The secret of change is to focus all of your energy not on fighting the old, but on building the new. – Socrates
A crisis of confidence during November wasn’t enough to derail global equity market momentum, which ultimately produced a third remarkable year in a row. Recall that this multi-year run began in the Spring of 2023 with splashy AI announcements from Microsoft and other technology titans.
Leveraging their $500 billion combined cash hoard initially, and more recently, their sizable borrowing capacity, the U.S. Information Technology and Communications complex continues to pour hundreds of billions of dollars into AI infrastructure, creating strong demand for a wide swath of economic sectors that typically don’t experience such strong demand dynamics. AI’s influence on U.S. economic activity is undeniable, if not directly quantifiable.
Despite talk of an AI bubble, our generally positive economic outlook remains intact, in part due to what we expect to be another strong year for AI investment, tailwinds from previously initiated deregulatory efforts, and steadily moderating inflation that allows the Federal Reserve to bring its policy rate back to neutral from its slightly restrictive level currently.
With that said, we suspect investors will be tested in 2026. We are witnessing a confluence of structural change; within the global geopolitical sphere, within the relationship between labor and capital, and to the relationship between the U.S. federal government and private business. Individually, any of these has the ability to alter the fundamental nature of economic activity; together, they will certainly reshape how business operates, how employees work, and how investors supply capital to and are rewarded by enterprise. We are witnessing the construction of a new economic and financial paradigm, one that we believe will outlive this current Presidential administration and therefore, warrants specific investor focus.
The Global Economy
The global economy’s modest growth trajectory continued through the fourth quarter, but with varying degrees of strength and weakness among individual countries.
In the U.S., skepticism regarding the accuracy and reliability of the official economic data following the prolonged government shutdown are legitimate, but our assessment leads us to believe that the labor market was largely unaffected by the government shutdown, and that although stories abound about the challenges of finding a new job after being let go or graduating from college, employees with more experience and stronger skillsets appear to be faring well. Employers appear to be steadily recovering from the Liberation Day shock that froze hiring decisions.
As a result, consumers remain in good shape overall. After a very strong spending spree in the third quarter, consumers may have hit the pause button before the holidays, but spending during the holidays was reasonably strong. The classic indications that the consumer is stressed do not appear to be flashing. For example, spending at restaurants continues to outpace spending on food at home, a classic trade-down tactic we often see when consumer spending is turning down. For lower-income consumers, moderating inflation for housing and outright declines in the price of gasoline are welcome relief, on reason why delinquency rates and charge offs for consumer credit continue to trend down.
There are still pockets of weakness, particularly in the manufacturing sector. And consumer surveys point to persistent skepticism about future economic growth. But consumer survey data often drifts from actual consumer activity, and in the meantime, services, the largest portion of the U.S. economy, continue to perform well, small businesses are more optimistic than they have been in two years, and new business creation continues to expand, which is the real engine for economic activity in the U.S.
With the labor market in somewhat of an equilibrium, labor costs are reasonably contained and with modest productivity growth, inflation should continue to recede towards the Federal Reserve’s 2% target. We believe the Fed relied to a large extent on this expectation when it cut its benchmark rate another 0.25% in December, and why we think an additional one or two 0.25% cuts are plausible in the first half of 2026.
Equities
U.S. equities closed 2025 with a modest positive performance, driven primarily by strength in the Health Care and Communications sectors. Despite strong earnings results and an upwardly revised outlook for the rest of the year and 2026, talk of an AI bubble spooked investors, who trimmed their exposure to the Information Technology sector.
Under the surface, Corporate America continues to perform exceptionally well. Third quarter earnings, reported during the fourth quarter, were strong, and, more importantly, fourth quarter and 2026 outlooks provided by management teams improved notably, especially for 2026, where earnings are now expected to rise 15% compared to 2025’s estimated 11% rise. Revenues are accelerating, profit margins are expanding, and cash flow and capital efficiency metrics are all rising, a positive indication that U.S. companies, after a tumultuous 2025, are entering 2026 on the front foot. Equity valuations are roughly the same as they were coming into the fourth quarter; elevated, but not extravagant, by historical standards, at least according to our preferred valuation metrics (Price / Equity metrics are close to historical peaks).
Fixed Income
Two rate cuts by the Federal Reserve brought short-term interest rates on U.S. Treasuries down, but the rest of the yield curve moved very little during the fourth quarter. Inflation expectations, implicitly priced into U.S. Treasury yields, declined steadily during the quarter to around 2.3%, not far from the Federal Reserve’s 2% target. Inflation-adjusted yields on U.S. Treasuries rose during the quarter, suggesting that bond investors are looking for stronger economic growth in 2026 and beyond. In fact, the Federal Reserve itself, in its December projections for inflation and economic growth, revised their inflation estimates down and their growth estimates up, so bond investors are merely confirming the Fed’s own expectations. In line with the strong corporate fundamentals we see for equities, bond investors are little concerned about corporate credit risk, so corporate yield spreads to U.S. Treasuries remain narrow.
Commodities
Gold had another outstanding quarter, capping off an outstanding year. With the U.S. dollar depreciating against foreign currencies, inflation moderating, and short-term yields on U.S. Treasuries falling, Gold investors couldn’t ask for a better backdrop. Crude oil and gasoline face a future in which the existing supply surplus is likely to grow in 2026, unwelcome news for oil and gas investors, but good news for the U.S. consumer.
