The year has started nicely for both stock and bond investors. In the early part of January, stocks rallied, largely from a broadening of market participation, while interest rates declined slightly. The economic backdrop for 2026 looks favorable, as moderation in both the employment market and inflation might give the Federal Reserve room to continue lowering rates. On the fiscal policy front, tax cuts and increases in government spending represent a tailwind to growth.

As we start 2026, GDP growth appears to be accelerating. The latest estimate from the Federal Reserve Bank of Atlanta’s GDPNow forecast for fourth quarter 2025 growth is 5.1%. Besides relatively strong consumer spending, AI data center infrastructure is having a noticeable impact on growth. A January 12th study by the Federal Reserve Bank of St. Louis examined three Bureau of Economic Analysis data series – software, R&D, and information processing equipment – along with Census Bureau data on data center construction. The study estimates that AI categories contributed 0.97 percentage points to real GDP growth in the first three quarters of 2025. Recent announcements of additional AI data centers should further contribute to GDP growth.

Inflation remained relatively contained at the close of 2025 despite turbulence from tariffs. Consumer prices rose 2.7% in December from a year earlier, unchanged from November’s pace and in line with market expectations. During 2025 inflation readings were volatile but cooled over the year from a starting point of 3% in January. Core inflation, excluding the volatile food and energy categories, increased 2.6%. The government shutdown in the fall likely impacted the calculation of inflation as the Bureau of Labor Statistics, the agency responsible for these numbers, had to use technical workarounds to deal with missing data. Even so, inflation trending lower is good news for consumers in 2026.

Not so good news for consumers is the slowdown in the labor market. According to the Labor Department, the economy added 50,000 jobs in December, down slightly from November’s 56,000 gain. The unemployment rate of 4.4% ticked down from November’s 4.6% but drifted up over 2025, starting at 4% last January. Employers added on average 49,000 jobs per month during 2025, the slowest pace outside recessions since 2003. For the year, the economy created 584,000 jobs compared to roughly 2.0 million in 2024. Tariffs, federal job cuts and immigration have played roles in the employment slowdown. The Federal Reserve Bank of Kansas City estimates that tariff uncertainty caused employers to hold back hiring by about 225,000 for the year. Federal government employment is down by 277,000 jobs since January 2025. Net immigration fell to 410,000 in 2025 from 2.27 million the year before, holding down the expansion of the labor force and unemployment rate.

Usually, an employment slowdown of this magnitude results in slowing economic growth. Modest wage growth hasn’t helped, as average hourly earnings in December grew by 3.6% year over year, down from 4% growth in January 2025. However, consumption is getting a boost from high-income consumers who are receiving relatively larger wage increases and own assets that have significantly appreciated since the pandemic. This “wealth effect” spurring consumption is a risk to growth if asset values stagnate or decline.

As we head into fourth quarter earnings season, analysts expect a strong end to 2025. According to FactSet Earnings Insight, fourth quarter earnings are expected to grow 8.3%, faster than the September 30th prediction of 7.2%. Increasing the growth estimate as the quarter progresses is notable as analysts typically predict faster growth that is later revised downward. The forward P/E ratio for the market-cap weighted S&P 500 is 22.2, above the five-year average of 20.0 and 10-year average of 18.7. A few very expensive stocks are pulling up the average. For comparison, the equal weight S&P 500 forward P/E ratio is about 17.

Investment in AI is a catalyst for 2026, and analyst estimates strongly reflect the narrative. For 2026, analysts project earnings to grow 14.9% (on revenue growth of 7.3%) with growth expected to accelerate from 12.6% in the first quarter to 18.3% in the fourth. Information Technology and Communication Services, making up 45% of the S&P 500 and driven by mega-cap companies, are expected to grow earnings 28.9% and 11.8%, respectively. If AI investment falters it will be up to the rest of the economy to drive overall earnings growth, but meeting the consensus estimates would be quite a lift as six out of the remaining nine sectors aren’t expected to grow earnings faster than 10%.

Investors also need to pay attention to political risks. Tariff policy might change based on the Supreme Court’s view of President Trump’s tariff authority. With the mid-term elections coming into view, affordability has emerged as a central issue, and the President is proposing solutions that impact sectors and/or individual companies. An example is his proposal to cap credit card interest rates at 10%, leading to recent share price weakness for banks and credit card processors. The President’s invasion of Venezuela might embolden China to do the same with Taiwan which could negatively impact trade as many of the semiconductors the U.S. relies upon for AI are made there.

The yield on the 10-year Treasury bond started 2025 at about 4.6% and ended the year around 4.2%, largely due to moderating inflation. Market expectations call for the Federal Reserve to cut interest rates twice during 2026, but bond investors should remember that long-term interest rates are set by market participants, with the Fed’s short-term rate targets serving as just one input. Other inputs are stronger economic growth, higher-than-average inflation and large budget deficits measuring around 6% of GDP even when including tariff revenue. These factors could push long-term rates higher.

Investors are also grappling with how the Federal Reserve might change as Chair Jerome Powell steps down in May and a new chair takes over. President Trump’s pressure campaign to lower rates and his ability to nominate a replacement chair more aligned with his views has the potential to spook bond investors who might respond by demanding a premium for perceived inflation risk. Governor Stephen Miran’s term expires January 31st, giving the administration an early opportunity to alter the board’s composition. Further, the annual rotation of voting regional banks occurs in January and will include the presidents of New York, Cleveland, Philadelphia, Dallas, and Minneapolis, all of whom have expressed hawkish interpretations of recent data.

2026 could be another good year for equities, but a lot depends on how the AI investment cycle proceeds: will it continue to accelerate or moderate? As for bonds, current rates are not out of line with growth, and all eyes will be on the Federal Reserve. As always, we continue to look for well-managed companies at fair prices that can grow in any environment.

In this issue, we introduce a midsized consumer brand name that has wide appeal across gender, age, income, and geographies with its ubiquitous products.

Our second selection is a second look at a large pharmaceutical company that is practically debt-free with a growing portfolio of transformative therapies.