Between family, work, and other responsibilities, many of us may feel pulled in different directions. Markets have faced a similar tension this year: AI is driving a profits boom at the microeconomic level, while inflation and interest rates are weighing on the broader economy.
So far, the micro side appears to be winning, as judged by a 13% total return for the S&P 500 year-to-date. However, changes at both the micro and macro levels could determine what’s next for the economy, profits, and markets. This quarter’s client letter explores how we got here and what types of upside- and downside- scenarios we anticipate as we approach year-end and look forward to 2027.
AI boom driving micro growth
To understand the forces driving markets this year, let’s begin with the relatively good news on the micro side: the nearly four-year-old AI boom. Mega-cap technology companies that are building AI infrastructure, such as Microsoft, continue to report that demand for AI services exceeds supply. If that remains the case, we believe AI has a reasonable chance of driving corporate profits above investor expectations.
And while AI is helping companies and markets for now, we are also keeping a close eye on risk factors that could derail the AI train. Potential threats include significant up-front capital spending, complex financing arrangements, and supply shortages. In the next few weeks, earnings results and forward guidance from the mega-cap tech companies will give investors a sense of the durability of the current AI expansion.
Macro challenges remain
The AI trade and market conditions have been generally favorable for investors, but macro forces continue to provide a counterweight. The Iran conflict has stirred up global inflation as oil shipping volumes remain well below pre-conflict levels. This rising inflation is adding upward pressure on interest rates which tend to move in concert with inflation and economic growth expectations.
Additionally, the bond market appears to be showing its disapproval of rising federal deficits and debt levels. We are seeing this disappointment manifest in the rapid ascent of the 10-year US Treasury yield, now around 5.25%. The rise in interest rates has resulted in depressed bond valuations and year-to-date bond returns.
As higher inflation and interest rates are mostly bad news for macro forces, more favorable trends in the job market have provided a dose of good news. High employment levels and job growth could help consumers offset the sticker shock of inflation.
With employment and inflation on the rise, central bankers are trying to navigate a tricky path that avoids the extremes of overheating and recession. Federal Reserve Chair Kevin Warsh spent several months hinting that the Fed should raise interest rates in order to cool the economy, and last month he took action with a quarter-point interest rate hike.
Looking ahead, both Fed members and futures markets expect at least one more hike in the next year and our sense is markets can probably handle one or two well-timed interest rate hikes. However, an inflation surprise that triggers a wall of rate hikes within a few months could weigh heavily on both stocks and bonds.
Market outlook and positioning
As we close out 2026 and begin planning for 2027, we believe AI-related growth will continue to help the economy and markets offset the pressures of rising inflation and interest rates. Within this base case, we continue to favor high-quality U.S. stocks, which tend to deliver faster earnings growth than companies outside the United States. We also view U.S. stock valuations as increasingly attractive because profits have grown faster than share prices.
Within the U.S., we view small and mid-cap stocks as attractive, with diversification benefits and valuations below long-term averages. We’ve historically been a bit more cautious with international stocks, based on slower growth. However, as earnings growth is picking up (and with reasonable valuations), we are warming up to growing exposure to international equities.
While year-to-date bond returns have been mediocre, we remain committed to continuing to add to fixed income portfolios where we continue to emphasize investment-grade corporates to capture additional yield and preserve capital over the long run.
Our research team continues to evaluate investment options available within the expanding alternative asset landscape. Holdings in this asset class across both public and private markets offer opportunities to generate returns that are less correlated with stock and bond markets.
Putting these pieces together, we continue to monitor the ongoing tensions between micro and macro forces. We believe the best preparation for any surprises that may change the current dynamic is a fully invested but diversified approach, focusing on companies and securities that meet or exceed expectations. We continue to focus on asset classes with durable growth prospects as a way to compound wealth, ever mindful of your long-term goals and objectives.
We wish you all the best this fall.
Michael Bailey, CFA
Director of Research
Michael Mussio, CFA, CFP®
President
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