Conclusion
Our constructive outlook for the economy and U.S. equities remains intact; the labor market is in good shape, deregulatory efforts initiated in 2025 should begin to bear fruit in 2026, price shocks from tariffs are in the rear view mirror, ongoing AI investment will support various sectors, and with inflation poised to moderate further, the Federal Reserve should feel comfortable cutting its benchmark rate once or twice before the mid-year mark, all of which would provide incremental tailwinds to an economy already performing reasonably well. We agree to some extent that a bubble may be building in the AI complex (more on that in a future Review), but believe that should one develop, it’s unlikely to happen in 2026. We’ll be watching it closely, but that’s not our primary focus at the moment in terms of risk.
Rather, we are more closely watching how the U.S. federal government reacts to China’s newest five-year plan, which will be unveiled later this year. In our opinion, 2026 will mark the beginning of a multi-decade rivalry between the U.S. and China, with potential implications for the future of liberal democracy and capitalism around the world. How the U.S. responds to will significantly alter how businesses operate and how investors evaluate risk and potential return.
What many may not recognize is that since China entered the World Trade Organization, its rise to global superpower has been relentless. In 25 years, the country has transitioned from being the world’s low-skill, low-cost manufacturing hub churning out cheap and cheaply made labor-intensive goods to, according to many outside China, the most technologically advanced economy on the planet, surpassing even the U.S.
China is widely considered to have one of, if not the, most advanced manufacturing footprints in the world. Its EV automotive industry is without doubt the most advanced in the world, and the country’s capabilities in Artificial Intelligence, Quantum Computing, Communications, Defense / Aerospace, and Biotechnology are widely considered to be either rapidly approaching, already similar to, or in some cases, slightly more advanced that those in the U.S. While the quantity of patent applications doesn’t necessarily translate to intellectual property quality, China files nearly 6x the number of patent applications globally than does the U.S.
Through its foreign relations efforts and significant financial resources, China is now the largest trading partner for more countries than the U.S., replacing the U.S. throughout Asia, most of Africa, and with key countries in South America. For many countries, China’s yuan is increasingly an acceptable currency with which to trade and because many countries now conduct trade with China in yuan, not the U.S. dollar, bad actors such as Russia, Iran, North Korea, Cuba, and Venezuela are able to reduce the economic impact of U.S. sanctions and blunt U.S. influence globally.
This is where the U.S. finds itself in 2026 – facing an intense economic and political rivalry for the first time in over 35 years, coming from a country that believes it is the rightful global superpower, but one who’s world views on individual freedom differ drastically from the U.S. We believe the Turmp administration views this moment as the renewal of an age-old competition between liberal democracy and capitalism on the one hand and Communism / Socialism and state-controlled economic policy on the other. We agree with that assessment.
The problem is that the U.S. is not in as strong of a competitive position as it was the first time this rivalry was fought. At the end of World War II and for the next 50 years, U.S. companies were the most innovative in the world and the U.S. manufacturing base was the best and most modern in the world. But the elimination of trade barriers has allowed U.S. companies to diversify some of that innovation and to move production sites overseas, where ongoing investments to modernize the manufacturing base have largely occurred outside of the U.S. In essence, private companies have prioritized profits over nation, and the U.S. consumer / citizen, has complicitly supported it.
It’s a vulnerability that can’t be rectified by simply rousing our nation’s pride to inspire companies to bring innovation and manufacturing back onto American shores or consumers to buy American goods. Nationalistic fervor is all but dead, trampled out by the country’s university system; consumers prefer quantity of goods over quality and private enterprises prioritize profits over national security. Without a patriotic foundation, we’ve discovered that free market capitalism opens the door to national security vulnerabilities.
The only solution appears to be a greater degree of federal government involvement in the private sector, something Trump began to implement in 2025, as evidenced by his tariffs, his deregulatory efforts, his energy policy, the deals he’s signed with foreign companies who are and will be investing capital in the U.S. to build advanced manufacturing and materials processing facilities, and in his Investment Accelerator Program, through which the U.S. Federal Government has and will continue to invest capital and take equity stakes in a variety of U.S. companies deemed critical for the nation’s security and economic interests. It’s a blend of traditional free market principles such as deregulation and lower taxes and industrial policy, which is anathema to free market economists.
To be sure, the U.S., in addition to other countries such as Germany, the Netherlands, Japan, Taiwan, and South Korea, still lead China by a large margin in a few key areas, most importantly in the most advanced semiconductors and the most advanced equipment required to make the most advanced semiconductors. But China is now a legitimate rivalry, and because of that, the key takeaway from 2025 in our view is unmistakable; government intervention in the U.S. economy and private sector has arrived and is here to stay because it has bipartisan support. The potential implications for investors are wide-ranging, but in general, they all come back to risk.
Because stock returns are in part dependent on the U.S. government taking equity stakes directly in companies based not on investment merit but based on national security factors, poorly run but strategically important companies may actually turn out to be winning investments. Investors must therefore speculate on whether a company could potentially receive an equity investment as part of their due diligence.
Additionally, stock valuations for companies and/or sectors investors believe could be recipients of federal investment dollars are likely to remain elevated, which suppresses future investment returns for investors that want to buy those stocks. And then there is the issue of governance, which broke open last week when Trump publicly castigated the defense contractors for failing to serve the U.S. government adequately while at the same time paying egregious executive compensation and handing out exorbitant amounts to shareholders in the form of share repurchases and cash dividends. We haven’t even broached the potential for corruption, in which a sitting president can direct investment funds to companies that benefit people with whom they have a relationship.
The rules of investing are changing and while we can conceptually tolerate them provided strong checks and balances are established to retain the U.S.’ greatest strength, its entrepreneurial spirit and fair reward for risks taken, we suspect that many investors are going to struggle with this new paradigm. 2026 will mark the first year of intense rivalry and potentially higher volatility, lower returns, and greater speculation, but we expect it to last for many years.
