foreign stocks generated strong returns in 2025, driven by stimulus programs across many parts of the world, the ongoing economic expansion, a decline in the U.S. dollar, and attractive valuations. Within this segment, stocks in emerging markets outperformed those in developed countries, but the returns were broadly based. 

The recent drivers of international equity returns are well anchored, and they remain supportive. The adoption of stimulus measures is resulting in a more favorable economic backdrop for international equities. Valuations are also more attractive in foreign markets relative to the U.S. Accordingly, we expect a combination of earnings growth and rising valuations to support foreign markets. We also expect greater symmetry in returns between U.S. and foreign stocks.

Commodity

Commodities provided mixed results in 2025. Precious metals were the best-performing segment last year, with gold up more than 60 percent; however, industrial metals also participated in the rally. Oil prices fell significantly as crude production remains robust and the market is well supplied. Prices for agricultural commodities were mixed but generally declined amid solid supply increases and modest demand growth. 

We maintain our positive long-term view on commodities but anticipate volatility within the group. In the coming months, oil prices are likely to remain at historically low levels given the strong supply backdrop. However, we expect demand for precious metals to remain strong given rising government debt and ongoing efforts to diversify away from fiat currencies.

Potential opportunities & risks

OPPORTUNITIES

The emergence of artificial intelligence and other innovative technologies—The convergence of cloud computing, significant increases in computing power, and the advent of the smartphone—has created a connected world in which new technologies are changing how we live. This convergence has created investment opportunities centered around long-term themes such as the growth of artificial intelligence, Big Data, quantum technologies, and cloud computing..

A productivity boom—The advancements in technology noted above, coupled with rising costs and a persistent shortage of skilled labor, are leading companies to invest in new technologies to automate processes and boost productivity. Higher productivity enables faster economic growth without a sustained rise in inflation.

Rising demand for power—Power demand is poised to expand for the first time in a generation. The proliferation of artificial intelligence and the increasing number of data centers are catalysts for this trend, along with industrial reshoring and the rising use of electricity as a substitute for fossil fuels. The increase in demand marks a pivotal shift for the electrical equipment and grid infrastructure industry, which provides the hardware, software, and services that enable modern power systems. The industry is poised to benefit from rising electricity demand and a second-order effect in the transformation of how energy is generated, transmitted, and managed.

The evolution of finance—Technological advancements are disrupting the financial services industry. We are experiencing a global shift from paper currency to electronic payments, driven by the growing popularity of credit cards, debit cards, stablecoins, and cryptocurrencies. Online payment systems facilitating money transfers, e-commerce, and electronic bill-paying services are also experiencing strong demand. This shift is still in its early stages and has a long runway as it is occurring across both developed and emerging economies. In the coming years, blockchain technology may become a significant disruptor in the finance industry, creating opportunities for new entrants and risks for the firms currently dominating this space.

Expansion of robotics—5G communications, sensors, and artificial intelligence are facilitating technological advancements that are advancing robotics in healthcare, restaurants, construction, and other industries. Some estimates project that global robotics spending will jump from $40 billion in 2023 to $260 billion in 2030.

Personalized healthcare—Advancements in technology support tailoring treatments to each patient, streamlining the drug discovery process, providing continuous data analysis in real-time, and improving clinical trials through digitization. Investment opportunities across the healthcare spectrum will be enhanced as artificial intelligence and machine learning increasingly result in better healthcare experiences.

RISKS

A Policy Mistake by the Federal Reserve—The Federal Reserve has shifted its focus from fighting inflation to sustaining the economic expansion. If our central bank provides too much stimulus, the economy may overheat, and stock prices may rise to excessive levels, leading to a boom-bust scenario in the coming years.

A Pullback in Investments in Artificial Intelligence (AI)—Last year, the major hyperscalers (Alphabet, Amazon, Meta, Microsoft, and Oracle) spent an estimated $400 billion on AI. In 2026, they are expected to invest more than $500 billion. These investments have been a significant driver of corporate earnings growth in recent years, and that trend is expected to continue.

Advancements in technology can also help boost the economy’s productivity. In fact, the last productivity report was strong, suggesting the economy can grow at a relatively fast pace without inflationary pressure. A pullback in AI investment, if that occurs, is likely to lead to disappointing results for corporate profits and economic growth. Accordingly, that is a metric we are closely monitoring.

Deglobalization/protectionism—The trend toward globalization that has been in place since the fall of the Berlin Wall is now being reversed. A renewed priority to ensure independence by securing access to commodities, promoting domestic manufacturing, and a race to establish global dominance in certain technologies have led to a reversal of the free trade movement. We expect this development to be accompanied by sustained increases in geopolitical tensions, upward pressure on inflation, rising costs in some industries, and the potential for a moderation in economic growth.

Rising government debt—Sovereign debt levels were rising before the outbreak of COVID-19. However, in the wake of the virus, they have increased significantly. In the U.S., government debt outstanding has increased 68 percent since the end of 2019. While the short-term implications of higher debt levels are manageable, the long-term impact may be substantial as rising interest costs burden taxpayers.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We are closely monitoring the wars in Ukraine and the Middle East, as well as the relationship between the West and China.

Inflation—Given the implementation of new tariffs, persistent federal budget deficits, a high level of government debt, reduced investment in production capacity for some commodities, the trend towards deglobalization, and a shortage of labor, there is a risk that inflation may return to a sustained upward trend and remain above the average of the last thirty years.

Originally posted on January 23, 2026.

Disclosure: This document contains forward-looking statements, predictions, and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements. Past performance is not a guarantee of future results. All investments involve risk, including the loss of principal. All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable. However, Badgley Phelps cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Badgley Phelps does not provide tax, legal, or accounting advice, and nothing contained in these materials should be taken as such.