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

What You Should Know

With markets hot again and valuations high, worries about an AI bubble and growth will be top of mind in 2026. Investors should be intentional and expect volatility as markets navigate the gap between fundamentals and high expectations.

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.

Yields and Curve: A Strong Starting Point for Bonds

Bond investors face a steeper US Treasury yield curve than they did a year ago. Yields at most maturities fell substantially, more so than in the shorter maturities, boosting the yield pickup between the two-year Treasury bond and the 10- and 30-year bonds.

The carry potential from a steeper curve and the possibility that rates fall set up a good environment for bonds in 2026. And the US isn’t the only region with potential. In fact, on a currency-hedged basis, the yield curves in other regions of the world seem more attractive (Display). That’s why we feel strongly that investors should scour the globe for opportunities in their bond allocations.

Credit markets could see more dispersion in 2026, creating opportunities for active management. Investment-grade corporates offer diversification and compelling overall yields despite tight spreads. That’s true for high-yield bonds, too, where yields have historically been a strong return predictor. Securitized opportunities include agency mortgage-backed securities, with attractive spreads versus investment-grade corporates, and certain collateralized loan obligations—we’re cautious about the underlying loans, but the securitizations offer a sturdy structure and attractive spread.

In Munis, Yield-Curve Positioning and Credit Are Key

In 2025, the muni market saw record new-issue supply and a twisting yield curve, with short-term yields falling by more than long yields. Returns for the year were back-loaded, as tax policy concerns abated and technical conditions improved. Inflows from muni funds helped, too.

Municipal bond yields remain high, and the yield curve is steep (Display), but we could see bouts of volatility as the market digests new issuance. We think positioning on the yield curve is critical. A barbell maturity structure seems best suited to maximize income and return potential, with the short and long ends of the curve boasting the most attractive municipal/Treasury after-tax spreads.

Historically, periods of steepening yield curves tend to give way to curve flattening, which has historically favored long-term bonds. Muni credit, in our view, remains the best yield opportunity for high-tax-bracket investors, and fundamentals provide important support. It’s critical to be selective in choosing individual issuers.